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Demystifying Credit Scores

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One of the few positive outcomes of the 2008 financial crisis was that it helped shine a light on the importance of understanding and staying on top of your credit profile. Along with that heightened visibility, however, has come a great deal of confusion and misunderstanding -- particularly around the all-important credit score.

"The consequences of not maintaining a sound credit score can be very costly," says Anthony Sprauve, senior consumer credit specialist at FICO. "A low score can bar you from getting a new loan, doom you to higher interest rates and even cost you a new job or apartment."

Here's what often happens to people with poor, or even fair, credit scores:
  • It's harder to qualify for a mortgage, you'll need a bigger down payment and you'll pay a higher interest rate, which adds up over time. According to this MyFICO calculator, someone with poor credit might pay an extra $103,305 in interest over the life of a typical 30-year, $300,000 mortgage, compared to someone with excellent credit.
  • Similarly, someone with a poor score might pay an additional $10,400 in interest on a 60-month, $25,000 auto loan.
  • Credit card interest rates are often 10 or more percentage points higher and credit limits are typically much lower.
  • Although credit scores aren't factored into federal student loan interest rates, they are with private student loans, often resulting in much higher rates.

Five factors are used to determine your credit score: payment history (usually around 35 percent of your score), amount owed (30 percent), length of credit history (15 percent), newly opened credit accounts (10 percent), and types of credit used (10 percent). These five categories may be weighted differently depending on your individual circumstances.

Fortunately, if your credit score has taken a hit, you can initiate several actions that will begin improving it almost immediately. Just be aware that it can take many years to recover from severe credit-damaging situation such as bankruptcy or foreclosure.

First, find out where you currently stand by reviewing your credit reports from each major credit bureau (Equifax, Experian and TransUnion). Look for negative actions your creditors may have reported. Also, look for errors (like mistakenly noted late payments) and fraudulent activity on your accounts and challenge them through the bureau's dispute resolution process. You can order one free report per year from each bureau through the government-authorized site, AnnualCreditReport.com; otherwise you'll pay a small fee.

You might also want to order your credit score. Lenders use credit scores to supplement their own selection criteria to determine whether you are a worthy credit risk. Several types of scores are available, including FICO® Score, VantageScore (a competing model jointly created by Equifax, Experian and TransUnion) and proprietary credit scores from each of the three bureaus, among others. Scores typically cost from $15 to $20 each.

Note: You may see offers for free credit scores, but they're usually tied to expensive ongoing credit-monitoring services you may or may not want. Read the contract carefully.

Credit score ranges vary depending on the version being used. According to Sprauve, "Each lender ultimately decides for itself what constitutes a good score, but we find that FICO scores above 720 generally will qualify you for the best available interest rates and loan terms. FICO scores below 650 are usually considered poor and may make it tough to even qualify for a loan."

Here are a few tips for improving your credit history:
  • Always pay bills on time and catch up on missed payments. A few late payments can be very damaging.
  • Set up automatic payments for recurring bills and automatic minimum credit card payments if you often miss deadlines.
  • Sign up for text or email alerts telling you when your balance drops or payments are due.
  • Never exceed credit card limits.
  • Monitor your credit utilization ratio (the percentage of available credit you're using). Try to keep your cumulative utilization ratio -- and the ratios on individual cards or lines of credit -- below 30 percent.
  • Transferring balances to a new card for a lower rate will slightly ding your credit score -- although it won't take long to recover. But be careful the transfer doesn't increase your utilization ratio on the new card.
  • Make sure that card credit limits reported to the credit bureaus are accurate.
  • Don't automatically close older, unused accounts; 15 percent of your score is based on credit history.
  • Each time you open a new account it slightly impacts your score, so avoid doing so in the months before a major purchase.
  • Pay off medical bills, as well as parking, traffic and even library fines. Once old, unpaid bills go into collection, they'll appear on your credit report.

Sprauve has a good suggestion for people who put most purchases on a single credit card to earn higher rewards: "If you're paying your balance off every month anyway, pay it off midway through the billing cycle and then again at the end of the month so your reported outstanding balance appears lower," he says.

"Bottom line, don't lose hope," adds Sprauve. "The negative impact of past credit problems will gradually fade as recent good payment behavior begins to show up on your credit reports."

To learn more about ways to repair and protect your credit scores, visit MyFICO.com's Credit Basics Center, the Consumer Financial Protection Bureau's Credits and Loans and Credit Reports and Scores websites and What's My Score, a financial literacy program run by my employer, Visa Inc.

This article is intended to provide general information and should not be considered legal, tax or financial advice. It's always a good idea to consult a legal, tax or financial advisor for specific information on how certain laws apply to you and about your individual financial situation.

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