"Just because someone will lend money to you doesn't mean you should borrow it." 
-- Jean Chatzky  

Chatzky is right. Many lenders are happy to give us money to spend, but their terms can vary quite a bit, with some offers being quite unattractive. That will often be the case if you have a poor credit score, as lenders will then charge you high interest rates. Thus, it's valuable to understand how the credit world and credit scores work and how to keep your score high.

The words "FACTS" and "MYTHS" with myths being crossed out

Image source: Getty Images.

A good first step is clearing up some credit score myths.

Credit score myth No. 1: Everyone has a credit score.

You might be surprised to learn that many people do not have a credit score associated with them -- because they may never have used credit. If you go through life without borrowing money and without using credit cards and paying for things with cash or checks, your credit score may be a big fat "N/A."

Still, many millions of us do have credit scores -- and when we do, we don't have just one. There's a particularly prominent credit score that most major lenders use, called a "FICO" score, developed by the Fair Isaac company. But there are other credit scores besides FICO scores, and there are even a range of different FICO scores, too. A "Base" FICO score will range from 300 to 850, while other varieties of credit scores will have different ranges. Another commonly used credit score is VantageScore, offered by the three main credit bureaus -- Experian, Equifax, and TransUnion -- and it, too, ranges from 300 to 850.

Credit score myth No. 2: Credit scores are based on how often you pay your bills on time.

That's actually a partial myth. How reliably you pay your bills on time is indeed a factor in determining your credit score, and paying bills on time is a good way to increase your credit score, but your payment history is not the only factor that matters to your credit score. Here are the components determining your FICO score:

  • 35%: Payment history.
  • 30%: How much you owe.
  • 15%: Length of credit history.
  • 10%: New credit.
  • 10%: Other factors such as your credit mix.

Your payment history is the most important factor, but nearly as important is how much you owe. If you're saddled with enormous mortgage payments, for example, that can make you a riskier borrower than someone with less debt. The score will take into account how much of your available credit you're using. So if you've nearly maxed out your available credit limits, that can hurt your score. Meanwhile, the score favors people who have a lengthy credit history, and doesn't favor those who have recently taken on new credit, perhaps by opening several new credit card accounts.

Part of a man in a suit seen - he's holding out a card on which is written "Credit score" and below it the words excellent, good, fair, and poor

Image source: Getty Images.

Credit score myth No. 3: Credit scores suffer every time someone checks your credit.

This is another myth with some truth to it. That's because there are two different kinds of credit inquiries -- a "hard" one and a "soft" one. A hard inquiry involves a lender looking into your credit report because you are applying for credit -- perhaps wanting a car loan, a mortgage, or a new credit card. Your consent will be required for this, and this inquiry is likely to shrink your credit score to some degree -- reportedly by about five points with a FICO score and 10 to 20 points with a VantagePoint score. Note that if you're shopping around with a bunch of lenders and they all pull your credit report within a few weeks, it will generally count as just one inquiry.

A soft inquiry, meanwhile, will not affect your credit score -- which is good, as these inquiries generally happen without your even being aware of them. If you get credit card offers in the mail, for example, it's likely that the card issuer has looked into your credit record to determine whether it wants you as a customer. Looking up your own credit report is another soft inquiry that won't hurt your score.

Credit score myth No. 4: It's best not to use credit much for a high score.

It's actually good for your score if you use credit. Potential lenders like to see that you've borrowed money and have paid it back -- especially without being late. It's good to have one or more credit cards, too, and for lenders to see that you are managing them well.

Credit score myth No. 5: Closing credit card accounts can boost my score.

Closing credit card accounts can actually hurt your score. That's because your score takes your "credit utilization" into account, comparing how much you have borrowed with how much you could borrow (i.e. all your various credit limits). If you close an account, you lose that credit limit, so your credit utilization ratio will rise. For example, if you owe $4,000 and your combined credit limit is $20,000, your credit utilization ratio will be $4,000 divided by $20,000, or 20%. If you close an account and your total credit limit drops to $12,000, your ratio will rise to 33%.

Still, you might want or need to close an account at some point. If so, it's best to close newer accounts, as older accounts are more valuable, demonstrating a long credit history.

The power of your credit score

If you're not yet sold on the value of keeping your credit score as high as you can, consider the following table, which shows you some recent sample interest rates from the folks at FICO that borrowers with various credit scores might be offered -- and what kind of difference the rate will make in your payments. If you were borrowing $200,000 via a 30-year fixed-rate mortgage, and you had a top FICO score, in the 760 to 850 range, you might get an interest rate of 3.61%, with a monthly payment of $910 and total interest paid over the 30 years of $127,668. If your score was 630, though, your rate would be very different, at 5.20%, with a monthly payment of $1,098 and total interest of $195,226. That's $188 more per month ($2,256 per year) and a whopping $67,558 more in interest.

FICO Score

APR

Monthly Payment

Total Interest Paid

760-850

3.608%

$910

$127,668

700-759

3.83%

$935

$136,720

680-699

4.007%

$956

$144,030

660-679

4.221%

$980

$152,975

640-659

4.651%

$1,031

$171,302

620-639

5.197%

$1,098

$195,226

Source: MyFICO.com. 

Keep this information in mind to help motivate you to pay bills on time and to be a good manager of your credit, in general.

Selena Maranjian has no position in any stocks mentioned. The Motley Fool recommends Experian. The Motley Fool has a disclosure policy.