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Understanding Credit Scores

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If you've tried to take out a loan or open a new credit account recently, you know that the days of easy credit are long gone. Lenders, insurers, landlords and even some employers are more diligently scrutinizing people's credit histories to see if they're a worthwhile risk.

In this economic climate, it's more important than ever to protect -- and repair -- your credit score. A low credit score can cost a small fortune over the course of a lifetime. What often happens to people with poor, or even fair, credit scores is:
  • 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 $100,000 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 $10,500 in interest on a 60-month, $25,000 auto loan (see MyFICO calculator).
  • Credit card interest rates can be 10 or more percentage points higher and credit limits are typically much smaller.
  • Although credit scores aren't factored into federal student loan interest rates, they are with private student loans, often resulting in rates several percentage points higher.

To get a better handle on your credit status, it helps to understand a few key concepts:

Credit bureaus. Each of the three major credit bureaus -- Equifax, Experian and TransUnion -- compiles information from lenders that have extended credit to you, tracking how many and what types of credit accounts you use (credit cards, loans, etc.), how long your accounts have been open and whether you've paid your bills on time.

Credit report. Upon request from you or a potential lender (and, increasingly, from employers and landlords), bureaus assemble a credit report showing your credit history to date. Among other things, it contains a summary of open and closed accounts and any outstanding balances, recent inquiries (which may indicate that you've requested credit) and negative items (late/missed payments, bankruptcy, tax liens, etc.)

Credit scores. When you apply for new credit, the lender will ask a credit bureau to compile a three-digit credit score, based on information in your credit report -- essentially a snapshot of your credit profile at that moment. The lender uses your credit score to supplement its own selection criteria to determine whether you are a worthy credit risk.

Most credit scores use software developed by FICO, which is why they're commonly called FICO scores. Each bureau uses its own calculation method and relies on slightly different information, which is why scores may vary, even if pulled on the same day.

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.

To find out where you stand, you can order one free credit report a year from each bureau. (Order through the government-authorized AnnualCreditReport.com; otherwise you'll pay a small fee.) This helps you identify bad credit behavior and spot fraudulent activity or errors before they damage your credit. Bureaus are required by law to investigate any disputed item and correct inaccuracies.

A good strategy is to rotate ordering a free report from one bureau every four months; that way, you'll keep year-round tabs on what's being reported about you. You can also order individual credit scores from each bureau for around $15.

Opinions vary about what constitutes an excellent, good, fair or poor credit score, but these days, it's safe to say that anything over a 740 FICO score will probably qualify you for the most favorable credit terms. Fall below 620 or so and you may have a tough time even getting a loan or opening an account.

What is undeniable is that certain negative actions can have a devastating effect on your credit score.
  • Actual point losses can vary widely depending on your individual situation, but according to FICO:
  • Exceeding a credit card limit might lower your score by 10 to 45 points.
  • A single late payment exceeding 30 days -- 60 to 110 points.
  • Losing property to foreclosure -- 85 to 160 points.
  • Filing for bankruptcy -- anywhere from 130 to 240 points.

There are many good resources for learning more about what you can do to protect -- or repair -- your credit scores, including MyFICO.com's Credit Education Center, the FTC's Credit & Loans page, and What's My Score, a financial literacy program run by my employer, Visa Inc., which also features a free FICO Score Estimator that can help you approximate your score.

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.

To participate in a free, online Financial Literacy and Education Summit on April 4, 2011, go to Practical Money Skills.