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Your credit score is a number generated by a mathematical formula
based on information in your credit report, compared to information on tens
of millions of other people. The resulting number is a highly accurate prediction
of how likely you are to pay your bills.
If it sounds arcane and unimportant, you couldn't be more wrong. Credit scores
are used extensively, and if you've gotten a mortgage, a car loan, a credit card,
or auto insurance, the rate you received was directly related to your credit
score. The higher the number, the better you look to lenders. People with the
highest scores get the lowest interest rates.
Powerful little number
If you rented an apartment, got braces, bought cell phone service, applied for
a job that involved handling a lot of money, or needed to get utilities connected,
there's a good chance your score was pulled. If you have an existing credit card,
the issuer is likely to look at your credit score to decide whether to increase
your credit line or charge you a higher interest rate.
Buying a car? Most car dealers want to know your credit score when you walk in
the door. They
want to know how they can put a loan together for you. The score has made
it easier for many people to get credit. Before, it was up to individual
lending institutions to come up with their own criteria. They
would hedge their risk and tend to go conservatively. It's opened up lending
to a lot more people.
Consumers' rights
Until recently, many Americans didn't even know this number existed because it
was a closely guarded secret in the lending industry. In fact, lenders were prohibited
from telling borrowers their credit score.
This changed recently though when consumers began finding out about the
score and demanding to see it. In an unprecedented move in 2000, online lender
E-Loan offered to give consumers their scores for free, with information explaining
how the score is calculated and how they might improve it.
Public outcry on the possibility of people being denied credit based on bad information
in credit reports led to several pieces of legislation and a much more open
attitude about credit scores. Fast forward to current day: not only can consumers
buy their score online from any number of sources, but they are now entitled
to one free credit report per year.
Key factors of your score
Just what goes into the score? The model looks at more than 20 factors in five
categories.
1. How you pay your bills (35 percent of the score)
The most important factor is how you've paid your bills in the past, placing
the most emphasis on recent activity. Paying all your bills on time is good.
Paying them late on a consistent basis is bad. Having accounts that were sent
to collections is worse. Declaring bankruptcy is worst.
2. Amount of money you owe and the amount of available credit (30 percent)
The second most important area is your outstanding debt -- how much money you
owe on credit cards, car loans, mortgages, home equity lines, etc. Also considered
is the total amount of credit you have available. If you have 10 credit cards
that each have $10,000 credit limits, that's $100,000 of available credit. Statistically,
people who have a lot of credit available tend to use it, which makes them a
less attractive credit risk.
Carrying a lot of debt doesn't necessarily mean you'll have a lower credit score.
It
doesn't hurt as much as carrying close to the maximum. People who consistently
max out their balances are perceived as riskier. People who
never use their credit don't have a track history. People with the highest scores
use credit sparingly and keep their balances low.
3. Length of credit history (15 percent)
The third factor is the length of your credit history. The longer you've had
credit, particularly if it's with the same credit issuers, the more points
you get.
4. Mix of credit (10 percent)
The best scores will have a mix of both revolving credit, such as credit cards,
and installment credit, such as mortgages and car loans. Statistically,
consumers with a richer variety of experiences are better credit risks. They
know how to handle money.
5. New credit applications (10 percent)
The final category is your interest in new credit -- how many credit applications
you're filling out. The model compensates for people who are rate shopping for
the best mortgage or car loan rates. The only time shopping really hurts your
score is when you have previous recent credit stumbles, such as
late payments or bills sent to collections.
The scoring model doesn't look at:
• age
• race
•
job
• income
• education |
• marital status
•
if you've been turned down for credit
• length of time at your current address
• whether you own a home or rent
• time on job |
A lender may consider all these factors when deciding whether to approve a loan
application, but they aren't part of how a FICO score is calculated.
Credit scores are not perfect
The major drawback to credit scoring is that it relies on information in your
credit report, which is quite likely to contain errors. That's why it's critical
that you check your credit reports annually or at the very least three to six
months before planning to buy a house or a car. This will give you sufficient
time to correct any errors before a lender pulls your score. |
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