How these scores really work and can affect your finances.
You likely know that your credit score is the litmus test lenders use to determine whether you’ll be a responsible borrower and deserve to be approved for loans and credit cards. But there’s a good chance you have one or more misconceptions about how credit scores are calculated and what can nick yours.
While the actual calculations used by the three major credit reporting bureaus (TransUnion, Equifax and Experian) are confidential and complex, the underlying concept behind them is fairly straightforward: if you have a history of paying your loan payments on time and in full, generally you’ll have a great credit score.
Credit scores may seem a bit complex and convoluted. However, it pays to understand how they work so you can make informed decisions about your finances. Here are six of the most common credit score myths to stop believing:
Myth No. 1: Closing out your credit cards improves your credit score. If you’re thinking about terminating a card to boost your credit score, think again before you reach for the scissors.
Here’s why: One of the five factors that determines your credit score is your debt utilization ratio, which is how much debt you carry relative to how much credit is available to you. So when you close a credit card, your available credit decreases, your debt utilization ratio increases and your credit score drops because lenders see you as more of a risk.
Myth No. 2: Closing a credit card erases its history from your credit report. Some people believe that once you close a credit card, its history disappears. This is false.
Sure, it would be great if late payments and overdrafts on a card could be wiped away by closing the card. In reality, late payments and other black marks stay on your credit report for seven to 10 years, even if you close the card you made the mistakes with.
Myth No. 3: Things like your age, race and sex affect your credit score. Here’s a quiz: Which of these two people is more likely to have the better credit score, a 60-year-old white woman who just moved to Massachusetts from France or a 25-year-old man born to Filippino parents in Oakland, Calif.?
It’s a trick question. None of that information is used to determine credit scores.
Ever since President Ford signed amendments to the Equal Credit Opportunity Act into law in 1976, creditors have not been able to base lending decisions on a borrower’s race, color, religion, national origin, sex, marital status, or age. Likewise, none of this information is used to determine your credit score.
Myth No. 4: You’re penalized when you check your credit score. This mistake is easy to make because many people don’t understand the difference between a hard inquiry about your credit report and a soft inquiry.
When you check your credit score and credit report with one of the three major credit bureaus, that’s a soft inquiry and doesn’t affect your score. However, whenever an outside party checks your credit score — typically when you apply for a new line of credit — that’s a hard inquiry. In this case, you do receive a small nick to your credit score because you have the temporary appearance of not being able to meet your financial obligations.
Myth No. 5: As a cosigner, your credit score is safe. Some people think that once you cosign for someone else’s new line of credit — say, your child’s — your participation ends then and there. This couldn’t be further from the truth.
For all intents and purposes, that loan or credit card you just cosigned for is just as much your kid’s responsibility as it is yours. If he or she misses a payment, exceeds their credit limit or defaults, both of you see your credit scores penalized.
So before you cosign for someone else’s loan or credit card — especially a teen or young adult — make sure both of you understand the terms and what it’ll mean for both of you if there’s a missed payment.
Myth No. 6: All credit scores are the same. False. While FICO is by and large the most popular and widely-used credit score metric for lenders, it’s not the only one. For example, in 2006 the three credit bureaus created their own metric called the VantageScore. While most credit scores draw on a consumer’s financial history, some, like LexisNexis’ RiskView, actually take into account factors from nontraditional credit scoring sources and avoid data from the three major credit bureaus entirely. The scores are sometimes calculated slightly differently and use different scales.
While you’re legally entitled to credit reports from the three major bureaus once a year through Annualcreditreport.com, this service does not actually provide you a credit score. Rather, a credit score (often, but not always, based on credit reports) is a figure lenders use to quickly assess a consumer’s creditworthiness.
Copyright© 2015 Next Avenue, a division of Twin Cities Public Television, Inc.