Understanding the Importance of Your Credit Score

Understanding the Importance of Your Credit Score, How it Works and How to Improve It

By Attorney Patrick C. Burpee

Consumers today have become ever increasingly dependent on credit, yet many of us do not understand the importance of a credit score. Your car loan, mortgage, insurance premiums, utility services, and your ability to get or retain a job can all be dependent on your credit report and score. Because credit reports are generated for almost every consumer who applies for credit, it is critical one understands the credit reporting system and credit scores.

This article explores the credit scoring system, how it works, who uses it, how it affects you, how credit scores are created, common myths regarding credit scoring and how to improve a damaged credit score.

What is a Credit Score?

When you use credit, you are borrowing money that you promise to pay back within a specified period of time. A credit score is a statistical method used to determine the likelihood that an individual will pay back the money they borrow. The company behind the credit-score system, Fair Isaac & Co., developed its first scoring system in 1989 to give lenders a method for determining applicants' credit-worthiness. Fair Isaac & Co. developed its "FICO" credit score, which ranges between 300 and 850, with a score above 720 considered to be "good credit" and a score below 600 considered to be poor. FICO is the most widely used scoring system used by lenders today. A FICO score lower than 620 (considered "sub-prime") does not automatically prevent a potential borrower from obtaining a loan, but they are usually only able to acquire a mortgage or car loan from the private sub-prime market where interest rates tend to be higher due to the borrower's credit risk. A low credit score can cost you not only thousands of dollars a year in additional finance charges, but you might also be denied car or homeowner's insurance, telephone service, an apartment, or even a job.

Alarmingly, 80 percent of all credit reports contain mistakes, and 25 percent of credit reports have errors serious enough to cause consumers to be turned down for a loan or job, according to a 2004 survey by the U.S. Public Interest Research Group.

Guess what though--you don't have just one credit report. There are three major credit bureaus--Equifax, Experian and TransUnion, and each generate their own credit report and score on you. In other words, you can, and most likely will, have three different credit reports and scores because your credit history at each bureau can be different based on what positive and negative credit information was reported to each credit bureau by your lenders and how that information fits into their credit scoring models.

Scores from the three major credit bureaus can vary by 50 points or more because of errors or out-of-date information. That difference could result in a $100-per month swing on a $150,000, 30-year fixed-rate mortgage. For a $150,000 (which in Seattle is highly unlikely), 30-year fixed rate mortgage, consumers with scores of 720 and above would be eligible for a bank's most favorable loan: an interest rate of 5.55 percent (as of early June 2005) and a monthly payment of $856. For a credit score between 675 and 699, the rate jumps to 6.21 percent, or $920 a month. For consumers with a score of 620 to 674, a rate of 7.36 percent would be available, or $1,034 a month. While this might not seem like a big deal each month, over the life of a thirty-year loan, the consumers with the worst credit scores may pay at least $135,000 more than those consumers with the best credit scores.

Not all lenders use all three credit scores when determining whether to give you a loan. Some lenders may grant you credit or approve your auto loan, for example, based on only one credit bureau score or all three. Mortgage lenders typically consider all three credit scores, and in the case of a home loan, lenders often use the middle score rather than an average of the three.

What Makes up a Credit Score?

When you borrow money, your lender typically sends information to at least one credit bureau which details, in the form of items on your credit report, how well you handle your debt. Although the precise formulas for calculating credit scores are well-guarded trade secrets, much like the Coca-Cola formula, Fair Isaac & Co. has released enough information to generally understand how credit scores are calculated. Based on the information reported to the credit bureaus, a numerical score is based on five major factors: 1) Payment History, 2) Present Amount of Debt, 3) Length of Credit History, 4) Types of Credit, and 5) Credit Inquiries.

Payment History: (35%) Your payment history is simply your history of paying your bills on time. It is the most important factor in determining your credit score. The better your payment history, the better your score. However, just one late payment on a credit card bill can dramatically affect your credit score. Severe unpaid debts, such as bankruptcy, foreclosure, judgment, and collection accounts can cause a credit score to plummet.

Present Amount of Debt: (30%) Your present amount of debt is calculated as a ratio, based on the amount of debt you presently have in relation to total available credit. If you are close to maxing out available credit on credit cards or other loans, your score will be negatively affected.

Length of Credit History: (15%) Your length of credit history is fairly self explanatory: the longer the better; however, many consumers mistakenly hurt their score while trying to improve it. For example, if you have just a few credit accounts with a long reported history, and then open several new credit accounts hoping to increase your available credit (and your debt to credit ratio discussed above), you will be dinged on your score because the average age of all your credit accounts (which now includes your newly- established accounts) will be lowered.

Types of Credit: (10%) Types of credit also affect your score, although clearly not as much as your Payment History or Present Amount of Debt. Lenders like to see a good mix of credit and so having a student loan, car loan and a few credit cards is better than having no credit cards at all, or conversely, having ten credit cards and no other forms of credit accounts.

Credit Inquiries: (10%) The more you apply for credit, the more credit inquiries you will have. Furthermore, the more frequently you apply for credit, the riskier you appear to lenders who are afraid that you may not be able to manage your new found credit opportunities, thereby lowering your credit score. One recent exception to this is if you are shopping for the best interest rate for a car loan or a mortgage loan. As a result of recent changes in federal law, consumers are no longer are penalized for shopping for the best interest rate deals for these types of loans.

Common Myths

• Increasing your income will improve your credit score. Wrong. However, if a consumer increased their income and used this extra income to pay down high balance credit cards, they would see their score improve.
• If a consumer pays a delinquent debt that is being held by a collection agency, the collection agency must delete all information from the consumer's credit report regarding that account. Wrong. The collection agency has a duty to report properly, which in this scenario means reporting the debt as paid, rather than deleting it.
• A consumer's occupation affects their credit score. Wrong. Employment information is not part of the credit score calculation.
• Consumers who marry will have a combined credit score. Wrong. Spouses never have combined scores. However, your spouse's ability to timely repay jointly held credit cards can certainly affect your credit score.
• Pulling your own credit report hurts your credit score. Wrong. There will be a notation or "soft hit" when you pull your credit report; however, your credit score will not be negatively affected.

Ways to Improve or Maintain a High Credit Score

• Make loan payments on time and for more than the minimum balance. Paying your balance in full every month is best. Consider signing up for automatic bill payment; by automating the process, you eliminate the chance of having late payments. Keep in mind that your score can drop by as much as 100 points if a payment is reported as more than thirty days late.
• Each time a consumer applies for credit, an "inquiry" shows up on their credit report, negatively affecting their credit score. Therefore, follow the rule, "apply for credit cards sparingly and use your old ones regularly."
• Do not close unused credit cards as a short-term strategy to improve your credit score. Why? Because by doing so, you lower the average age of credit accounts, thereby lowering your credit score.
• Consider retaining an attorney familiar with the debt collection laws in your state for claims or lawsuits from collection agencies and debt buyers regarding your unpaid collection accounts. If a collection agency or debt buyer has made a legal mistake in the course of trying to collect from you, they may be willing to delete the negative information from your credit report altogether.
• Order a free copy of your credit report from each of the three major credit bureaus at www.annualcreditreport.com. One strategy is to request a free report from a different credit bureau every four months. (Federal law now requires each credit bureau to provide consumers with a free copy of their credit report each year.) Knowing what is on your credit report several months before you need credit in the form of a car loan, home mortgage or loan refinance will give you ample time to correct any problems that exist in order to avoid a high interest rate or a flat-out credit denial. Identify theft is an ever-increasing problem these days, costing consumers and businesses billions of dollars annually.

Conclusion

Overlooking or ignoring your credit score today can be detrimental to your financial health. Being aware of how a score is calculated, what hurts and what helps your credit score can save you thousands, if not hundreds of thousands of dollars over the course of your lifetime. Now that you understand how the system works, strive toward improving or maintaining your financial well being with a respectable credit score.

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