Your Credit Score: What it is & Why You Need to Know

Your credit score bears a striking resemblance to a high-powered megaphone; it's always on and it loudly broadcasts to the financial world how responsible you are with money. Ironically, although your credit score isn't something you'll find 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 are rightfully yours, you should know what your credit score is, understand the factors that affect it, and be conscious of how your financial behavior (for better or worse) impacts its value.

Essentially, your credit score is just a number, but it's value is critical because it enables would-be lenders to scour your financial history and, based on a detailed analysis of the information they find, determine 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 late payments, or, worse yet, default on your debts altogether. Moreover, credit scores not only influence your chances of getting a loan, they determine what interest rate you’ll pay for the privilege of receiving one. If you have something in common with 99% of the population at large, 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.

In the world of money, credit scores provide the information that enables lenders of varying shapes and sizes to quickly and easily predict, quantify and price the level of financial risk they're accepting before lending money to consumers, governments and businesses. Were it not for the widespread availability of data to provide a clear sense of a prospective borrower's creditworthiness, financial capital wouldn't flow as smoothly as it does. Without credit scores and the information they convey, the wheels and cogs of economy would grind to a noisy halt. Case in point: ever wonder how retailers can, in mere seconds, decide who qualifies for in-store financing? Credit scores are the reason why. Put yourself in a lender’s glossy wing tips and imagine having to decide, on a case-by-case basis, who qualifies for a loan and under what terms. As a savvy money man (or woman), would you freely hand over your precious and presumably hard-earned capital to someone without first making reasonably sure it would be repaid—on time and with interest? Probably not. And just as surely, neither would a bank.

A few decades ago, consumers could easily evade the unsavory consequences of a spotty credit history. This could be accomplished by striking up a new relationship with an unfamiliar financial institution, one that's unaware of a prospective borrower's checkered financial past. Because we're living in the information age, those days are long gone. For better or worse, the lurid details of everyone’s financial life are readily accessible and they can be read in much the same way as a book pulled from the shelf of a local library. Today, a handful of large financial institutions collect, store and update consumers' financial data. After analyzing this information, they can neatly distill a person's complete financial record into a numerical score that's simple, easy to interpret, and allows would-be creditors to custom tailor loan terms that precisely reflect the overall quality of an individual borrower's financial history. Not surprisingly, a reckless borrower with a spotty credit history will be perceived as a greater credit risk, and so, will receive harsh loan terms. Conversely, people who consistently pay their bills on time and have proven themselves to be reliable in repaying their loans are rewarded with financing options that are comparatively much more attractive. Now, you’re probably wondering: “How can a financial firm, particularly one that I’ve never done business with before, possibly know so much about my financial history?”

If you’ve ever read George Orwell’s 1984, then you’ve heard of the expression "Big-Brother." It’s a term Orwell used to describe an all-knowing all-seeing entity, one that’s tasked with regulating a futuristic society. It’s more than a little eerie, then, that although 1984 is a fictional work and was written back in 1949, there's not just one but three Big Brother-like government endorsed organizations operating behind-the-scenes in our society today. It’s true; they’re out there and they're keeping meticulous tabs on the financial activities of consumers and businesses everywhere. But what are these mysterious all-powerful firms? They’re called credit bureaus… What do they do with the information that they collect? They report credit scores… What organizations do they routinely coordinate with? Banks, state and local governments, corporations, individuals and even sovereign nations. So you see, the credit bureaus are extremely well connected and their operational tentacles are everywhere. It might interest you to know that Uncle Sam has a credit score, as does Canada--our good neighbor to the north. In fact, every nation with a developed economy has one. Interested in learning more about credit scores? Read on…

Are people with credit scores special? No. Anyone with revolving debt (that is, a monthly car payment, mortgage, student loan, credit card and cell phone bill) has one. If you're an off the financial gridder who doesn’t yet have a credit score, and you aspire to someday possess one or more of the items mentioned above, you should think very seriously about getting one. If you’re a student, it might help to think of credit scores as the financial equivalent of SAT scores. There's a striking similarity between the two 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. On the other hand, though SAT and credit scores have certain things in common, there are significant differences between them. Unlike an SAT score, which, let’s face it, becomes practically irrelevant once you’ve graduated school or have entered the workforce, credit scores follow you for life, never obsolesce, and will continually help or hinder your economic progress. Another noteworthy distinction between SAT and credit scores is that, unlike an SAT score—whose value, once determined, is permanently fixed—the value of your credit scores actually fluctuates 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 contains all of the raw source data that the credit bureaus use to manufacture credit scores. When money sloshes through the electronic ether—as it so frequently does nowadays via transactions the originate on credit cards, payment kiosks, and online—an electronic record is created. So, when credit accounts are opened or closed, debt is serviced, lines of credit are tapped, or lenders report payments as delinquent, this information finds its way to a person’s credit file. Equifax, Trans Union, and Fair Isaac (the three Orwellian Big-Brother-like entities referred to earlier) are the custodial gatekeepers of this information. Collectively, these de-facto monopolies routinely add-to, monitor and update consumers’ financial data at a rate that's more-or-less in-step with consumers' real-time financial activity. When called upon to do so, the credit bureaus will obligingly locate an individual’s credit file, systematically scan and analyze its contents, and, on the far side of that intensely analytical process, produce something called a credit score.

Because each of the credit bureaus pull consumers’ credit file data at different times of month, and each uses a different approach to interpret credit file data, the magnitude of an individual's credit score will vary by as much as 100 points depending on which of the three bureaus is reporting it. Frankly, I find it more than a little peculiar that our esteemed government sanctioned credit reporting agencies can scan the exact same credit file, and yet, despite their alleged expertise when it comes to accurately evaluating and reporting credit scores, assign such a wide range of scores to the exact same person. Go figure. Anyway, BEACON is Equifax’s credit scoring system, EMPIRICA is Trans Union’s, and FICO is Fair Isaac’s. It’s also worth noting that although everyone has three different credit scores (one for each of the three credit bureaus) they all serve the same purpose: helping lenders process and evaluate prospective borrowers... FICO scores, which, for some reason have become the gold standard of the lending industry, range from 300 to 850. When it comes to interpreting a credit score—be it an EMPIRICA, FICO, or BEACON score—the higher the value the better it is. BusinessWeek once reported that only 13% of Americans have FICO scores above 800 and that, nationwide, the average FICO score is 723.

But how do the credit bureaus transform credit file data into credit scores? Much like Colonel Sander’s original recipe for tasty fried chicken, that’s a closely guarded secret. Although the complex algorithms 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, typically seven years. Why is this bit of trivia worth knowing and remembering? Well, suppose that, to celebrate the receipt of your very first credit card, you went on a giant shopping spree and happily racked up a towering heap of fresh debt. To make things interesting, suppose you accidentally misplaced the credit card bill(s) that subsequently arrived in the mail; or, better yet, let's say you didn’t receive your credit card statement(s) in the mail at all thanks to a colossal postal mix-up. Of course, you’d have a perfectly good explanation for any resulting lapse of payment, and, I’m sure, would be only too happy to elaborate if asked to do so. As equally fallible human beings, you might wrongly assume that bill collectors are blessedly charitable human beings born with a head 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 care... So long as an event is factually accurate, that’s all that matters. So, rest assured, if you accidentally miss a payment and are unable to get the resulting blemish expunged from your credit record, it will lower your credit score for seven years. Gosh, you might think that this is an awfully long time for a one innocent financial misdeed to linger on your permanent record--and you'd be right... But that's exactly the point; which is why it pays to know a little bit about how the credit scoring system works and to take repaying your debts seriously from the get-go. Even minor missteps can hurt your credit score, subjecting you to a littany of one-time fees and astronomically higher future borrowing costs.

But what can you do to transform a poor credit score into a specimen of glistening perfection? Unfortunately, there are no simple answer to this question because credit scores are calculated based on a combination 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 the remaining 30% of your overall credit score. Because creditors like to see credit-utilization rates of no more than 35 percent, it’s important to think about how your debts are structured. So, instead of maxing out a single credit card with a $1,000 limit, you might be better off trying to raise your credit limit to $3,333 and utilize less than a third of it. Expanding your credit limit, however, will lower the “length of credit history” component of your score.

But how, you might wonder, are specific scores in each of these five areas assigned? Ultimately, only the credit bureaus have this information--and they're not sharing it. Conceptually, credit scores are like cumulative grade point averages in that initial values are volatile and easy to change. Over time, however, as a track record emerges, it becomes steadily and progressively more difficult to dramatically change the overall average. Think of it this way: can a high school student who’s embarking on the first semester of their senior year graduate with a sterling 4.0 GPA if their academic performance in prior years was solidly mediocre? Of course not, and credit scores work in much the same way. Once a long-term track record is established, it becomes that much more difficult to change the overall average. So, when you’re just beginning 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 starting score—which will be easier to maintain thereafter.

Interested in knowing 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 is required by law to provide at no cost on request once a year, it costs anywhere from ten to fifty bucks to view your credit score(s). Even if you're don't want to know what your credit scores are, this site is still worth visiting because it's chalked full of other useful content. For instance, last time I checked, there was a handy chart that shows how credit scores, interest rates and borrowing costs are interrelated. As you'll see after visiting this site, the difference between a low FICO score and a high FICO score can amount to BIG money in borrowing costs over the life of a large loan—especially when it comes to big-ticket purchases like, say, a house or car. Preparing for future expenses and avoiding the crippling pinch of punatively high borrowing costs is a good reason to pay close attention to the value of your credit score now, when you're young and starting out.

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 have no immediate prospect of establishing a credit history independently, you can get a jump on the process by adding yourself to someone else's credit account. For instance, if a parent or relative were to add your name to a household utility bill, you could stealthily build a solid credit history that will be handy later on when it's needed. Luckily, FICO reversed an earlier decision to drop this piggy-back clause on authorized user accounts. So, it's worth taking advantage of this opportunity if you can. Trust me, you don’t want to discover at a time of urgent need that lenders are wary of borrowers who lack a lengthy and proven credit history. Sure, people with no credit or even awful credit can still get a loan, but, often times, they'll pay dearly for the privilege of doing so. A widely held misconception is that banks and credit card companies make higher profits on loans to risky borrowers. After all, this is an easy conclusion to jump to since risky borrowers are (and for good reason) charged far more for a loan. Nevertheless, the nose-bleed interest rates that riskier borrowers pay doesn't necessarily translate to a more profitable loan for the lender. Why? Because the hefty revenues that banks collect from subprime borrowers are largely offset by a higher overall default rate since sizeable financial losses result from a much higher percentage of risky borrowers who eventually do default. You see, just like any other profit driven enterprise, financial firms pass their cost of doing business onto their customers. Consequently, consumers with a sterling credit history enjoy significantly lower borrowing costs because lenders know that, based on careful scrutiny of loan loss histories, they're less likely to default on their loans. And so, naturally, they tend to pay less for the privilge of borrowing money.

Obviously, when debts aren't repaid, creditors get burned. Imagine walking into a U-Haul to rent a truck for an upcoming move. Naturally, you’d expect to pay something for using their truck, right? In a broadly metaphorical sense, money is much like a truck in that it's 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 getting your hands on the keys to that U-Haul truck, if it so happens that you've got a less than stellar driving record that's well seasoned with accidents and/or DUIs, this will lower your chances of obtaining that rental truck. Understandably, because of the greater perceived risk associated with loaning a truck to a reckless driver as opposed to a responsible one with an immaculate record, the truck rental company would (assuming they'd agree to do business with such a high risk customer at all) look to offset this added risk of damage to their vehicle by charging a higher rental fee. Essentially, the same logic applies to borrowing money. If you need a loan and have an awful credit score, brace for bad news. People who don't take their financial oblidations seriously may indeed walk away with a bit of extra pocket change strictly on a one-time basis, but they’ll pay dearly for their financial indiscretions in the long run because their borrowing costs will (assuming they’re lent money at all) 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 monitor your credit report year-round and for free. To access your credit report, simply go to www.annualcreditreport.com. Annoyingly, requesting your credit report online requires navigating an endless maze of pop-up menus that are designed to lure you away toward for-pay alternatives. You can sidestep these nuisances by phoning in your request directly at (877) 322-8228. It’s important to periodically inspect your credit report because missinformation in your credit file will cost you, and—trust me—errors in credit reports are depressingly common. 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 report is that it will alert you to identity theft. A credit report that's full of suspicious entries and unfamiliar transactions could signal foul play. The number of ID theft fraud victims rose by 1.8 million, or 22%, between 2006 and 2008 according to the "2009 Identity Fraud Survey Report" by Javelin Strategy & Research. So, if someone hijacks your identity and fraudulently racks up a bunch of charges on your behalf, the subsequent late payment(s) will eventually appear on your credit report and, if not paid, will start to lower your credit score as the outstanding unpaid balance become more and more delinquent. By periodically inspecting your credit reports, you can detect such anomalies and take immediate corrective action.

If you find suspicious entries 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. Sure, they’re funny, but only from a distance. Also, you can reduce your risk of ID theft by keeping unwanted credit card solicitations and other sensitive materials from cluttering your mailbox. Unless you routinely shred personal information that's been discarded, dumpster divers can ferret out this data and use it in ways that you probably wouldn't approve of. To keep credit card offers from cluttering your waste can, call (888) 567-8688. You’ll need to provide your social security number. To block catalogues—which kill trees and also provide valuable personal information—go to dmaconsumers.org. It costs a buck to remove your name from catalog mailing lists. This is especially relevant for students and young professionals because, according to Kiplinger (July 2009), "Most victims of ID theft are between the ages of 20 and 29."

And finally, though credit scores and credit reports sound very similar, they’re not. Remember, a credit report allows you a momentary snapshot glimpse of the information your credit file contains. A credit score, on the other hand, is what the credit bureaus produce after exhaustively analyzing the information in your credit file. 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 literally 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 first credit report, they’re difficult to read and accurately interpret. Although this is a source of understandable frustration for many consumers, the architecture of the system serves the credit bureaus’ interests remarkably well. After all, the density and illegibility of credit reports necessitates their involvement in the highly profitable business of examining credit files and reporting credit scores. Unlike a thick credit file, credit scores are much easier to access and understand.

Finally, though a sterling credit score is worth its weight in gold, a sterling credit score is valuable for other reasons as well. Utility-companies, cell-phone service providers, landlords and even insurance companies routinely use them to evaluate and screen prospective applicants. According to a 2006 survey by the Society for Human Resource Managment, 42% of employers, including the U.S. government, run credit checks on job candidates. And this makes perfect sense when you consider that someone who takes their financial responsibilities seriously is likely to be just as diligent in how they handle other important responsibilities. By understanding how the credit scoring system works and handling your finances responsibly, you can slowly ratchet-up the value of your credit score and save yourself a ton of money--not to mention lots of heartache—later in life.