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Your Credit Score: What it is & Why You Need to Know
Your credit score is like a high-powered megaphone that it loudly broadcasts to the world how financially responsible you are. What’s more, even though our credit score isn’t something you can tote around in your wallet, it’s easily as valuable as the money it may contain. Over the course of a lifetime, the value of your credit score could easily cost or save you thousands of dollars. If you’re fond of money (and would like to hang onto more of what’s rightfully yours) you should know what your credit score is, understand how its value is calculated, and be aware of how your financial behavior affects it.
Sure, your credit score is just a number, but it’s a critically important number because it enables prospective lenders to scour your entire financial history, and, after carefully assessing its quality, judge your creditworthiness. The value of your credit score reveals whether you’re the type of person who’s likely to repay your debts in a timely and consistent fashion, eventually lapse into a pattern of delinquent payments, or, worse yet, someday default on your debts entirely. More importantly, credit scores not only affect your chances of being granted a loan, they determine what interest rate you’ll pay for the privilege of receiving one. If you have one thing in common with 99% of the general population, it’s that someday you’ll need to borrow money. And when you do, the value of your credit score will be glaringly–perhaps even painfully–apparent.
Credit scores serve a critical purpose by enabling lenders large and small to predict, quantify, and price the degree of financial risk that they’re accepting before they lend money to consumers, governments and businesses. Simply put, were it not for the widespread accessibility of credit information and the existence of a robust credit mechanism to process the torrential flow of capital between lenders and borrowers of various descriptions and sizes, the gears and cogs of capitalism wouldn’t churn nearly as smoothly or efficiently as they do. Ever wonder how retailers can, in a matter of mere minutes, determine who qualifies for in-store financing? Credit scores are the reason why. Put yourself in a lender’s glossy wing tips and imagine being faced with the difficult quandry of having to decide which borrowers should be lent money and under what terms. As a money man (or woman) would you entrust your hard-earned capital to someone without first making reasonably certain that it would be repaid—on time and with interest? Probably not. And just as surely, neither would a bank.
Decades ago, consumers could easily evade the unsavory consequences of a spotty credit history by conveniently striking up a new borrowing relationship with an unfamiliar financial institution, one which (if all goes well) is blissfully unaware of a would-be borrower’s poor credentials. Because principles of lending have radically changed and we’re now citizens of an information age economy, those days are long gone. Consequently, the lurid details of everyone’s financial life are easily accessible and can be read like an open book. Because lenders now enjoy timely and presumably accurate access to consumers’ financial transactions and repayment patterns, they can use this information to tailor loan terms that reflect each consumer’s individualized financial history and risk profile. So, before credit is extended to a prospective borrower, a lender can quickly and easily ascertain how frequently a loan applicant has borrowed in the past; what institutions they’ve borrowed from; how much money they were lent; whether all debt(s) were eventually repaid in-full; and if all installment payments were made in a consistent and timely fashion. Now, you’re probably wondering: “How could a financial firm, particularly one that I’ve never done business with before, possibly know so much about the details of my financial history?”
If you’ve ever read George Orwell’s 1984, then you’re probably heard of the expression Big-Brother. It’s a term Orwell uses to describe an all-knowing all-seeing entity that’s tasked with micro-managing a futuristic society. It’s more than a little spooky, then, that although 1984 is a fictional work (written in 1949), there are, in fact, three Big Brother-like financial entities operating behind the scenes of our economy today. It’s true. They’re out there, and they’re keeping meticulous tabs on the financial activities of consumers everywhere. But what are these all-powerful organizations? They’re called credit bureaus… What do they do with the information they collect? They report credit scores… What organizations do they associate with? Banks, corporations, and even sovereign governments. It might interest you to know that the United States has a credit score, as does Canada, our good neighbor to the north. As a matter of fact, every nation with a modern 21st century economy has one. Interested in learning more about credit scores? Read on…
Are people with credit scores special? No. Anyone with revolving debt–i.e., a monthly car payment, mortgage, student loan, credit card, cell phone bill, etc.–has one. And if you don’t currently have a credit score, but anticipate someday needing any of the items mentioned above, you’ll need to get one. If you’re a student, it might help to think of a credit score as you would the financial equivalent of an SAT score. It’s a useful analogy because, regardless of whether it’s an SAT or credit score, people in positions of authority will use them to make important decisions about you. And though there are conceptual similarities between SAT and credit scores, there are also striking differences between them. Unlike an SAT score, which, let’s face it, quickly becomes irrelevant once you’ve finished school or have entered the workforce, credit scores follow you for life, never obsolesce, and will forever help or hinder your economic progress. Another important distinction between SAT and credit scores is that, unlike an SAT score—whose value, once determined, is fixed for all time and space—the value of your credit score(s) actually fluctuate in response to information that’s posted to your credit file.
But what, exactly, is a credit file? It’s a vast networked database, a virtual archive, if you will, that stores all of the raw source information that the credit bureaus manipulate to manufacture credit scores. When money sloshes around in cyberspace—as it so frequently does nowadays via transactions that originate from credit cards, point of sale kiosks, and online—it creates an indelible electronic record. So, whenever credit accounts are opened or closed, debt is serviced, new lines of credit are opened and accessed, or lenders report payments as delinquent, this information eventually finds its way to an individual’s credit file. Equifax, Trans Union, and Fair Isaac (the three Orwellian Big-Brother-like entities mentioned earlier) are the custodial gatekeepers of this information. They routinely add-to, monitor, and update consumers’ financial data at a pace that’s more-or-less in-step with consumers’ real-time financial behavior. When asked to do so, the credit bureaus will obligingly locate an individual’s credit file, systematically scan and analyze its contents, and, after running the numbers through their complex mathematical formulas, produce something called a credit score. Welcome to the financial Matrix, Nero.
Because each of the three credit bureaus pulls consumers’ credit file data at different times of month and each applies a slightly differentiated analytical technique to evaluate credit file data, your credit score values will naturally vary by as much as 100 points depending on which of the three bureaus is asked to report it. Frankly, I find it more than a little disconcerting that the credit rating agencies can examine the exact same credit file, and yet, despite their professed expertise in fabricating credit scores, come up with such a wide range of interpretations. Go figure. Anyway, BEACON is Equifax’s credit scoring system, EMPIRICA is Trans Union’s, and FICO is Fair Isaac’s. It’s worth emphasizing that although there are three distinct credit scoring methods (one for each credit bureau) they all serve the same basic purpose: helping lenders evaluate and screen borrowers… FICO scores, which have somehow become the de facto gold standard of the industry, range from as low as 300 to as high as 850. When it comes to interpreting the value of a personal credit score—be it an EMPIRICA, FICO, or BEACON score—higher numbers are better. BusinessWeek once reported that only 13% of Americans have FICO scores above 800 and that, nationwide, the average FICO score is 723.
How do the credit bureaus magically transform raw credit file data into credit scores? Much like Colonel Sander’s recipe for tasty chicken, that’s a closely guarded secret. Although the precise nature of the mathematical formulas that are used to calculate credit scores aren’t publicly disclosed; one thing’s for sure: information that enters a credit file usually stays there for a very long time—usually seven years. Why is this fact worth remembering? Let’s say that, to celebrate the receipt of your very first credit card, you racked up a fresh heap of debt. After that, suppose you were to accidentally misplace the credit card bill(s) that later arrived in the mail; or, better yet, because of a colosal postal mix-up, you didn’t receive your credit card statement(s) at all. Of course, you’d have perfectly good explanations for any resulting lapse of payment, and, I’m sure, would be only too happy to elaborate. As equally fallible human beings, you might mistakenly assume that bill collectors are blessedly sympathetic human beings born with a knack for understanding and a heart for forgiveness… Unfortunately, no matter how convincingly you plead your case, when it comes to repaying your debts, excuses don’t matter—not one whit. Why? Because (and don’t take this personally) creditors don’t really care… So long as an event is factually accurate, that’s all that matters. So, rest assured, if you miss a payment and are unable to subsequently get the blemish expunged from your credit file, it will adversely affect your credit score for seven years. Gosh, you might be thinking that this an awfully long time for evidence of one innocent financial misdeed to loiter on your permanent record–and you’d be right… But that’s precisely the point, which is why it’s vitally important to take your debts seriously and always pay them on time. Even minor missteps can cost you by lowering the value of your credit score and subjecting you to a litany of fees and higher loan costs on future amounts borrowed.
But what specific action steps will transform an awful credit score into a specimen of glistening perfection? Unfortunately, there are no easy answers to this simple question. In large part, this is because credit scores are a complex amalgamation of five different factors. On-time payment history accounts for 35% of your overall credit score; length of borrowing history is 15%; new credit is 10%; how your debts are allocated (that is, how much credit card vs. student loan vs. housing debt you’re carrying) is another 10%. And finally, the percentage of your maximum credit limit that’s currently in use accounts for 30% of your total score. Because creditors like to see credit-utilization rates that are lower than 35 percent, it’s important to be mindful of how your debts are structured. For instance, instead of maxing out a single credit card with a $1,000 max limit, you might consider first increasing your credit limit to $3,333 and then utilize less than a third of it. Opening a bunch of new credit accounts, however, will reduce the “length of credit history” component of your overall score.
But how, you might ask, are specific values in each of these five categories assigned? Nobody knows. Credit scores are roughly analogous to cumulative grade point averages in that, at least initially, starting values are more volatile and easy to change. Over time, however, as a track record emerges, it becomes steadily and progressively more difficult to change the overall average. Look at it this way, can a high school student who’s embarking on the first semester of their senior year graduate in a few semesters with a sterling 4.0 GPA if their academic performance in prior years was solidly mediocre? Of course not, and credit scores are conceptually similar. Once a long-term track record is established, you’ll have to work that much harder to produce a dramatic change in the value of overall average. So, when you’re starting to establish a credit history, it’s important to watch your debts closely and to always pay them on time. Doing so will set the tone for a higher credit score—which will be easier to maintain thereafter.
Want to know the value of your credit score(s)? You can view them online by going to myfico.com. Unlike your credit report, which each of the three credit bureaus must, by law, provide consumers at no charge on request once a year, it’ll cost you anywhere from ten to fifty bucks to view your credit score(s). Even if you’re not interested in knowing what the value of your credit score(s) are, this site is still worth a visit because it contains plenty of other useful information. For instance, myfico.com has a handy chart that shows how credit scores, interest rates, and borrowing costs are all interrelated. As you’ll see after exploring this site, the difference between a low FICO score and a high FICO score can amount to big bucks—especially if you have to borrow oodles of money for big-ticket purchases, like a house or car. Preparing for future expenses, and avoiding the burdensome pinch of unreasonably high borrowing costs, is a good reason to pay close attention to the value of your credit score now, when you’re young.
If you’re a high school or college student who hasn’t yet established a credit history, it pays to do so—and the sooner the better. Even if you’re financially inactive and are too young to have a credit history you can still build a positive credit record passively by adding yourself as an authorized user to someone else’s account. This way, you can indirectly benefit even if you’re not the one paying the household bills (Foruntately, FICO reversed an earlier decision to drop the halo benefits of authorized user accounts). You don’t want to discover at a time of urgent need that lenders are circumspect about lending money to would-be borrowers who lack a lengthy and proven credit history. Sure, people with no credit or even awful credit can still obtain a loan, but they’ll pay dearly for the privilege of doing so. Opinions to the contrary notwithstanding, banks and credit card companies delight in lending money to low credit quality (sometimes also referred to as subprime) borrowers. After all, financial institutions can bilk this group of borrowers and charge them exorbitant interest rates on money lent. You see, just like any other profit driven enterprise, banks and credit card companies pass their cost of doing business onto their customers. Consequently, although sub-prime borrowers who don’t default on their debts and who somehow manage to avoid buckling under the yoke of higher borrowing costs will eventually be rewarded with higher credit score(s) and lower future borrowing costs, the hefty loan premiums that subprime borrowers collectively generate aren’t necessarily pure profit for lenders because much of this money offsets the outsized financial losses that result from a disproportionately higher default rate among riskier borrowers. Consumers with sterling credit scores, however, enjoy significantly lower borrowing costs because lenders know that this group is less likely to default, and so, charges them less for money borrowed.
Obviously, when borrowers welsh on their debts, creditors get burned. Imagine walking into a U-Haul to get a rental truck to help a friend with an upcoming move. Naturally, you’d expect to pay something for the use of the truck, right? Money, much like a truck, is a commodity. You’ve got to pay up for the privilege of using it whenever you need it. Think of “interest” as “rent” on borrowed money. Now; when it comes to walking out the door with the keys to that U-Haul truck, if it turns out that you’ve got a less than stellar driving record that’s generously garnished with a string of accidents and/or DUIs, this will impair your chances of obtaining the keys to that rental truck. Because of the greater perceived risk of loaning a vehicle to such a reckless driver, the rental company would (assuming they would decide to do business with such a person) probably charge an unaffordably steep rental fee. The same logic applies to borrowing money and establishing a reliable repayment history. If you’re shopping for a loan and have a poor credit score, then brace for bad news. People who don’t take their debts seriously may feel that they’ve gained the upper hand and have hit the jackpot, but, in time, they’ll pay dearly for their fiscal indescretions because their borrowing costs (assuming they’re lent money at all) will soar.
When it comes to monitoring your credit, it’s best to stagger your credit report requests to Experian, Equifax, and Trans-Union once every four months. This way, you can track your credit report year-round and for free. To obtain your credit report, go to www.annualcreitreport.com. Annoyingly, requesting your credit report online requires navigating an endless maze of pop-up menus which are designed to lure you away toward for-pay alternatives. You can sidestep these nuisances by phoning in your request at (877) 322-8228. It’s important to inspect your credit report periodically because mistakes will cost you, and—trust me—errors in credit reports are common. In fact, according to the Public Interest Research Group www.uspirg.org, “25% of the credit reports they surveyed contained serious errors that could result in the denial of credit, such as false delinquencies or accounts that did not belong to the consumer.” Another reason to inspect your credit repotr is that it can alert you to identity theft. A credit report that’s riddled with suspicious entries and unfamiliar transactions could signal foul play. If someone hijacks your identity and racks up a bunch of fraudulent charges on your behalf, the subsequent late payment(s) will ultimately appear on your credit report and will gradually reduce your credit score. By proactively inspecting your credit reports, you can take immediate corrective action should the need arise.
If you find anything suspicious in your credit report, notify all three credit bureaus at once. They’ll work with you to correct and contain the problem. Trust me; you don’t want to end up as one of those vaguely befuddled looking characters portrayed in ID theft commercials on TV. Sure, they’re funny, but only from a distance. Also, you can reduce the risk of ID theft by keeping unwanted credit card solicitations from cluttering your mailbox. According to Kiplinger (July 2009), “Most victims of ID theft are between the ages of 20 and 29.” So, unless you regularly shred sensitive information that arrives in the mail, dumpster divers can ferret out this data and use it in ways that you probably wouldn’t approve of. To ward off unsolicited credit card offers, call (888) 567-8688. You’ll need to provide your social security number. To block unwanted catalogues—which eliminate trees and also reveal valuable personal information—go to dmaconsumers.org. It costs a buck to remove your name from catalog mailing lists.
And finally, though credit scores and credit reports sound curiously alike, they’re not. Remember, a credit report allows you to glimpse the information that your credit file contains. A credit score, on the other hand, is what the credit bureaus are paid to provide after applying their sordid analytical techniques to the information that your credit file contains. Rest assured, if inaccurate information enters your credit file, it can and most likely will lower your credit score.
Depending on how far back your credit history extends, your credit file could be as thick as a small-town phone book. This explains why most consumers—myself included—bemoan credit reports. As you’ll see after inspecting your very first credit report, they’re unwieldy and difficult to interpret. Although this is a source of understandable frustration for most consumers, the byzantine way that this information is presented serves the credit bureaus’ interests remarkably well. After all, the density and unintelligibility of credit reports necessitates their involvement in the profitable business of examining credit files and distilling the information they contain down to an unambiguous and easy to understand numerical score. Unlike a thick credit file, credit scores are easy to work with.
Finally, though a sterling credit score is easily worth its weight in gold, a good credit score is worth having for other reasons as well. Employers, utility-companies, cell-phone service providers, landlords, and even insurance companies use them to evaluate and screen prospective applicants. After all, someone who takes their financial responsibilities seriously is likely to be every bit as diligent about handling other important obligations. By understanding how the credit scoring system works and handling your finances in a consistently responsible manner, you can ratchet up the value of your credit score and save a heap of money—not to mention lots of heartache—later in life.