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

A credit score is like a high-powered megaphone. Only, it doesn't have an off switch and it's loudly broadcasting to the financial world how financially responsible you are. Although your credit score isn't something you'll find in your wallet, it could be many times more valuable than the money it contains. Fact is, over the course of a lifetime, 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 those dollars that are rightfully yours, you should know what your credit score is, understand what factors affect its value, and be aware of how your financial choices (good or bad) influence it.

Sure, a credit score is a number, but its magnitude is hugely relevant because it enables lenders to thoroughly analyze your entire financial history and use this information to determine if you're the type of person who's likely to repay your debts in a consistent and timely manner; eventually lapse into a pattern of making late payments; or, worse yet, eventually default on your debts entirely. More importantly, credit scores not only determine whether you'll get 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, it’s this: someday, you’ll need money that's conspicuously absent from your wallet and bank account. When and if this moment comes, the value of your credit score will be glaringly--perhaps even painfully--apparent.

In the world of money, credit scores provide valuable information that enables creditors to determine how much financial risk they're taking before lending money to would-be borrowers. Essentially, this information is the oxygen that our economy needs to function. Without it, lenders large-and-small would be unable to determine who is loan worthy. Creditors would be flying blind and would have no basis for pricing and evaluating borrowers' default risk. Imagine the far-reaching economic chaos that would result if such an informational framework were to suddenly disappear: college loans wouldn't be funded; millions of consumers would lack the purchasing power to buy cars, homes and other necessities; companies that manufacture goods and provide services would suffer from falling sales; credit card accounts would be closed and businesses that rely on external funding to purchase inventory and issue payroll checks would teeter on the brink of insolvency. Cash strapped and credit fueled governments, to say nothing of the millions depending on them, would be financially crippled. Should such a nightmarish scenario actually occur (as it nearly did in March 2009), the many interlocking wheels and cogs that keep our economy frantically churning would grind to a screeching halt. Were it not for a credit dispensing mechanism to guide Adam Smith's famous invisible hand in the productive allocation of scarce yet vitally necessary monetary capital, society as we've long known it would end... Because people and institutions would lack the money needed to go about their urgent day-to-day business. Happily, there's a vast and remarkably dynamic information marketplace that keeps this problem at bay. It's driven by hundreds of millions of simultaneous inputs that, in turn, correspond to consumers' and businesses' individual and collective economic activity. Every day, billions of financial transactions take place as goods and services are bought and sold; in a virtual yet increasingly real sense, they're mapped, analyzed and modeled to yield predictive insights into consumers' economic behavior.

Ever wonder how big retailers like Macy's or Target can, in mere seconds, decide who qualifies for in-store financing? Credit scores are the reason why. Put yourself into a banker’s tassled loafers and imagine having to evaluate, on a case-by-case basis, who qualifies for a loan and under what terms financing should be extended. The mind boggling scale and complexity of this seemingly simple task is such that, by and large, people don't make these choices; computers and software programs do. How much cash would you lend a borrower in need who you don't know and have never met? What interest rate would you assign such an individual and what decision making criteria would you use to establish it? These are just a few of many relevant factors to consider in deciding if and how much money should change hands between you and a hypothetical stranger. As a savvy money man (or woman), would you feel comfortable handing over your hard-earned capital to someone without first making reasonably certain that it'd be repaid—on time and with interest? Probably not. And just as surely, neither would a bank.

In simpler times, before the advent of personal computers and back when black-and-white television was all the rage, consumers could more easily evade the unsavory consequences of a spotty credit history. This could be easily accomplished by establishing a banking relationship with a new and unfamiliar financial institution, perhaps one just around the corner or across the street from the bank that had been previously patronized. Presumably, this new financial entity would be unaware of a new customer's checkered financial past. Of course, in the mid 1900s, open and honest communication among competing banks was rare. In today's robust and technologically turbo-charged economy, however, those days are long gone. Why? Because, like-it-or-not, the sordid details of everyone’s financial life are readily accessible and can be read like an open book. You see, our government has granted valuable license to three financial entities which, collectively, are tasked with gathering, storing and updating information pertaining to consumers' and businesses' day-to-day financial activities. After gathering and analyzing this immense volume of data, these companies neatly and methodically compress it into a simple numerical score. This byproduct, a credit score, is a kind of pseudo-currency in itself because creditors use it to design loan terms that are customized to each individual borrowers' financial history. As you might guess, someone with a poor credit history-- that is, anyone with a stringof missed or late payments and one or more bankruptices--will be rightly regarded as a significant credit risk. Chances are, should such an individual bother to complete and submit a loan application and receive a requested loan, they'll be subjected to unfavorable loan terms, higher borrowing costs and various up-front fees. On the other hand, borrowers who've established a consistent and timely history of paying their bills and have never defaulted on a loan will receive better financing terms and avoid these costly penalties. Now, you may be asking yourself: “How can a financial institution, particularly one I’ve never done business with before, possibly know so much about my personal financial history?”

If you’ve read George Orwell’s 1984, then you’re probably familiar with the expression "Big-Brother." It’s a phrase Orwell uses to describe an all-knowing all-seeing entity that's tasked with regulating a futuristic society. Eerily, even though 1984 is a work of fiction and was written long ago (1949), it so happens that there's not just one but three Orwellian Big Brother-like organizations operating behind the scenes of our economy today. It’s true, they’re out there. And they're closely monitoring and reporting on all things financial. But what are these mysterious all-powerful firms? They’re called credit bureaus… What do they do with the information they collect? They report credit scores… What organizations do they coordinate with? Banks, all levels of government, businesses and private citizens. You see, credit bureaus are extremely well connected and their operational tentacles encircle the globe many times over. It might interest you to know that Uncle Sam has a credit score, as does Canada, our neighbor to the north. Even our golden state of California has one. Want to learn more about credit scores? Read on…

Are people with credit scores special? No. Anyone with a large and outstanding loan, revolving line of credit, car payment, mortgage, student debt, credit card or cell phone bill has one. And, in the unlikely event that you don't have a credit score, should you someday wish to acquire any of the items listed above, you'll need to get one. If you’re a student, it might help to think of a credit score as the financial equivalent of an SAT score. They're identical in the sense that SAT and credit scores are important indicators that people in positions of authority will use them to evaluate your standing relative to others and, ultimately, make major decisions about you. On a lighter note, though SAT and credit scores are alike in some ways, there are striking differences between them. Unlike an SAT score, which, let’s face it, becomes practically irrelevant once you’ve graduated high school or have landed your first "real" job, your credit score(s) follow you for life, never obsolesce, and will forever help or hinder your economic progress. Another key distinction between SAT and credit scores is that, unlike an SAT score—whose value, once determined, is fixed—your credit score(s) constantly change in value depending on what information is 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. Now, when money sloshes through cyberspace—as it frequently does nowadays since most financial transactions are electronically processed with credit cards, payment kiosks and the Internet—a semi-permanent and easily traceable record is created. So, when credit accounts are opened or closed, debts are repaid, credit lines are accessed, or lenders report borrowers as delinquent, this information eventually makes its way to a person’s credit file. Equifax, Trans Union, and Fair Isaac (the three Orwellian Big-Brother-like firms mentioned earlier) act as the custodial gatekeepers of this information. These de-facto oligopolies are responsible for monitoring and updating consumers' credit file data at a pace that's more-or-less in step with their real-time financial activity. When paid to do so, the credit bureaus will obligingly locate an individual’s credit file, systematically scan and analyze its contents, and, on the far end of a long convoluted process, produce something called a credit score.

Because each credit bureau evaluates consumers’ credit file data at different times of month, and each uses a different formula to process credit file data, the value of a person's credit score can vary by as much as 100 points depending on which credit bureau reports it. Frankly, I find it more than a little upsetting that our government has awarded these institutions exclusive license to forecast and report credit risk; and yet, after crunching an individual's credit file, they (despite their alleged expertise) can assign such a wide range of scores to the exact same person. Go figure... Anyhoo, BEACON is the name of Equifax’s credit scoring system, EMPIRICA is Trans Union’s, and FICO is Fair Isaac’s. It’s worth noting that consumers have not just one but three credit scores (one for each credit bureau). But they all serve the same generic purpose: helping lenders size-up potential borrowers... FICO scores, for reasons I don't understand, have become the de facto gold standard of the lending industry. They are the most frequently cited and range in value from 300 to 850. When it comes to interpreting the value of a credit score—be it an EMPIRICA, FICO, or BEACON score—the higher the number, the better it is. BusinessWeek once reported that only 13% of Americans have FICO scores above 800. Nationwide, the average FICO score is 696 and the minimum credit value to qualify for "prime" (meaning favorable) consumer loans is 660.

But how do the credit bureaus transform credit file data into credit scores? Much like Colonel Sander’s recipe for tasty chicken, that’s a closely guarded secret. Although the algorithms that are used to spin credit file data into 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 detail worth remembering? Well, by way of an answer, consider the following hypothetical scenario. Suppose that, to celebrate the receipt of your very first credit card, you went binge spending and racked up a heap of fresh debt. Now, to make this hypothetical situation slightly more interesting, let's say you inadvertently misplaced or lost the credit card bill(s) that subsequently arrived in the mail. Better yet, owing to a colossal postal mix-up, suppose your credit card statement(s) never arrived in the mail at all. Of course, you'd have a perfectly reasonable explanation for any resulting lapse of payment; and, if pressed for relevant details, I'm sure you'd happily elaborate. As equally fallible human beings, you might wrongly assume that creditors are blessedly charitable human beings born with a head for forgiveness and a heart for understanding… Unfortunately, no matter how convincingly you plead your case, when it comes to repaying your debts on time, excuses don’t matter—not one whit. Why? Because (and please, don’t take this personally) lenders don’t care... So long as an event is factually accurate, that’s all that matters. So, rest assured, if you miss a payment here or there and are unable to get the blemish removed from your credit file, it will lower your credit score for years to come. Now, you're probably thinking, that's an unreasonably long amount of time for one innocent economic misdeed to stain a credit record--and you'd be absolutely right... But that's precisely the point; which is why it pays to understand how credit scores work, take your debts seriously from day one, and make timely repayment a top priority. If you don't heed this sage financial advice, the joke will be on you. Even minor missteps can dent your credit score, subjecting you to punative one-time fees and nosebleed interest rates on future amounts borrowed.

But what specific actions can you take to transform an awful credit score into a specimen of glistening perfection? Unfortunately, there are no simple or easy answers to this straightforward question. In large part, this is because credit scores are calculated based on consumers' financial history in five different areas. On-time payment history accounts for approximately 35% of your overall credit score; length of borrowing history is 15%; new credit is 10%; how your debts are allocated (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 being utilized accounts for 30% of your overall score. Because creditors like to see credit-utilization rates of no more than 35%, it’s worth considering how your debts are structured. So, instead of maxing out a single credit card with a $1,000 limit, you might consider trying to raise your credit limit to $3,333 and use less than a third of it. Extending your credit limit, however, will adversely affect the “length of credit history” component of your overall score. Like I said, it's a complex financial alchemy and all five factors are used to calculate the value of your credit score.

But how are numeric values in each of these five areas determined? Unfortunately, only the credit bureaus know--and they aren't sharing this information with the public. That said, credit scores are similar to cumulative grade point averages. Initially, values are volatile and extremely sensitive to incoming data. Over time, as a financial track record emerges and begins to harden, the overall average becomes steadily and progressively more difficult to change. This makes sense. After all, will a student who's beginning their senior year in high school be able to turn their cumulative GPA around and graduate with a sterling 4.0 if, in prior years, their academic performance was solidly mediocre? Of course not, and credit scores operate the same way. Once a weighted average is established, it's hard to change. So, when you’re establishing a new credit history, it’s important to watch your debts closely and to pay them on time. Doing so will set the tone for a higher starting credit score—which will be easier for you 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 the credit bureaus are, upoin request, legally obligated to provide at no charge once a year, it costs anywhere from ten to fifty bucks to view your credit score(s). Even if you're not interested in knowing what your credit scores are, this site is still worth browsing because it's loaded with useful content. Last time I checked, myfico.com featured a handy chart showing how credit scores, interest rates and borrowing costs are interrelated. As you'll see after browsing this site, the difference between a low FICO score and a high FICO score can easily amount to BIG money—especially if you need to borrow for big-ticket items like a house or car. Preparing for future expenses and avoiding the crippling pinch of higher borrowing costs is a good reason to start paying close attention to the value of your credit score(s) now, when you're young and just starting out.

If you’re a high school or college student, and haven’t yet established a credit history, it pays to do so—and the sooner the better. Even if you're unable to establish and build a solid credit history right now, you can add yourself to a friend or family member's credit account. For instance, if a parent or relative added your name to their household utility bills (assuming, of course, they pay on time) you'll passively build a positive credit history that will come in handy later on. Luckily, FICO reversed an earlier ruling to drop the so-called piggy-back clause on authorized user accounts. Obviously, 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 reluctant to deal with unproven borrowers. Sure, people with no credit or even awful credit can still get a loan. Often times, though, they'll pay dearly for the privilege. A common misconception is that banks and credit card companies reap outsized profits for lending money to "risky" or "sub-prime" borrowers. This is an easy conclusion to reach since such borrowers are (and for good reason) charged higher loan fees and interest rates. Nevertheless, the additional money that banks collect on these types of loans don't necessarily result in a more profitable transaction for lenders. Why? Because the outsized revenues that's collected from sub-prime borrowers are offset by disproportionately higher default rates. After all, a higher percentage of sub-prime borrowers won't repay their loans. In any high risk loan portfolio, it's the minority of debtors who struggle under difficult loan terms and avoid outright default that pay for the majority of those who do. But, in exchange for paying their economic penance and satisfying burdensome loan terms, such borrowers benefit from higher credit scores. You see, like any other profit driven enterprise, financial firms pass their cost of doing business onto their customers. Ultimately, this is why those with a flawless credit history enjoy lower borrowing costs in a fiercely competitive lending market. Creditors know that (based on a careful analysis of loan loss histories) money lent to risky borrowers is unlikely to be recovered in full. Naturally, creditors compensate themselves for this added economic risk by ratcheting up interest rates and imposing stiff up-front fees on subprime borrowers.

Imagine walking into a U-Haul for a rental truck to help a friend with an upcoming move. Naturally, you'd expect to pay something for the temporary use of a truck, right? Metaphorically speaking, money is like a truck. It's a useful and commonly needed resource. Of course, just as you'd expect to pay for using a truck that's not yours, you'll have to pay to borrow money whenever you need it. Think of “interest” as “rent” on borrowed money. Now; when it comes to obtaining the keys to that U-Haul truck, if it turns out that you've got a shabby driving record, a few fender benders and a DUI, this will adversely affect your ability to borrow a vehicle. Chances are, to offset the extra risk of loaning a vehicle to a reckless driver, U-Haul would aggressively jack- up the price of the rental. Similarly, if you're shopping for a loan and have a terrible credit score, brace for bad news. While it's true that those who don't repay their debts may walk away with a bit of extra pocket change on a one-time basis, they’re going to pay many times the amount they walked away with in the long run because their future borrowing costs will skyrocket. 

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 history year-round and for free. To view your credit report, go to www.annualcreditreport.com. Annoyingly, because requesting your report online requires navigating an endless maze of diversional pop-up menus that are designed to lure you toward for-pay alternatives, it's best to phone in your request directly by calling (877) 322-8228. It’s important to periodically inspect your credit reports because they're often riddled with mistakes. 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 doing so will alert you to identity theft. If your credit report is full of suspicious entries or unfamiliar transactions, this could signal foul play. According to the 2009 Identity Fraud Survey Report by Javelin Strategy & Research, the number of ID theft fraud victims rose by 1.8 million (22%) from 2006 and 2008. If someone hijacks your identity and fraudulently racks up a heap of debt in your name, the eventual late payment(s) will appear on your credit report, and, if unpaid, will lower your credit score(s) as the unpaid balances mount. By carefully inspecting your credit reports, you can preemptively detect such anomalies and take immediate corrective action.

If you find suspicious entries in your credit report, be sure to 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 bewildered looking characters portayed in ID theft commercials on TV. Sure, they’re comical, but only from a distance. Also, you can reduce the risk of ID theft by keeping unwanted credit card solicitations from cluttering your mailbox, and later, garbage can. If you don't routinely shred sensitive and discarded personal information, dumpster divers can ferret out this data and use it in innovative ways that you probably wouldn't appreciate. Call (888) 567-8688 to prevent unwanted credit card offers. You’ll need to provide your social security number. To block commercial catalogues—which waste lots of trees—go to dmaconsumers.org. It costs a buck to remove your name from catalog mailing lists. These precautionary measures are vitally important for students and young professionals because cybercrime is on the rise and this demographic is especially vulnerable. According to Kiplinger (July 2009), "Most victims of ID theft are between the ages of 20 and 29."

Finally, though credit scores and credit reports sound similar, they’re not. A credit report allows you to momentarily glimpse whatever information your credit file contains. A credit score, however is what the credit bureaus produce after they've processed and analyzed your credit file information. Depending on how far back your credit history extends, your credit file could be as thick as a small-town phone book. Which is why many consumers—myself included—bemoan credit reports. As you’ll see after inspecting your first credit report, they’re unwieldy and difficult to interpret. Although this is a source of understandable frustration for many consumers, the way the system is rigged serves the credit bureaus’ interests remarkably well. After all, the difficulty of interpreting credit reports necessitates their involvement in the lucrative business of distilling credit file data into unambiguous user friendly credit scores.  

Although a lofty credit score is easily worth its weight in gold, outstanding credit is worth establishing and maintaining for other reasons as well. Utility companies, cell phone service providers, landlords and some insurance companies 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 prospective applicants. When you think about it, this is a sensible screening criterion because those who take their financial oblifations seriously are likely to be equally diligent about handling other important responsibilities. By understanding how credit scores work and responsibly managing your finances, you'll increase the value of your credit score(s) and save yourself lots of money--not to mention pllenty of heartache--later in life.