By Joshua J. Robbins CFP®, CDFA®, AIF®, Associate Wealth Advisor
Your credit score silently shapes some of the most important financial decisions in your life – from the interest rate on your car loan to whether you can obtain a home mortgage at all. Despite this, individuals still rely on outdated information or flat-out myths that can be costing them money. This article will outline what your credit score is, factors that impact it, and three common myths that can ultimately hurt you in the long run.
Your credit score is essentially a rating provided by a credit scoring system—think FICO® Score or VantageScore—that utilizes existing credit reporting information to predict whether you’ll pay your debts as agreed. The three primary nationwide credit reporting agencies are Equifax, Experian, and TransUnion. All three collect personal financial data on individuals to calculate scores.
Key Takeaways
- Your credit score plays a major role in financial decisions. It can impact loan approvals, interest rates, and overall financial flexibility.
- Payment history and credit utilization are the biggest drivers. Paying on time and keeping balances low are key to maintaining a strong score.
- Common credit myths may potentially do more harm than good. Carrying balances or closing cards may actually lower your score rather than improve it.
How is your Credit Score Calculated?
The exact formulas used for FICO® or Vantage Scores are kept secret, but we do know what data is often used and may affect the ending score. For both, payment history remains the most important factor. This reveals if you’ve paid your loans and credit cards on time or if you’ve missed payments. Collections and bankruptcy are also included in this section. Total Credit Usage/Outstanding Balances is the next most influential section of the calculation. This looks at your total available credit vs. how much you currently owe. Although there is no exact point when credit utilization goes from “good” to “bad,” high credit utilization can impact your overall score negatively.
The remaining factors in your credit score calculation are credit mix, length of credit history, and recent credit applications/new accounts. Credit mix shows an individual’s capacity to manage multiple different types of debt, which can improve your overall score. Examples include student loans, mortgages, car loans, personal loans, credit cards, and lines of credit. The minimum credit history for generating a FICO® Score is having an account open for at least six months, with reporting to the credit bureaus taking place during that period.
Here are three common misconceptions about credit scores that may be hurting you in the long run.
Myth #1: Carrying a balance or paying off debt slowly helps build your credit score.
This credit score misconception is extremely common—typically among those newer to credit cards. Many people are purposefully carrying balances on credit cards in the hopes of building credit faster.
Credit card data is reported to credit agencies, so utilizing them in a smart way can help build up your score over time. Carrying a balance, on the other hand, does not directly help it. Holding a large balance can hurt your score, given that it increases your overall credit utilization.
Additionally, when you don’t pay off your credit card statement balance in full each month, you’re required to pay interest. With national averages for credit card interest rates hovering between 19% and 24%, these interest payments quickly snowball into a problem. Smart credit card guidance points towards paying off monthly statement balances in full, making payments on time, and keeping credit utilization at a manageable level.
Myth #2: Checking your own credit can hurt your score.
So-called “hard inquiries” on your credit report are those made when you apply for credit, such as a new credit card, home loan, or auto loan. But when you pull your own credit report online through one of the three credit agencies or a credit monitoring service, it’s considered a “soft inquiry” and has no adverse effects on your score.
Why is checking your score important? Aside from keeping track of your financial wellness, it’s extremely important to periodically check your credit to spot potential errors or malfeasance. Unfamiliar hard inquiries, accounts, or incorrect personal information may all be signs of identity theft and should be reported immediately.
Myth #3: Closing credit cards can help your credit score.
Closing out a credit card can impact your credit score in different ways. For one, if the available line of credit on the account you’re looking to close is high, closing out the account will lower your overall available credit, causing your credit utilization percentage to go up across the board.
Here’s an example. Say you have two primary credit cards with an average balance of $8,000 per month and a total credit limit of $20,000 between both of them. You’re well on top of your finances and pay off all statement balances monthly. But you also have an old unused credit card with a credit limit of $20,000. As reported to the credit bureaus, you have an available credit limit of $40,000 and an average balance of $8,000, resulting in a credit utilization of around 20% ($8,000 divided by the $40,000 limit).
If you were to close out this unused card, your overall credit utilization would increase due to the removal of its $20,000 limit, causing your credit utilization percentage to jump to 40% ($8,000 divided by the $20,000 limit). This change could impact your score.
In addition, if the credit card account you’re contemplating closing is one of your oldest current accounts, this can negatively impact your score by lowering the average “age” of all the accounts you hold.
It may make sense, however, to close old accounts if the unused credit card has a high annual fee or if you struggle with overspending due to available credit.
Questions about credit myths and facts? Reach out to an advisor
Virtually all of us hold lines of credit. We believe becoming more knowledgeable about credit and credit scores—and how they can impact your financial life—can help you keep better track of your financial well-being.
If you’re seeking to learn more about the credit reporting system, or have questions about any line of credit you currently hold, our dedicated advisors at Halbert Hargrove are here to help.
Halbert Hargrove Global Advisors, LLC (“HH”) is an SEC registered investment adviser with its principal place of business in Long Beach, California. HH may only transact business in those states in which it is registered, notice filed, or qualifies for an exemption or exclusion from registration or notice filing requirements. Registration does not imply a certain level of skill or training. For information pertaining to the registration status of HH, please contact HH or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov). Additional information about HH, including our registration status, fees, and services can be found at www.halberthargrove.com.
This blog is provided for general information purposes only. No portion of the content serves as the receipt of, or as a substitute for, personalized investment advice from HH or any other investment professional of your choosing. It should not be construed as a solicitation to offer personal securities transactions or provide personalized investment advice. Different types of investments involve varying degrees of risk, and it should not be assumed that future performance of any specific investment or investment strategy, or any non-investment related or planning services, discussion or content, will be profitable, be suitable for your portfolio or individual situation, or prove successful. Neither HH’s investment adviser registration status, nor any amount of prior experience or success, should be construed that a certain level of results or satisfaction will be achieved if HH is engaged, or continues to be engaged, to provide investment advisory services. HH is neither a law firm nor accounting firm, nor does it serve as an attorney, accountant, or insurance agent. No portion of its services, or this content, should be construed as legal or accounting advice. HH does not prepare legal documents or tax returns, nor does it sell insurance products. No portion of the content should be construed by a client or prospective client as a guarantee that he/she will experience a certain level of results if HH is engaged, or continues to be engaged, to provide investment advisory services. All opinions or views reflect the judgment of the author as of the publication date and are subject to change without notice. All information presented herein is considered to be accurate at the time of writing, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted.
