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, too, 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.
Fenona Blackett of Glen Burnie heard it from a mortgage broker. Blackett, a medical accountant, stopped using credit cards about five years ago, partly because she didn't like paying interest. "You don't have that debt. It's like a weight lifted off your shoulders," she says about being card-free.
But when she was in the market for a house about two years ago, a mortgage broker advised her to get a credit card and carry a balance from month to month to boost her score. Blackett did. She got the house, but also needlessly paid interest on the card for months.
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. And maintaining a balance could damage your score if it's high in relation to your credit limit.
Myth: Closing cards improves a score
Canceling a credit card could lower your score by raising your so-called utilization rate, or how much debt you carry on plastic compared to 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.
But you don't have to keep cards open forever for the sake of your score, either. If you carry very low balances on credit cards, closing one shouldn't change your utilization rate and affect your score, says Craig Watts, a FICO spokesman.
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, Watts says.
Myth: Shopping for loans lowers your score
When you're looking to get a loan for a major purchase - a 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. "It's very consumer-friendly logic," Ulzheimer says.
So, shop as much as you want for a loan, but try to do it within a month, he says.
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, Watts says. If the lender uses this new code, the FICO system will ignore the information and there's no negative impact on your score, he 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, Watts says.
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. But scores don't help an employer. Scores "are trying to predict credit risk and not employee performance," 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, a major credit bureau. "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. Under state law, Marylanders are entitled to a free report each year.
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.
Myth: A score must be perfect to get the best terms
FICO scores range from 300 to 850, and the higher the number the better. But FICO's online calculator shows you'll likely get the same terms from a lender whether your score is 760 or a perfect 850. That's a 90-point spread.
Once borrowers' scores drop into the 600s and low 700s, though, they can get starkly different loan terms even if their scores aren't that far apart.
For example, take two Marylanders applying for a 30-year, $225,000 mortgage. The borrower with a score of 649 would pay $239,136 in interest over the life of the loan, according to FICO's calculator. But a neighbor with a score of 639 would pay $28,343 more in interest because that 10-point difference in the score was enough for the lender to charge a higher rate.