By now, you're probably aware of the wide use of credit scores and how this three-digit number can determine whether you get credit and under what terms. But there is a lot of misinformation about scores, and what you don't know can hurt you. You could end up unnecessarily paying interest on credit cards or lowering your score in attempts to improve it. Here are some of the myths:
Myth: You must carry a credit card balance for a good score.
This fallacy is prevalent. To generate a FICO score, the most widely used score, you must have at least one account older than six months that appears on your credit report and you must have had some activity in that account within the past six months. It doesn't have to be a credit card. FICO looks at student loans, mortgages, auto loans and other consumer loans, too.
Carrying balances on cards doesn't raise your score. Creditors ideally want to see that you pay your bills on time and in full each month.
Myth: Closing cards improves a score.
Canceling a credit card could lower your score by raising your "utilization rate," or how much debt you carry on plastic compared with your total credit limit.
Say you have three cards with a $5,000 credit limit on each, or $15,000 total. Your total balance is $7,500, so you're using half your total credit limit. But if you close one card, suddenly you're using 75 percent even though the balance didn't change. Your score will drop.
Your amount of debt, including the utilization rate, makes up 30 percent of your FICO score. The lower the utilization rate, the better. Aim to keep it under 10 percent, says John Ulzheimer, president of consumer education for Credit.com.
Also, closed accounts will stay on your credit report for years, so you will still reap any benefit from that account's history for a long time.
Myth: Shopping for loans lowers your score.
When you're looking to get a loan for a major purchase — car, house or college education — the scoring system assumes you'll shop around for the best terms. So if multiple prospective lenders make inquiries into your credit report within a short period of time, the scoring system won't penalize you, Ulzheimer says.
For example, when you look for a mortgage, the FICO scoring system ignores the first 30 days of inquiries from mortgage lenders. After that, the system will treat all loan inquiries within a 45-day period as a single loan inquiry.
Myth: A mortgage modification damages a score.
Not necessarily. At the request of the Treasury Department, all three credit bureaus in November began offering a new code lenders can use to report that a customer is in the government's mortgage loan modification program. If the lender uses this new code, the FICO system will ignore the information and there's no negative impact on your score, Ulzheimer says.
But this might only be temporary. When FICO updates its scoring formula in a year or two, it could decide to knock off points for those in the government's mortgage modification program.
Myth: Employers use credit scores.
Employers can't even get your score, Ulzheimer says.
This misunderstanding may arise because consumers often think of "credit reports" and "credit scores" as interchangeable, but they are not the same thing.
A credit report contains information reported by your creditors. Information in the report is used to develop a score that tries to predict the chances of your not paying your bills.
An employer might look at your credit report to measure how responsible you are or to determine if, say, putting you in a position of dealing with money is a good idea, Ulzheimer says.
Myth: A credit score is everything.
What's more important is that you make sure the information in your credit report is accurate, says Roslyn Whitehurst, a spokeswoman with Experian, one of the three major credit bureaus. "The score is only as important as the data that drives the score."
Fixing errors on a report can help a score. Federal law permits you to order a free copy of your report annually from the three major credit bureaus at AnnualCreditReport.com.
Myth: Paying on time guarantees a good score.
Payment history makes up 35 percent — the largest portion — of the FICO score.
"But 65 percent of the score has nothing to do with making payments on time," Ulzheimer says.
You can have a horrific score for other reasons, such as maxing out credit cards, opening lots of new credit lines in a short period and having credit for only a brief time, he says.