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Alright, people. I have been alluding to the fact that I was going to tackle your credit questions/myths for the past couple weeks now and the day has finally arrived.
I asked you to send me your questions about credit and I received quite a few of them. Many of them made me want to throw my laptop out the window but I shouldn’t have been too surprised. After all, I did ask for you to send them and I am happy that you did. Better to ask a basic question than to continue to make an obvious mistake.
I did my best to consolidate all of your responses into a few general categories to avoid answering the same questions over and over. I also split my responses in to 2 separate posts, so like DJ Casper in the Cha Cha Slide I’m going to have to ask you to be on the lookout for part 2.
I respond to every email that you send me so feel free to contact me with any follow-up questions that you might have.
Ok, let’s get started.
Credit Myth #1: Paying cash for everything will help your credit score
This was by far the most common topic that you asked about. Many of your responses sounded like this:
“I always pay with cash because I find it to be more convenient. I have never had a credit card and don’t have any other debt. What does this mean for my credit score?”
Put simply, it means that your credit score is probably pretty mediocre.
The only way to build your credit score is to use credit accounts. Period.
Cash, debit cards, checks, gift cards, or any other form of currency will do nothing for your score.
This is a tough one for a lot of people because they prefer to take the “hands off” approach. Conventional credit card wisdom tells them that if they take care of their finances then everything will work itself out.
The truth is quite the opposite. If you don’t use any form of credit then you will never be able to build a solid credit score. This means you will end up paying more interest when you purchase a home, car, or any other item that requires a loan.
And I don’t mean a few measly dollars more. I mean thousands and thousands of dollars more. More on that in a future post.
Put simply, using cash or debit cards to pay for everything is a bad financial move. I wish I could find a nicer way to say it.
Actually, never mind. That’s exactly how I wanted to say it. You might not like my delivery but I am going to give you the straight truth every time.
If you are using cash or a debit card for your everyday purchases then you are making a mistake.
Are there exceptions to that statement? Sure. If you are so uncontrollably bad at spending money that you can’t trust yourself with a credit card then I wouldn’t recommend using one.
But if you are using cash or debit cards simply because you don’t know any better, then I would HIGHLY recommend that you pick up a credit card right away and start building some credit history.
You can check out my Best Current Deals page for a list of my favorites.
Credit Myth #2: Having too many credit cards will hurt your credit score
This is the age-old question of credit cards. What is the right number of cards to have?
I hate the answer “it depends”, but in this case it seems appropriate. Allow me to elaborate.
As we discussed in my post about how credit scores work, 30% of your credit score is based on the amount of debt that you owe. More specifically, it is based on the amount of debt that you owe with respect to your total available credit. This is referred to as your credit card utilization and generally speaking, the lower it is the better.
In an ideal world you would always keep it below 20% (i.e. $200 on a credit limit of $1,000). Below 10% would be even better but 20% is a good benchmark.
So take the amount of money that you spend in a typical month, multiply it by 5, and that’s the minimum amount of credit that you should have available at any given time. If your credit limit is any lower than that then you should probably apply for another credit card or two.
So if 20% is the minimum, what is the maximum? Will having a bunch of credit cards hurt your score?
Nope, in fact that will likely help your credit score by reducing your credit card utilization.
I’m sure that you don’t believe that last statement so I will use my own situation as proof.
I currently have more than 20 credit cards. Two zero. Which is more than most people have in a lifetime.
Add them all up and I have over $100,000 of available credit to my name.
Surely opening 20 cards open has destroyed my credit score right? At least that’s what your mother/cousin/neighbor/one friend who works at a bank told you.
Let’s take a look, compliments of Barclay’s new free FICO credit score feature.
If this were Mythbusters we could officially call this myth “busted”.
A 763 FICO score puts me well within the range of “Excellent” scores, meaning that I will receive the best rates on the market for things like car loans and mortgages.
We will talk about why I have so many credit cards in a future post. Spoiler alert, it involves lots of cheap travel.
Credit Myth #3: Checking your credit will hurt your score
This is another one of my favorites.
In the world of credit scores there are two types of credit checks, “hard inquiries” and “soft inquiries”.
A “hard inquiry” is used by a company that has a legitimate business reason to look into your credit report. This usually occurs when you apply for some form of credit such as a credit card or loan. A hard inquiry will cause your score to drop slightly (usually by less than 5 points) before fully recovering a few weeks later.
A “soft inquiry” occurs when you pull your own credit report or when a company pulls your report for a non-credit use such as a background check. Unlike a hard inquiry, a soft inquiry has no effect on your credit score.
So how do you go about checking your score (and not hurting it)?
I personally recommend that you use Credit Karma or Credit Sesame (or both). These two sites are very user friendly and completely free. You will never be asked for your credit card information in order to see your score.
Don’t bother with sites like freecreditreport.com that ask for your credit card info. They will end up charging you a monthly fee for a bunch of credit monitoring services that you probably don’t need.
Credit Myth #4: You should close accounts after paying them off
This myth is related to the number of credit cards myth, but the number of questions I received about it justified the use of a separate section.
Generally speaking, you should never close a credit account unless you have a reason to. Common reasons include avoiding an annual fee, transferring your credit to another card, etc. Never close an account just for convenience.
Closing accounts reduces your total available credit, causing your credit card utilization to increase and therefore your credit score to fall.
Closing accounts also prevents you from building additional credit history, which makes up 15% of your score.
This myth persists because people think that closing an account will remove it from their credit report, therefore hiding any bad history from future lenders.
Unlike bad relationships, you can’t just delete all of the evidence of a bad credit account and forget that it ever happened. The account will remain on your credit report for up to 7 years.
The best course of action is to keep the account open and in good standing, allowing you to build credit history and maintain a good credit utilization ratio.
Credit Myth #5: You need to carry a balance to build your credit score
I never really understood this myth. I’m supposed to believe that by not making all of my payments on time I am somehow improving a metric that measures my likelihood of making my payments on time?
Conventional credit card wisdom continues to baffle me.
The most common justification for this practice is the belief that carrying a balance on your credit card is the only way to build credit history, which makes up 15% of your score. After all, having no balance means you have no credit history right?
This is completely false. You are building credit history regardless of whether or not you carry a balance on your card. Carrying a balance will only leave you with tons of late fees, interest charges, and likely a damaged credit score.
That’s all for today. As I mentioned, I will be posting the second part of your questions sometime next week. Feel free to submit any additional questions that you may have.
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