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Understanding Credit Scores

By Jason Alderman

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 and landlords are more diligently scrutinizing your credit history to see if you're a worthwhile risk.

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. Someone with poor credit might pay an extra $100,000 in interest over the life of a typical 30-year, $300,000 mortgage.
  • Similarly, someone with a poor score might pay an additional $10,500 in interest on a 60-month, $25,000 auto loan.
  • 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.

Here are a few key concepts:

Credit bureaus. Each major credit bureau – Equifax (www.equifax.com), Experian (www.experian.com) and TransUnion (www.transunion.com) - compiles information from lenders who've extended you credit, tracking the number and types of credit accounts you use, how long they've been open and whether you've paid your bills on time.

Credit report. Upon request from you or a potential lender (and, increasingly, employers and landlords), bureaus assemble a report showing your credit history to date. Among other things, it contains a summary of open and closed accounts, outstanding balances, recent inquiries 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.

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.

You can order one free credit report a year from each bureau. (Order through the government-authorized www.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.

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 for around $15.

Many good resources share what you can do to protect – or repair – your credit scores, including the Credit Education center at www.myfico.com, the Federal Trade Commission's Credit & Loans page under "Consumer Protection" at www.ftc.gov, and What's My Score, a financial literacy program run by Visa Inc., which also features a free FICO Score Estimator that can help you approximate your score (www.whatsmyscore.org).




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 tax or financial advisor for specific information on how certain laws apply to your situation and about your individual financial situation.

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