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Millennials think they know a lot about credit. But the numbers tell a different story.
More than 7 in 10 millennials said they feel confident about their credit knowledge, according to a recent survey by Experian. If fact, millennials on average estimated they had a score of 654. But it turns out that for many 18-to-34-year-olds, even that was an overestimation. And millennials are less likely to check their credit reports, Experian said.
"I would say they don't understand their credit. … Clearly they don't know how [credit scores] are calculated," said Guy Abramo, president of Experian consumer services.
Abramo said many people don't have a strong knowledge of how credit works and how scores are calculated. But most people don't overestimate the way millennials did. "Most people aren't overconfident," he said.
Here's how it works: Thirty-five percent of your credit score is determined by your payment history, or whether you have made payments on time, 30 percent is your credit utilization, or the amount borrowed compared to the total credit available, 15 percent is determined by the length of your credit history, 10 percent comes from the number of applications for new credit and 10 percent is from the types of credit you have (i.e. revolving, installment, mortgage etc.).
Generally, credit companies prefer a mix of credit because the variety suggests you know how to use credit responsibly. A combination of car and student loans along with some credit card use, for example, helps build up your credit score as long as you pay on time over an extended period.
Scores range from 300 to 850. If your score is above 750, you're considered to have excellent credit, which paves the way to the lowest interest rates and a better chance of getting approved for loans. If your score is on the lower side, it can cost you — that means higher interest rates on everything from credit cards to auto loans.
Here's the breakdown:
800+ = exceptional
740-799 = very good
670-739 = good
580-699 = fair
Below 580 = poor
Financial advisers warn that a bad score may even hurt your chances of getting a job. Employers have access to your score and can factor it in to their decisions.
Your credit score is a reflection of you, said Larry Luxenberg, a financial adviser at Lexington Avenue Capital Management in New City, New York. "If your credit is bad, it injects some doubt about your ability to handle personal matters and business matters."
The difference between a fair score and a good score could be substantial but also depends on the bank. "It is up to the lender to determine what score range is acceptable," Abramo said.
You may still get a loan, but you will likely have to put more money down as a down payment and pay a higher rate, which can be costly.
For example, having a score of 650 versus 760 can cost you $125 more a month on a 30-year fixed rate mortgage for a $200,000 loan, according to credit tracking firm CreditSesame.com. That's $1,500 more a year, or $45,000 over the life of the loan.
Abramo suggests checking your credit report before you apply for a loan, credit card, mortgage, etc. "If nothing else it gives you that reflection of how a lender will view you."
Many credit card issuers like Citibank, Discover and Capital One now offer free scores to select cardholders on their monthly statement or through their online account, otherwise you may have to pay a small fee to see the actual score.
Experts suggest checking your report regularly. Once a year is sufficient to get a gauge on your number, and check for any errors, like an incorrect payment status or delinquencies that have since been remedied. "The best way to avoid surprises is to see what is on your report," Abramo said. "This is the case where knowledge is power."
Read MoreHow to avoid credit card pitfalls
Remember to keep an eye on the debt-to-limit ratio. What you borrow compared to the total credit available, also known as your debt utilization ratio, counts for a whopping 30 percent of your credit score. A debt utilization ratio greater than 30 percent will have a negative effect.
If you are borrowing too much, start a debt repayment plan to lower the ratio as much as possible.
Ideally, credit cards should be paid in full at the end of each payment period to avoid sky high interest. Paying in full each month also demonstrates that you are a responsible borrower. This will help build up good credit and save you money since the faster you pay down debt, the less interest you'll pay.
Even if you don't pay off all of your debt right away, make sure you are always paying on time. Set up automatic payments to avoid late payments. A missed payment will also hurt your score.
Ultimately, a credit score is one of the most important numbers you have. In the long run, a bad score could raise the cost of a car or home loan, increase you credit card interest from a single digit to double digits or even deny you credit entirely.
Not only does a good credit score save you money by lowering interest rates, it's a reflection of you and your personal matters. So it is worth putting in the time to build up a good report.
"A credit score is one of the building blocks of your financial future and that has a big bearing on your entire life," Luxenberg said.