Planning to apply for a loan soon? You are in good company. In 2020, there were 22.7 million home loan applications, according to the Consumer Financial Protection Bureau. Meanwhile, Experian says auto loans grew to a record high of $1.37 trillion. So, there is a lot of lending going on.
Your credit score and credit report are among the most significant factors lenders look at when you apply for a loan or mortgage. If you have struggled with your finances in the past, learning about your credit score can be intimidating. But understanding your score and what goes into it are crucial to landing the loan you need.
There are many myths surrounding your credit score and what does or does not affect it. Let’s look at some of the most common myths and the truth behind them.
Carrying a credit card balance boosts my credit score
This is a persistent myth around building credit. Carrying a credit card balance from month to month may hurt your credit score and will probably cost you money in the long run, since you’re paying interest to the credit card company on any balance not paid in full.
Generally, people with the highest credit scores have a credit utilization ratio — how much total credit you are using compared to how much credit you have available to you — of 10% or less. When your utilization rate gets above 30%, your credit score may be negatively impacted, since lenders may be concerned about how much credit you are using.
Paying off debt quickly removes it from your credit report
Paying off revolving debt, like a credit card, can be a good plan because it improves your credit utilization ratio. A history of on-time payments and responsible credit usage is usually helpful in loan applications because it shows lenders that you use credit responsibly.
Some people think a closed account or paid-off debt quickly disappears from your credit report. In fact, if you paid your debt in full and made all payments on time, credit-reporting agencies might keep the account on your credit report for up to a decade.
In addition, a history of late payments can stay on your credit report for up to seven years, and some types of bankruptcies can remain on your report for up to 10 years. As you pay off a credit card, make sure you do so responsibly. Consider setting up autopayments so you don’t accidentally miss a payment.
You have to be rich to have a good credit score
Your bank balance and income have nothing to do with your credit score. It’s possible to have a high income and a bad credit score because you carry a large credit card balance, have made late payments, or otherwise mishandled your finances.
Likewise, you can have an average salary and still achieve a high credit score. Many lenders use the FICO score, created by the Fair Isaac Corp. The highest FICO score you can achieve is 850. Anything above 800 is generally considered excellent and might help you qualify for the best loan rates and terms.
All debts have an equal impact on your credit score
Paying down a credit card or other revolving debt could help your credit score because it increases your credit utilization ratio. Paying off installment loans, like an auto loan or mortgage, could also affect your score, but the impact is unlikely to be as great as that of paying off revolving debt.
So, develop a strategy to help you pay down your revolving debts if you want to boost your score. Methods of doing so include the debt snowball or debt avalanche approaches. With the debt snowball, you pay off your smallest debts first and progress to the largest. With the debt avalanche, you attack your debts beginning with the obligations that have the highest interest rates.
Student loans don’t impact your credit score
All loans, including student loans, mortgages, auto loans, medical debt, and even your utilities, are included in your credit score. Even one late payment could cause your credit score to drop, so paying your bills on time is essential.
Payment history is one of the most significant factors in computing your credit score. For example, it accounts for roughly 35% of your FICO score composition. So, making payments on time is one of the most important things you can do to potentially build your score. Develop a budget and call your lenders before missing a payment so they can help you work out a strategy that might prevent a negative impact on your score.
Checking your report hurts your credit score
Regularly checking your credit report can be an excellent way to keep tabs on your credit profile. Checking your own report doesn’t affect your score.
When you are pre-approved for a loan or mortgage, it is traditionally considered a “soft pull” since you haven’t applied for credit yet. Soft pulls do not impact your score.
On the other hand, when you take the next step and submit a formal credit application, the lender will make a “hard pull” to check your credit report, which may cause your credit score to drop a few points. The same is true when applying for a credit card or other credit applications.
Be careful about the number of credit cards or loans you apply for, especially if you plan on buying a home or car shortly. Multiple applications for credit and multiple hard pulls can lower your score and raise red flags for lenders.
How much I make affects my credit score
Your income and job title don’t impact your credit score and aren’t reported to the credit bureaus. Lenders generally get your salary range and job title directly from you since it is not on your credit report and therefore not factored into your credit score.
Instead, your FICO credit score is made up of the following factors, from most impactful to least:
- Payment history (35%)
- The amount owed (30%)
- Length of credit history (15%)
- New credit (10%)
- Mix of credit products you have (10%)
No matter your income, make sure you develop a budget that accounts for your needs like your mortgage or rent, food, utilities, debt repayment and retirement savings. And try to leave room for the fun stuff in life, like hobbies or travel.
Using a debit card helps build my credit score
Debit cards are tied to a checking account and are not a form of credit, so they don’t usually impact your credit score. The money is withdrawn directly from your checking account and doesn’t touch your available credit.
If you don’t have a credit card, applying for and using one responsibly can be an excellent way to help improve your credit score. Paying off the balance in full every month and making payments on time will help boost your score. If you’re looking for a credit card, check out the best credit cards to find one that fits your needs.
It’s important to note that your credit score is just an overall snapshot of your financial life at a given moment in time. Focusing on paying down debt, increasing your credit utilization ratio, and making payments on time can help you improve your credit score.
If you’re applying for a mortgage or auto loan soon, check your credit score and credit report to know what lenders will find. Then, make a plan to improve your score as much as possible.