As the U.S. became a consumer culture and buying on credit became common, lenders needed a way to score borrowers. In 1958, the Fair Isaac Corporation (FICO) introduced the first credit scoring system. In 1991, FICO released its FICO risk score to the three major credit bureaus: Equifax, Transunion and Experian. Over 100 billion scores later, FICOs are used in 90% of consumer lending and are a ubiquitous part of our financial system.
Along with a rapid rise of credit usage came an equally rapid rise of misinformation. People knew they had a score, but they weren’t always sure what it was, where it was or how it was computed. Myths began to form as the proprietary nature of the FICO score kept truth in short supply. People tended to learn about credit from their parents, which often meant bad credit habits or misinformation were passed down to the next generation.
Common Misconceptions About Credit
Before you can improve your credit score, you need to be aware of the common misconceptions about credit.
Connecting Your Credit to Your Income
- Myth: If I get a better job, make more money, and have a house and car, my score will go up.
- Truth: Your credit isn’t dependent on how much money you make or your job title. Credit bureaus and lenders are more interested in how you handle the credit you have. This myth also applies to age, marital status, etc.—they don’t matter.
Avoiding Using Credit
- Myth: As long as I pay for everything in cash and never use credit, my score should be excellent.
- Truth: An excellent score depends on your consistent, responsible use of credit. If you never apply for or use any credit, lenders can’t ever know for sure how you’ll handle it when you do. (For related reading, see: 10 Reasons to Use Your Credit Card.)
Closing Your Credit Cards
- Myth: I have these old credit cards lying around, I should close them to improve my credit.
- Truth: Absolutely not. Your credit history includes how long you've had each account open and the amount of credit available in each account. If you close all your old accounts, you’ve just shortened the length of time you've had credit and reduced the amount of credit available to you, and that’s going to lower your score.
Pulling Your Credit Score
- Myth: I don’t want to pull my credit report because it will count against my score.
- Truth: When you access your credit report it’s considered a soft pull and doesn’t impact your score. In fact, you should be reviewing your credit report at least annually.
Shopping for Different Mortgages
- Myth: I don’t want to shop around for different mortgages because it will lower my score.
- Truth: These are considered hard pulls of your credit, and doing so will briefly lower your score, but the credit agencies know when you’re shopping. If they see a bunch of mortgage lenders showing up all at once, they lump that together as just one hard pull. (For related reading, see: Shopping for Mortgage Rates.)
- Myth: I don’t monitor my credit because it costs money.
- Truth: In 2003, some politicians realized how ridiculous it was that our scores were "hidden" from us, and passed a law that required the three credit agencies to make your report available once per year, for free. (See below for more info.)
Applying for New Credit
- Myth: Applying for new credit cards will ruin my score.
- Truth: This is perhaps the biggest misconception, and one that is hurting a lot of scores. The biggest contributor to your score is not how many credit cards you've applied to, it is your payment history.
4 Ways to Improve Your Credit Score
To improve your credit score, you should first know exactly how your score is determined. See the chart below to understand the factors that determine your score:
1. Payment History
You have to pay your bills on time. If you’re late, or worse, get sent to collections, your score will be significantly impacted. (For related reading, see: The 5 Biggest Factors That Affect Your Credit.)
2. Don’t Close Old Credit Cards
Length of credit is 15% of your score. It looks at your oldest account, your newest account, and an average of all of them. Unless you’re paying a huge fee to keep a card open, you should not close it.
3. Get Your Credit Report and Check for Inaccuracy
You can obtain your report once per year at annualcreditreport.com. If you see an issue, the process to correct it is sometimes arduous, and credit agencies aren’t exactly quick to respond, but you should contact all three in writing and ask for the error to be removed.
4. Utilize Your Credit Appropriately
Credit utilization makes up 30% of your score, and can be manipulated fairly easily through new habits. This is the simple equation for it:
This ratio should be low: less than 10%, but not zero. Ideally you shouldn't spreading the used portion over 20 accounts. Remember, credit bureaus are looking for regular, responsible use of revolving credit. Revolving credit is the kind where you choose the amount, as opposed to installment credit, which are fixed payments that must be paid monthly, like a mortgage or car loan.
For example, if you have two credit cards, each with a $10,000 limit, and you spend $5,000 on one card, here’s how that’ll look to credit bureaus:
Even though you may regularly pay off your $5,000 and feel like you’re using your credit well, the credit agencies will view this percentage as too high and penalize you for it. You can fix this by charging less each month, but what if you’re earning points or miles for that $5,000? Another way to improve the ratio is to apply for more credit (as long as you are able to pay your bills in full every month).
Let’s be clear, applying for credit and a new card does negatively affect your score, but only at first. From the pie chart above, 10% of your score is new credit, but utilization rate is 30%. What you’re doing is trading a temporary deduction in the 10% category for a permanent boost in the 30% category. (For related reading, see: Should You Increase Your Credit Card Limit?)
Find a credit card that’s free and provides a good point or bonus system. If you’re approved and get a new card with $10,000 more in credit, based on our example above, your monthly utilization now looks like this:
After about six months to a year, the negative hit you took in new credit will disappear, but the boost you got from utilization will remain, resulting in a higher score.
If you don’t really understand how your credit works, you are not alone. But by paying your bills on time, not closing old credit cards, reviewing your reports annually and decreasing your utilization percentage by increasing your credit available, you can work toward improving your credit score. Don't be confused by the myths about credit. Instead, educate yourself and make the most of it.
(For more from this author, see: Why You Should Care About the Fiduciary Standard.)