The FICO score was first introduced in 1989, but 28 years later, most people still only have a topical understanding of how they work. A recent study by NerdWallet and Harris Poll found that 91% of Americans don't know that there are actually more than three scores that can be used to judge your creditworthiness. These scores are compiled by the three major bureaus, Equifax, Experian, and TransUnion.
That poll result tells me we have a long way to go in educating consumers about their credit scores.
People who understand how scores work can get a leg up on their peers, save tens of thousands of dollars in mortgage interest, and even qualify for lower insurance premiums. Over the course of time, I've heard more than my fair share of bad credit score tips, but these three are among the very worst.
1. "Carry a balance to get a better credit score"
A friend was ready to pay off his car loan balance in full. When he walked into the bank, his banker advised that paying off the car loan ahead of schedule would be a bad choice.
"You won't get the benefit to your credit score if you pay off the loan early," the banker said to my friend. I told my friend to kick his banker to the curb.
This false tip is repeated frequently by people who should know better, or people who are incentivized not to tell the truth. Carrying a balance that you don't need to have on any loan or credit card is a good way to throw money away -- not bolster your credit score.
Think about what credit scoring algorithms are designed to do. Their main job is to quantify the risk that a borrower won't pay. To that end, credit scores do a really good job at predicting the default risk of borrowers based on their credit profiles.
With this in mind, put yourself in the banker's shoes:
- All else being equal, would you rather make a new loan to someone with $5,000 in credit card limits who never carries a balance, or a person who has $5,000 in credit card limits and routinely carries a $4,000 balance at an 18% interest rate?
- All else being equal, would you rather lend to someone who is making minimum monthly payments on a $15,000 car loan, or someone who paid off their $15,000 car loan two years earlier than scheduled?
I'd prefer to lend to the person who uses credit sparingly and pays down loans aggressively. I think you would, too.
Time and money spent trying to perfectly optimize a credit score is time and money wasted. You can have a super-prime credit score by simply having an open credit card account, keeping the balance to less than 30% of the credit limit at all times, and by paying it on time every month. Ideally, you should pay it in full. There's no prize awarded to people who pay interest on balances they don't need to have.
2. "Don't check your credit, it will hurt your score"
When someone pulls your credit report, it's recorded as a credit inquiry. There are two types of inquiries, so-called "soft" and "hard" inquiries. Soft inquiries appear when you pull your own report, or when an employer pulls it for a background check, for example. Hard inquiries are added to your record when a lender pulls your report to make a credit decision.
Hard inquiries are the inquiries that really matter, but it's important to understand why they matter. If a lender pulls your credit and sees recent hard inquiries, the lender will naturally start to wonder if you have a new account that isn't currently showing up on your credit report. For obvious reasons, a mortgage underwriter would be right to worry if someone had hard inquiries for a car loan a day before applying for a mortgage.
Likewise, it can be a red flag if someone is desperately seeking credit in multiple forms (credit cards, car loans, etc.), as the borrower may be going on an application spree before an expected job loss, or some other negative change to his or her financial picture. The most important question lenders have to ask themselves is, "What does the borrower know that we do not?" In an abstract way, hard inquiries can help answer that question.
It's a good practice to check your credit report once per year. AnnualCreditReport.com is the only free way to check your report at all three credit bureaus. It exists because the federal government demands credit reporting bureaus provide this information to individuals for free, once per year. As for checking your credit score rather than your credit report, a number of credit cards provide true FICO scores to their customers for free.
Using these free benefits won't hurt you, and in fact, it really only can help you.
3. "Don't sign up for a new credit card, it will hurt your score"
This credit score tip is unfortunate because, while it is often true, it's misguided. Opening a new credit card will likely result in a minor decline in your credit score, as it impacts two small pieces of information that go into the scoring algorithm:
- Your average account age will drop.
- You'll have a new hard inquiry on your credit report.
In some cases, opening a new account can actually improve your score, as the new credit line can reduce your total credit utilization. Your credit utilization ratio is equal to your balances divided by your credit lines. It's best to keep it lower than 30%.
I've opened and closed more credit accounts than most people. But even when I opened and closed cards aggressively, I never saw my score dip below a level that would disqualify me for the best possible rates on a mortgage or car loan. At my worst, I opened several new credit cards in a single college semester to rack up sign-up bonuses on my tuition payments. I enjoyed the trip the card companies paid for, and my credit score escaped unscathed.
My credit file is paper thin compared to most. With about a decade of credit history comprised of nothing more substantial than credit cards, my credit score is just where it needs to be for me to qualify for the best terms on any kind of financing.
My point is that many people have much more padding in their report than I do, and would likely experience a much smaller drop after opening a new account than I would. Alas, I toyed with a credit score simulator and found that a new credit card would have all of a five-point impact on my credit score. From experience, that sounds about right.
There's one scenario where you should avoid applying for new accounts, but for reasons that are only tangentially related to your credit score. If you expect to apply for a mortgage in the next six months, take it easy on credit applications. It makes things easier when you don't have to explain why you opened new accounts in the last few months. In an extreme case, lenders may be reticent to extend a $300,000 mortgage to someone whose credit card limits recently swelled from $3,000 to $30,000. Given how stringent underwriting standards have become in the post-crisis era, less is more.
Never lose sight of why having a good credit score matters. A good score can help you secure the best terms on a mortgage or car loan, collect big rewards on credit cards, or qualify for lower insurance premiums. Therefore, it makes little sense to simultaneously want to have the best possible score and fear what might happen if you used your high score to get a great deal.
Building a great credit score you won't use is a little like retooling your resume for a job you won't apply for. What's the point?