Comprehensive Guide to Credit Scores

Chances are, you have heard about credit scores and know that they are an important part of your financial life. Most people understand that a credit score matters when you apply for a loan. However, what you may not realize is that your credit score is used by insurers, cell phone providers and even employers to make decisions about you. If you want to enjoy successful personal finances, it is vital that you understand credit scores.

Credit Scoring: An Overview

The credit scoring system aims to assess what sort of financial risk you represent. Your credit score is, in a very real sense, your financial reputation. A credit score is created using information about your financial habits – specifically how you act when you borrow money. A special mathematical formula is used to come up with the number that is your credit score. Some of the information that is used to create your credit score includes:

  • Your payment history
  • How many loans you have
  • How long you have had credit
  • The length of time you have had all of your accounts
  • Collections against you (including tax liens)
  • Foreclosures
  • Bankruptcies
  • Amount of outstanding loan balances

With the help of statistical programs and mathematical formulas, your habits are compared to others’ habits. The number that results is supposed to be an indication of how likely you are to repay a debt. If you are more likely to repay a debt, as indicated by a higher credit score, you will receive a lower interest rate, and have access to better terms when it comes to insurance and other financial products and services. A lower credit score warns financial services companies that you are a bigger risk, and some may deny you in order to avoid taking the risk that they will lose money on you. If you do receive the financial products you want, you may have to pay a premium in order to help the provider reduce the cost of the risk being taken on you.

Many lenders and insurers have their own credit scoring systems. However, many of these credit scoring systems have a basis in the scoring algorithms pioneered by the Fair Isaac Company, also know as the FICO score. A credit scoring system is created when different characteristics are identified, and then assigned a specific weight. For instance, payment history is considered more important than how long you have had a specific account. The FICO score is the most famous of scoring methods. However, many banks and insurers use their own mathematical models, tweaking the FICO score to place more emphasis on certain characteristics. Some financial services providers base their models on other scoring systems (many banks use ChexSystems when deciding whether to accept an application for a deposit account), and others create their own credit scoring models.

It is important to note that under the Equal Credit Opportunity Act, any credit scoring system cannot consider the following personal characteristics when determining credit worthiness:

  • Race/Ethnicity
  • National origin
  • Marital Status
  • Sex
  • Religion

Age can be used in certain scoring systems, as long as equal treatment is giving to the elderly.

Because each credit scoring model is a little different, and because so many customized tweaks are used, it is common to have different credit scores from different financial services providers. Even so, credit scores are generally considered reliable for what they are measuring. Because a large sample size is used from all of the data on financial habits, these models are considered significant. A credit score is generally considered as a way to determine your level of financial risk to the company in a short period of time.

Weaknesses of credit scoring models: Critics of credit scoring models contend that the biggest weaknesses in credit scoring revolve around the fact that you have to borrow money in order to get a good score. This means that people who are quite financially responsible, paying with cash instead of borrowing, and using a debit card rather than a credit card, do not have good credit scores. Their credit histories are rather shallow because they don’t borrow. As a result, “consumer scoring” models are becoming more popular. However, they have yet to gain the widespread popularity and usage of credit scoring models.

Who Is Interested in Your Credit Score?

Lenders use your credit score to help them figure out how likely you are to repay your loan – and whether your payments will be on time. If your credit score is high, then you are considered to be financially responsible, and the terms you receive on loans are likely to be favorable. However, if your score is low, lenders will see you as a greater risk. You will have to pay a higher interest rate to help offset a creditor’s risk. This can cost you thousands extra over the term of a loan.

Many insurance companies also use credit scores to help determine what premiums you will pay. Someone with a low credit score might be considered a bigger risk, and may have to pay a higher insurance premium. Auto insurance companies, especially, make use of credit scores, reasoning that someone who is responsible in his or her financial life is more likely to be a careful driver.

Employers are becoming increasingly interested in the credit scores of job applicants. Some feel that a poor credit score indicates a lack of responsibility that might transfer to the job. However, there are those in certain industries that have very legitimate concerns about their applicants. Those who will handle money are often expected to have good credit scores. Additionally, those working in sensitive positions where they have access to proprietary information, or if they are working security, might be subject to a credit check. Concerns about embezzlement and bribery can lead some to red flag job applicants whose poor scores might indicate money problems that make the vulnerable.

Landlords want to measure your reliability as a tenant. In some cases, you might not be approved to live in some rentals if the landlord is concerned that you will be habitually late with rent payments, due to your credit score. Other landlords might require a higher security deposit of those with lower credit scores.

Finally, service providers might want your credit score. Satellite TV and cable companies might want to perform a credit check to determine whether you will reliable pay for their services. The same is true of cell phone service providers. Some will not approve you for plans that aren’t prepaid if you have poor credit.

Your Credit Report and Credit Scoring

One of the most important keys to any credit scoring system is your credit report. Most credit scoring models are based on the information contained in your credit report. It is your credit report that contains information about your history with loans. People and companies with whom you do business report to credit bureaus. The major credit bureaus – TransUnion, Experian, and Equifax – then compile reports about your habits. Credit card companies report your payment history, auto lenders provide details about your car loan, and others report information about your accounts to the credit bureaus. This information is then categorized, weighted, and plugged into credit score models.

Note that, because a credit scoring model is based on information in your credit report, the score is only as good as what’s in the report. Not all creditors report to every major bureau, or they may report at different intervals. Additionally, mistakes can be made on your credit report, and that can impact your credit score.

You are entitled to know what is in your credit report. The Fair Credit Reporting Act requires the three major bureaus to each provide you with a free copy of your credit report once a year. The official web site for receiving your free credit report is www.annualcreditreport.com. You are also entitled to receive your credit score from each of these bureaus for a “reasonable” fee. In most cases, this is between $7 and $10.

How To Improve Your Credit Score

Naturally, since your credit score is so important in today’s world of finances, you should strive to improve your credit score. Even though there are different credit scoring models, most of them have enough similarities in how they measure the importance of certain financial habits that you can improve your score by taking proper precautions. Here are some things that will help you improve your credit score:

  • Pay your bills on time: Since most providers of financial products and services want to know how reliably you make payments, this is often the most important factor in any credit scoring model. If you pay your bills on time consistently, you can see a higher credit score. Late and missed payments will result in a lower score. Even though some companies (such as utility companies) won’t report your on-time payments to credit bureaus, they will report your late payments. So paying on time is important even with non-credit accounts.
  • Pay off your debt: If you have a high level of debt compared to how much credit you have available, you will have a lower credit score. Pay off your debt, and many credit scoring models will reward you with a higher score.
  • Keep your oldest accounts: Because credit scoring models consider how long you have had credit, your oldest accounts can help you maintain a higher score. Many models also consider the “average age” of your accounts by adding up how long each account has been open, and dividing it by the total number of accounts that you have. Your older accounts help bring up your average.
  • Vary your account types: Credit scoring models consider the types of accounts you have. Revolving accounts, like credit cards, are those that you pay down as you go along and allow to keep borrowing as long as you remain below your limit. Installment accounts are those that you pay down over time, and that you can’t keep borrowing against. Credit scoring models reward those who have some installment accounts as well as revolving accounts.
  • Know which loans are “good”: Some credit score models also take into consideration where you are getting your loans. A loan from a bank is considered better than a payday loan. If you have a lot of payday and car title loans, some models may penalize you. A credit card branded with a major logo, such as MasterCard or Discover, is viewed more favorably than a department store credit card. When you borrow, consider the source of your funds, you are likely to see a better score.
  • Limit your credit inquiries: You are not penalized for looking at your own credit score. Nor are you penalized when marketers look at your score to decide whether to extend an unsolicited offer. However, you are penalized if you apply for credit. If you apply for several accounts in a short period of time, that can be damaging to your score.
  • Correct errors on your credit report: A significant number of credit reports – more than two-thirds – contain errors. Nearly 25% of credit reports have significant errors that can affect a credit score. Check your credit report regularly and correct errors. You can do this by notifying the credit bureau of the error, and providing documentation that proves the information should be removed or changed.

Understand that improving your credit score can take time. Promises of “quick fixes” are seldom effective in the long run. Those claiming that they can improve your score are usually scammers. By law, anything that can improve your score legally is something you can do yourself. Anyone claiming to give you “insider” help or fix your score with “secret” techniques is lying to you. There are some shady methods that can give your credit score a temporary bump, but once the methods come to light, your score can actually be hurt more in the long term.

Your best course of action is to use credit responsibly, only borrowing what you can afford to pay back quickly. Make payments on time, and concentrate on keeping debt levels low. If you only borrow what you need, and you make efforts to repay it quickly, you will likely be able to maintain a consistently high credit score over the long term.

What If My Credit Score Prompts a Negative Action?

Many people are disappointed to find that they are denied credit, or that they don’t get the interest rate they want. Others end up with a higher insurance premium because of what’s in a credit report. Anytime you are denied credit, you have the right to know exactly why. But you have to ask. So you should.

Acceptable reasons for denying you credit include a low income, or a short credit history. However, they can’t be vague, offering you information that you didn’t have enough points in the credit scoring system. You have the right to know exactly why you didn’t score enough points. Ask specifically for information on how you can improve your chances, or how you can improve your situation so that you receive better terms.

If you are denied credit based on information in your credit report, you can get a free report from the company in question if you write within 60 days. Then, if the information is incorrect, you can dispute it and have it removed, possibly earning another review of your loan application. You might also be able to argue for better terms later on, as you show improvement in your credit.

Once you know the problem, you can fix it. So it’s a good idea to ask. Educating yourself about credit, and your credit score, can help you save money, and can improve your chances of financial success.