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

Your credit score is like a high-powered megaphone. It's always on and it's loudly broadcasting to the financial world how fiscally responsible you are. Ironically, although your credit score cannot be found in your wallet, it's easily as valuable as the money it contains. Over time, your credit score can literally cost or save you many thousands of dollars. If you’re fond of money, and would like to hang onto more of the cash that's rightfully yours, you should know what your credit score is, understand what factors affect its value, and be vigilantly mindful of how your financial choices (good or bad) influence it.

Sure, a credit score is just a number; but it's magnitude is hugely important because it enables prospective lenders to delve into your financial history and, depending on what they find, determine whether you're the type of person who's likely to pay your debts in a timely and consistent fashion, eventually lapse into a pattern of making late payments, or, worse yet, someday default on your debts entirely. 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 just one thing in common with 99% of the population at large, it’s this: at some point in the not-so-distant future, you’ll need to borrow money that's conspicuously unavailable in your wallet and bank account. If and when this sobering moment arrives, the value of your credit score will be glaringly--perhaps even painfully--apparent.

In the world of money, credit scores provide invaluable information that enables lenders to determine how much financial risk they're accepting when lending money at arms length to complete strangers. In other words, if we didn't have a robust system for monitoring and evaluating economic data, lenders couldn't gauge the creditworthiness of potential borrowers and money wouldn't change hands nearly as often as it now does. No-doubt, should such a nightmare scenario actually come to pass (as it nearly did back in March of 2009), the many disparate wheels and cogs of our economy would quickly grind to a screeching halt. Under these sub-optimal circumstances, there'd be little-to-no basis for mutual trust between prospective lenders and borrowers. Without a sensible framework to guide Adam Smith's invisible hand in the allocation of scarce financial capital, millions of consumers--not to mention a few governments and plenty of corporations--couldn't go about their urgent day-to-day business. Luckily, there's a real-time information marketplace to address this problem and it's populated with millions of emotionally exhuberant and largely self-interested actors whose financial decisions and interactions collectively drive a mechanism that enables lenders to price the ongoing flow of money between lenders and borrowers. Ever wonder how gargantuan retailers like Macy's or Target can, in a matter of seconds, determine who qualifies for in-store financing? Credit scores are the reason why. Put yourself in a banker’s tassled loafers and imagine having to decide, on a case-by-case basis, who qualifies for a loan and under what terms. How much money should a particular borrower be able to borrow? What interest rate is appropriate given the overall quality of that borrower's financial track record? No-doubt, these questions should factor into your decision making process. As a savvy money man (or woman), would you lend your hard-earned capital to someone without first making reasonably sure that it'd eventually be repaid—on time and with interest? Probably not. And just as surely, neither would a bank.

Once upon a time, consumers could casually evade the unsavory consequences of a spotty credit record. This could be easily accomplished by establishing a new banking relationship with an unfamiliar financial institution, perhaps one directly across the street from the one you've worked with in the past. Presumably, this new financial entity would be blissfully unaware of a prospective borrower's past indiscretions. Of course, we now live in the 21st century and those days are long gone. Why? Because, like-it-or-not, the lurid details of everyone’s financial life are readily accessible and they can be read like an open book. Our government has granted valuable license to three financial firms which are collectively tasked with the awesome responsibility of gathering, storing and updating information pertaining to consumers' financial activities. After analyzing this immense volume of data, these companies are able to neatly compress an individual's entire financial history into a simple numerical score. The magnitude of this number is a kind of pseudo-currency because it enables creditors to tailor loan terms to each individual borrower's financial history. As you might rightly guess, someone with a dodgy credit history-- that is, a person with plenty of missed or late payments and one or more bankruptices--will be justly perceived by prospective lenders as a higher credit risk. Chances are, when this individual completes and submits a loan application, assuming they're granted the requested loan, they'll be subjected to harsh loan terms and hefty service fees. Conversely, borrowers who've established a consistent and timely track record of paying their bills and haven't defaulted on their debts will enjoy red carpet financing terms. Now, you may be wondering: “How can a financial firm, particularly one I’ve never done business with before, possibly know so much about my personal financial history?”

If you’ve ever read George Orwell’s 1984, then you’re probably familiar with the term "Big-Brother." It’s an expression Orwell uses to describe an all-knowing all-seeing entity that's tasked with overseeing a futuristic society. It’s somewhat strange that although 1984 is a fictional work and was written way back in 1949, there's not just one but three Orwellian Big Brother-like organizations operating freely 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, governments and businesses everywhere. But what are these all-powerful institutions? They’re called credit bureaus… What do they do with the information that they collect? They report credit scores… What organizations do they work with? Banks; various branches of local, state and federal government; businesses; citizens, and even sovereign countries. Clearly, the credit bureaus are well connected and their operational tentacles encircle the globe. Incidentally, it might interest you to know that Uncle Sam has a credit score, as does Canada--our likeable neighbor to the north, as does our very own Golden State of California. Want to learn more about credit scores? Read on…

Are people with credit scores special? No. Anyone with some form of revolving credit--i.e., a monthly car payment, mortgage, student loan, credit card or cell phone bill--has one. Moreover, if you're an off-the-financial-gridder who doesn’t yet have a credit score, and you wish 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 a credit score as the financial equivalent of an SAT score. They're somewhat similar because, it really doesn't matter if it's an SAT or credit score, people in positions of authority will definitely use them to make important decisions that are likely to affect your present and future quality of life. On a lighter note, although there are notable similarities between SAT and credit scores, there are also striking differences between them. Unlike an SAT score, which, let’s face it, becomes practically irrelevant once you’ve graduated high school and have landed your first "real" job, your credit score(s) will follow you for life, never obsolesce, and shall 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 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 contains all of the raw source data that the credit bureaus need to manufacture credit scores. Now, when money sloshes through cyberspace—as it so frequently does nowadays via electronic transactions involving credit cards, payment kiosks and over the Internet—an electronic record is created. When credit accounts are opened or closed, debts are repaid, lines of credit are accessed, or lenders report borrowers as delinquent on their payments, this information invariably finds its way to a person’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. These de-facto oligopolies routinely update consumers' credit file at a pace that's more-or-less in lockstep with their real-time financial activities. When asked 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 complex analytical process, produce something called a credit score.

Because the credit bureaus process consumers’ credit file data at different times of month and since each uses a slightly different formula to crunch credit file data, the value of a person's credit score can vary by as much as 100 points depending on which of the three credit bureaus is asked to report it. Frankly, I find it more than a little unsettling that our government has seen fit to give these three agencies exclusive license to model and forecast credit risk, and yet, after dutifully analyzing the contents of an individual's credit file, they can (despite their alleged expertise in this area) assign such a wide variance of scores to the exact same person. Go figure... Anyhoo, BEACON is Equifax’s credit scoring system, EMPIRICA is Trans Union’s, and FICO is Fair Isaac’s. It’s worth noting that consumers have not 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 (which, for reasons I don't understand, have somehow become the de facto gold standard of the lending industry) can range in value from 300 to 850. When it comes to interpreting a credit score—be it an EMPIRICA, FICO, or BEACON score—the higher the score, 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 recipe for tasty fried chicken, that’s a closely guarded industry secret. Although the algorithms that are used to calculate credit scores aren't publicly disclosed, one thing's for sure: information that enters a credit file stays there for a long time (typically, seven years). Why is this trivial detail worth remembering? Well, by way of an answer, suppose that you celebrated the receipt of your very first credit card by going out on a wild spending spree and racking up a fresh heap of debt. Now, to make this hypothetical scenario a little bit more interesting, suppose you were to misplace the credit card bill(s) that subsequently arrived in the mail; or, better yet, let's say that you didn’t receive your credit card statement(s) in the mail at all due to a colossal postal mix-up. Of course, you'd have a perfectly reasonable explanation for a resulting lapse of payment, and, if asked, I'm sure you'd be only too happy to 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 may feign sympathy for your plight, they don’t really care... So long as an event is factually accurate, that’s all that matters. So, rest assured, if you accidentally miss a payment or three and are unable to get the resulting blemish expunged from your record, this will lower your credit score for years to come. Now, you're probably thinking that this is an unreasonably long period of time for one innocent misdeed to tarnish your credit history--and you're absolutely right... But this is precisely the point; which is why it pays to understand how credit scores work and to make timely repayment a top priority. Should you forget, the joke will be on you. Even minor missteps can lower your credit, subjecting you to a host of punitive one-time fees and nosebleed future interest rates.

But what specific steps will transform an awful credit score into a specimen of glistening perfection? Unfortunately, there are no easy or simple answers to this straightforward question. In large part, this is because credit scores are a complex amalgamation of five different factors. 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 (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 that’s currently in use accounts for 30% of your overall score. Because creditors like to see credit-utilization rates of no more than 35 percent, it’s also important to think carefully about how your debts are structured. So, instead of maxing out a single credit card with a $1,000 limit, you might try to first raise your credit limit to $3,333 and then utilize less than a third of it. Extending your credit limit, however, will simultaneously lower the “length of credit history” component of your overall score. Like I said, it's complex.

How are specific values in each of these five categories assigned? Unfortunately, only the credit bureaus know--and they refuse to share this information with the consuming public. Credit scores are a lot like cumulative grade point averages in the sense that initial values are flexible and respond rather quickly to input data. Over time, as a financial track record emerges and hardens, it becomes steadily and progressively more difficult to change the overall average. Think of it this way: can a student who's about to begin their senior year in high school miraculously turn their academic record around and graduate with a sterling 4.0 GPA if their performance in prior years was solidly mediocre? Of course not, and credit scores operate the same way. Once a track record is established, it's much harder to change. So, when you’re starting out and beginning to establish a 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 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 credit bureaus must provide at no charge to consumers once a year upon request, 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 score values are, this site is worth visiting because it's chalked full of useful content. Last time I checked, there was a handy chart showing how credit scores, interest rates and borrowing costs are interrelated. As you'll see by browsing this site, the difference between a low FICO score and a high FICO score can amount to BIG money—especially if you're borrowing for big-ticket items like a house or car. Preparing for future expenses and avoiding the crippling pinch of high interest rates 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 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 a credit history independently, you can easily do so by adding yourself to someone else's revolving credit account. If a parent or relative adds your name to a utility bill (assuming they pay their bills on time) you'll passively build a sterling 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. For obvious reasons, 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. More often than not, however, they'll pay dearly for the privilege. A common misconception is that banks and credit card companies reap outsized profits on loans made to "risky" borrowers. This is an easy conclusion to reach since sub-prime borrowers are (and for good reason) charged higher loan fees and interest rates. Nevertheless, the additional money that banks make on such loans don't necessarily make lenders any wealthier. Why? Because the higher revenues that banks collect from less desirable borrowers are offset by financial losses resulting from a greater overall default rate. After all, a larger percentage of risky borrowers will default on their loans. You see, like any other profit driven enterprise, financial firms pass their cost of doing business onto their customers. In short, this is why consumers with an immaculate credit history receive lower borrowing costs in a fiercely competitive lending market. For the most part, lenders know that (based on a careful analysis of their loan loss histories) money that's lent to sketchy borrowers is unlikely to be repaid in full. Consequently, creditors compensate themselves for taking this economic risk by ratcheting up interest rates and imposing stiff up-front fees for those consumers who have a checkered financial past.

When debts aren't repaid, creditors get burned. Imagine walking into your local U-Haul looking for a rental truck to help a friend with an upcoming move. Naturally, you’d expect to pay something for temporary use of the truck, right? In metaphorical terms, money is like a truck in that it's a demanded commodity. Capitalism dictates that you have to pay for the privilege of using someone else's money whenever you need it. And lender's need to be fairly compensated for parting company with their hard earned capital. Think of “interest” as “rent” on borrowed money. Now; when it comes to obtaining the keys to that U-Haul truck, if you've got a shabby driving record that's has lots of accidents and/or DUIs, this will significantly reduce your chances of being trusted with someone else's vehicle. Because of the added perceived risk of loaning a rental vehicle to a reckless driver, U-Haul is likely to assess a higher truck rental fee. In a similar vein, if you're shopping for a loan with an awful credit score, brace for bad news. While it's definitely 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’ll pay dearly for welching on their debts in the long run because their borrowing costs will skyrocket. Over time, they'll probably end up paying a sizeable multiple of whatever paltry sum they scored.

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 for free. To view your credit report, go to www.annualcreditreport.com. Annoyingly, because 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, it's wise to phone in your request directly at (877) 322-8228. It’s important to periodically inspect your credit reports because they're often contain incorrect information. 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 carefully inspect your credit report is that doing so will alert you to identity theft. If your credit report has suspicious entries and 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%) between 2006 and 2008. If someone hijacks your identity and fraudulently racks up a heap of debt in your name without your consent, the eventual late payment(s) will appear on your credit report and, if unpaid, tarnish your credit score(s) as the unpaid balances grow. By periodically inspecting your credit reports, you can preemptively detect such anomalies and take immediate corrective action.

If you find suspicious entries in your credit report, notify all three credit bureaus at once. It's their job to work with you to correct and fix the problem. Trust me; you don’t want to end up as one of those vaguely befuddled looking characters on ID theft commercials. Sure, they’re somewhat funny, but only from a distance. What's more, you can reduce your risk of ID theft by preventing unwanted credit card solicitations and other highly sensitive materials from cluttering your mailbox, and later, your garbage can. If you don't regularly shred discarded personal information, dumpster divers can ferret out personal data and may use it in crafty ways that you wouldn't approve of. Call (888) 567-8688 to ward off unwanted credit card offers. You’ll need to provide your social security number. To block catalogues—which kill an unfortunate number of trees—go to dmaconsumers.org. It costs a buck to remove your name from catalog mailing lists. These precautionary measures are especially important for students and young professionals because cybercrime is on the rise and they're particularly vulnerable. 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 vaguely similar, they’re not. A credit report allows you to glimpse a momentary snapshot of the information in your credit file whereas a credit score is what the credit bureaus manufacture once they've exhaustively analyzed the information that's 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 personal credit history extends, your credit file could be as thick as a small-town phone book. Incidentally, this is why many consumers—myself included—loudly bemoan credit reports. As you’ll see after inspecting your first credit report, they’re dense, nettlesome and difficult to interpret. Although this is a source of understandable frustration for most consumers, the credit system's convoluted architecture serves the credit bureaus’ interests remarkably well. After all, the inordinate difficulty of understanding credit reports necessitates their involvement in the lucrative business of neatly distilling credit file data into a simple user friendly score.  

Although a lofty credit score is easily worth its weight in gold, outstanding credit is worth establishing for other reasons as well. Utility-companies, cell phone companies, landlords and even insurers 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 job candidates. When you think about it, this is a sensible strategy given that someone who takes their financial obligations seriously is likely to be equally diligent when it comes to handling other important responsibilities. By understanding how the credit scoring system works and managing your finances responsibly, you'll improve the value of your credit score and save yourself tons of money--not to mention plenty of heartache--later in life.