debt myths

Myths about Debt

Debt is a fact of life for millions of Americans. Taking the form of credit card bills, student loans, mortgages and numerous other types of loans, debt is often an integral tool for helping individuals reach their goals and live comfortably.

Yet if a person’s debt is unchecked or uncontrolled, debt isn’t a tool at all. It is a debilitating weight on someone’s shoulders.

While nearly everyone accrues at least some debt, many have unanswered questions about how the credit system actually works. From closing old lines of credit to making just the minimum payments, you may be unwittingly hurting your credit history and your finances.

A basic understanding of debt facts and myths can help you make wiser and more informed decisions about your financial well-being.

 1. Myth: Closing unused lines of credit or lowering your credit limits will boost your credit score

Many over-spenders think it’s a good idea to request lower credit limits or cancel credit cards they no longer use. This strategy can reduce the temptation to spend more and, therefore, reduce your total debt load.

But when it comes to your credit score, this practice can do more harm than good.

The FICO credit scoring model looks at your total available credit in relation to the total amount of credit you’ve used. If you lower your total available credit, either by lowering the limit or closing an account, you reduce the gap between used and available credit. Your score doesn’t reflect whether a lower limit is at your request, and it may decrease.

Closing unused accounts can also make your credit history seem younger. Your FICO score takes into account when you opened each line of credit. Older accounts tend to help your score, especially when you’ve made timely payments. You lose this age advantage when you close an older account.

 2. Myth: Paying off debts will instantly repair a credit report

Your credit report is meant to provide an overview of both your current credit standing and your credit history. Most negative information therefore stays on your credit report for seven years, and a bankruptcy stays with you for 10 years.

Paying off your debts will typically improve your credit report and credit score, but it won’t erase past problems. Time is the only thing that will get rid of accurate, negative information.

 3. Myth: Checking my credit report will lower my credit score

Credit bureaus understand your need to check your credit report. When determining your score, the FICO credit scoring model ignores your requests for your credit report so they don’t lower your score.

The government encourages you to check your credit report at least once a year – and you’re entitled to one free credit report every 12 months from each of the three national credit bureaus.

Use these to ensure that your credit report is accurate and up to date.

 4. Myth: Credit repair services can fix a credit score

Most commonly, credit repair companies charge you money and then provide no results.

Companies that offer credit repair services often try to scam you or use illegal credit repair tactics. No one can legally remove accurate and timely information from a credit report. It is also illegal to create a new identity in order to have a new credit report. Don’t trust the claims of any company that tells you otherwise.

 5. Myth: A divorce decree will separate joint accounts

A divorce decree does not affect joint accounts. This means that even after a divorce is final, your ex-spouse’s bad credit habits may continue to appear on your credit report. This is true even if the decree states that your ex is to be fully responsible for certain accounts.

To separate joint accounts and prevent this from happening, contact the creditor for each joint account. The company may be able to remove one of your names and turn the account into an individual one. If this cannot be done, you may instead be able to close the account and open a new one to replace it.

 6. Myth: It’s fine to make minimum payments on a debt

Making minimum payments on a debt won’t cost you late fees and won’t have negative consequences on your credit report. But you’ll pay an unnecessarily high amount of interest and be in debt far longer than if you increased your monthly payments slightly.

Assume you have a $5,000 balance on a credit card you no longer use and you only want to make minimum payments towards the debt. Your minimum monthly payment may start at $100 – 2 percent of the total debt – and you may be charged an annual interest rate of 15 percent. It’ll take you about 24 years to pay off your balance in full, costing you more than $7,000 just in interest.

If you can afford to increase your monthly payment even by a small amount, you can get out of debt sooner and save thousands of dollars in interest.

With the same $5,000 debt, assume you pay $125 each month instead of the minimum. You’ll only need five years to pay off the debt in full, and you’ll save more than $5000 in interest.

 7. Myth: All debt is a bad thing and only hurts you

There is such a thing as good debt: money borrowed for things that will increase your net worth or earn you more money. Good debt can include student loans, mortgages and small business loans.

But there are no guarantees that borrowing money will pan out as planned. A good education may not secure a high-paying job, a home may depreciate in value instead of appreciating and a small business may not prove profitable.

As with any type of loan, it’s important to make sure you can afford to repay good debts and keep your accounts in good standing.

 8. Myth: If you have a large amount of debt, your only option is bankruptcy

Bankruptcy should be your last option, to be used only after you’ve considered and ruled out the alternatives. You may find that your financial situation makes you a better candidate for debt consolidation or debt settlement.

Debt consolidation is a way to combine several loans into a single, larger loan. This new debt simplifies your monthly bills and typically lowers your interest rate.

Debt settlement is a method of negotiating with your creditors to have part of your loan erased. A successful debt settlement reduces the amount of money you’re responsible for paying back.

 9. Myth: Bankruptcy hurts a credit score so much that you will never be approved for credit again

If you’re considering bankruptcy, it’s likely your credit score is already damaged from late or missed payments and a high amount of debt. So declaring bankruptcy may not hurt your score as much as you think.

The Fair Isaac Corporation estimates that if you have a starting score of 680, bankruptcy may knock it down 130 to 150 points. The effect will vary based on your circumstances, however, and it is impossible to predict bankruptcy’s exact consequences.

Even with a dent in your credit score, you may still be approved for a line of credit. With the increasing rate of bankruptcy, many lenders no longer view it as a deal-breaker when approving and denying credit applications. They may even take into account the fact that bankruptcy can free up some of your income, helping you to pay future debts.

If you do have trouble obtaining credit, remember that bankruptcy’s effects don’t last forever. Bankruptcy is typically removed from your credit report after 10 years.

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