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6 Credit Myths That Can Wreck Your Finances

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Credit is a concept that many Americans struggle with. Although various theories exist, the most effective way to build credit is to make timely payments and keep the balances low.

Here are six common credit myths that you should be aware of:

1. You have one single credit score.

Although the three major credit reporting agencies use similar variations of the FICO score, there are dozens of different types of credit scores using models developed FICO, VantageScore and others. In some instances, creditors have their own distinct formula to calculate your credit score. As a result, you can’t assume a particular lender is using a particular score.

It can be helpful to inquire with the lender about the qualification criteria prior to applying.

2. If I cosign a loan, I am only responsible for 50% of the outstanding balance.

Unfortunately, co-signing for a loan puts you in a position to be the “go-to-guy” if the primary borrower defaults. This means that you will be responsible for the entire unpaid balance that remains on the loan.

Before you make the decision to sign on the dotted line, bear in mind that the lender more than likely is requesting a co-signer because the applicant poses too much of a risk, either as a result of past credit issues or a lack of credit history.

3. Debit cards will build my credit.

Many are led to believe this assertion because their financial institution may have required them to undergo a credit screening in order to become a member. (This is not uncommon with credit unions). However, debit cards bear no impact on your credit because the activity is not reported to the three credit bureaus. The exception to this rule is the negative marks that can result if your account is overdrawn and sent to collections if deposits to clear the negative balance are not made in a timely manner.

An alternative to build your credit is a secured credit card. They typically require a security deposit, but operate like credit cards.

4. As long as I make timely payments, it’s OK to rob Peter to pay Paul.

Timely payments are not the only important factor used to determine your credit score. Your total revolving debt can still drastically lower your credit score if it is too high. Simply robbing Peter to pay Paul (using one form of debt to pay down another) just shifts the debt around and the outstanding balances will continue to increase.

A more feasible solution is to cut your variable expenses, which will free up funds to pay down your debt obligations. If you cannot afford to do so, contact the creditor to inquire about temporary relief options or other arrangements that may be available to you.

5. Closing unused credit cards will strengthen my credit score.

In a perfect world, it may seem logical to close out any unused credit cards that are collecting dust. Here’s the problem with this approach: The lower the amount of your available credit, the higher your revolving utilization ratio if you have other outstanding debt obligations.

Therefore, you should hold on to those cards to give yourself the extra available credit, but be sure to avoid any dormancy fees that may apply by periodically charging a small amount that you can pay in full by the next statement.

6. I can ignore my credit report if I’m debt-free.

You might think that your credit report and credit score are useless once you are debt-free and have no intentions to purchase additional items through financing. Unfortunately, this short-term view doesn’t take into account the ever-present threat of identity theft. Suspicious activity that appears in your credit file can tip you off that your identity has been tampered with.

Not to mention that you never know when you’ll need access to your good credit — you might need an emergency loan, for example, or a prospective employer might want to check your credit report before they hire you.  By checking your credit reports and credit scores periodically (Credit.com’s free Credit Report Card lets you monitor your score once a month and gives you a snapshot of your credit report), you can ensure that you’re still on track for good credit, and that there are no errors on your report that could hurt your credit.

However, if you ultimately want to lock down access to your credit file, strongly consider a security freeze.

Image: iStockphoto

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    The Patriot Act does not require dealers to run a credit report on customers who pay cash but there are laws that may require them to check your identification if you were paying more than $10,000 in cash. They’re also required to report the cash transactions over $10k to the IRS. (You can read more about this here: http://www.edmunds.com/car-buying/car-dealership-credit-report-scams-and-the-patriot-act.html)

    As far as the downsides for credit freezes go, the biggest downside is convenience and the time (and cost) it takes to unfreeze your credit reports in the event you actually need to apply for credit –or, as you’ve just explained, when you need to apply for a vacation rental and the company needs to pull your credit as part of a rental application.

    Credit freezes are a great option for consumers that want to prevent identity theft but you do have to keep in mind that you’ll need to plan ahead before applying for credit (if you need it). With credit freezes, you’ll need to “thaw” or unfreeze your reports a few days before you apply and there may be a cost involved each time you freeze and unfreeze your reports.

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