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, potentially, it’s many times more valuable than the money it may contain. 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 personally relevant because it enables prospective lenders to glimpse your entire financial history and determine if you’re the type of person who, in the future, is likely to repay your debts on a consistent and timely basis; eventually lapse into a pattern of making late payments; or, even worse, default on your debts entirely. More importantly, credit scores not only determine whether you’ll get a loan, by fixing a borrower’s interest rate they also dictate how expensive it will be to get one. If you’ve got just one thing in common with 99% of the population at large, it’s this: someday, you’ll need to obtain money that’s conspicuously absent from your wallet and bank account. 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 convey valuable information that lenders use to evaluate and ultimately price the financial risk that they’re accepting before they extend money to hopeful borrowers. Essentially, this information is the oxygen fueling our economy. Without it, lenders large-and-small wouldn’t be able to discern who is loan worthy and what interest rates to assign would-be borrowers. Imagine the rampant economic chaos that would ensue from the sudden collapse of this essential informational framework: college loan applications would go unfunded; countless consumers would lack the wherewithal to buy cars, homes and other desired amenities; companies that manufacture and produce a wide variety of goods and services would suffer from the resulting knock-off effects of falling sales brought on by consumers dramatically curtailed purchasing power; credit card accounts would be summarily closed and businesses that depend on revolving credit lines to purchase inventory and fund payroll would flirt with insolvency. Cash strapped and credit fueled governments, to say nothing of the millions that depend on them, would be similarly hobbled. And, should such a nightmarish scenario actually occur (as it nearly did in March 2009), the many interlocking wheels and cogs that keep our economy churning along would abruptly grind to a noisy halt. It’s no exaggeration to suggest that if there weren’t a credit dispensing mechanism to help guide Adam Smith’s invisible hand in the productive and ongoing allocation of scarce economic capital, society as we know it would end. Luckily, there’s a robust and impressively dynamic information marketplace that keeps financial Armageddon at bay. In virtually real time, this complex system is driven by billions of simultaneous inputs that, in turn, correspond to consumers’ and businesses’ individual and collective economic activity. Every day, our credit scoring system maps and models countless financial transactions generated through the ongoing exchange of payment for goods and services; All of this disparate activity is analyzed and meticulously modeled by high powered computers to yield predictive insights into peoples’ future 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 fancy Italian 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. To better appreciate the dimensions of this sizable dilemma, let’s turn the tables. How much cash would you lend a prospective borrower who you don’t know and have never met before? What interest rate would you assign such an individual and what decision making criteria would you use to determine it? These are just a few of many relevant factors to consider when deciding how much money should change hands between you and a theoretical stranger. As a savvy money man (or woman), would you trustingly hand over your hard-earned capital to someone without first making reasonably certain that it’d be repaid—on time and with fair compensation in the form of interest? Probably not. And just as surely, neither would a bank.

In simpler times, before the advent of personal computers, at a time when black-and-white television was all the rage, consumers could more easily evade the unsavory consequences of a spotty credit history. This could often be accomplished by establishing a new banking relationship with another financial institution, perhaps one just across the street from the one you usually frequent. Presumably, such an entity would be blissfully unaware of a new customer’s checkered financial past. Of course, in the early 1900s, close cooperation among competing banks was something of a rarity. In today’s newly sophisticated and technologically turbo-charged financial environment, however, those days are long gone. Why? Because, like-it-or-not, the smallest details of everyone’s financial life are readily accessible to all and can be read like an open book. You see, our government has granted valuable license to three financial entities which, in turn, are collectively entrusted to gather, store, and update information reflecting the financial activities of consumers and businesses everywhere. After gathering and methodically analyzing astonishing volumes of source data, credit reporting agencies neatly compress it into a simple easy to understand numerical value. And voila! you have a credit score. As you might guess, someone with a spotty credit history– that is, anyone with a long and distinguished record of missed or late payments and perhaps a sprinkling of bankruptcies–will be warily regarded by prospective lenders as a significant credit risk. Chances are, should such an individual bother to complete and submit a loan application, their request for money would probably be denied. And if it weren’t, it’s a good bet they’d be penalized by high borrowing costs and harsh loan terms. Conversely, borrowers who’ve worked hard to establish a consistent and timely history of debt repayment will receive attractive financing terms and avoid such financial penalties altogether. 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, chances are, you’re 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, although 1984 is a fictional work published back in 1949, it’s oddly prescient in predicting one aspect of modern-day society because 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 keeping close tabs on financial records. 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 collaborate with? Banks, all levels of government, businesses, and, of course, the private sector. You see, credit bureaus are extremely well connected and their operational tentacles criss-cross the globe. It might interest you to know that Uncle Sam has a credit score, as does Canada, our good neighbor to the north. Even our very own golden state of California has one. Want to learn more about credit scores? Read on…

Are people with credit scores special? No. Anyone with an outstanding loan or revolving credit account in the form of a car payment, mortgage, student debt, credit card or cell phone has one. And, in the unlikely event you haven’t got a credit score, should you wish to acquire any of the above items under your own steam, you’ll need to get one. If you’re a student, it might help to think of credit scores as the financial equivalent of an SAT. They’re identical in the sense that people in positions of authority will use them to evaluate and compare you to others, and, ultimately, make decisions that may profoundly affect you. And while it’s true that SAT and credit scores share certain thematic similarities, there are also striking differences between them. For instance, unlike an SAT score, which, let’s face it, quickly obsolesces once you’ve graduated high school or landed your first “real” job, your credit score(s) follow you for life, will never become irrelevant, and will forever help or hinder your personal economic progress. Another key distinction between SAT and credit scores is that, unlike an SAT score, whose value, once established, is fixed for all time and space, the numerical value of 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 use to manufacture credit scores. Now, when money sloshes through cyberspace—as it frequently does nowadays thanks to the widespread use of credit cards, payment kiosks and the handling of various financial transactions on the Internet—a semi-permanent and easily traceable electronic record is created. Consequently, when credit accounts are opened or closed, debts are repaid, credit lines are tapped, or lenders report borrowers as delinquent on their loan repayments, this information invariably makes its way to a person’s credit file. Equifax, Trans Union, and Fair Isaac (the three Orwellian Big-Brother-like firms alluded to earlier) act as the custodial gatekeepers of all this information. These government sanctioned oligopolies record and update consumers’ credit file data at a rate that’s more-or-less real-time. When paid to do so, the credit bureaus will obligingly locate an individual’s, business’s or country’s credit file, systematically scan and analyze its contents, and, at the far end of a long convoluted process, produce something called a credit score.

Because each of the three credit bureaus process consumers’ credit file data on different dates, and each uses a slightly different formula that assigns different relative weights to different parts of a credit file, the numerical value of your credit score will vary (in some cases by as much as 100 points) depending on which credit bureau is asked to report it. Frankly, I find it more than a little unsettling that our government has given the credit reporting agencies exclusive license to forecast and report credit risk; and yet, after exhaustively analyzing the contents of an individual’s credit history, they (despite their alleged expertise) routinely assign such a wide variance of scores to the exact same credit file. Go figure… 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, are the de-facto gold standard of the lending industry. FICO scores range in value from as low as 300 to as high as 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. At the time of this writing, nationwide, the average FICO score is 696 and the minimum credit score needed to qualify for “prime” (meaning favorable) loan terms is 660.

But how, exactly, 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 mathematical formulas that these companies use to turn credit file data into credit scores aren’t publicly disclosed, one thing’s for sure: information that enters a credit file stays there for a very long time: seven years. Why is this particular factoid worth remembering? Well, by way of answering this question, consider the following hypothetical situation. Suppose that, to celebrate the receipt of your very first credit card, you went out on a reckless spending binge and racked up a heap of fresh debt. Now, to make this hypothetical scenario slightly more interesting, let’s say you inadvertently misplaced or lost the credit card bill(s) that subsequently arrived in the mail; or, better yet, owing to a colossal postal mix-up, suppose your credit card statement(s) never reached your mail box at all. Of course, you’d have a perfectly reasonable explanation for any resulting lapse of payment; and, if pressed for additional details, I’m sure you would happily elaborate. As equally fallible human beings, you might 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 accidentally miss a payment and are unsuccessful in getting the blemish removed from your credit file, the mistake will haunt you for seven years; all-the-while lowering your credit score. Now, you’re probably thinking, that’s an unreasonably long time for an innocent economic misdeed to harm your financial reputation–and you’re absolutely right… But this is also the tip of my point; which is why it pays to understand how credit scores work and take the repayment of your debts very seriously. Should you ignore this wise financial counsel, the joke will be on you.

But what specific actions must 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 distinct 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 disclosing this information to the public. That said, credit scores are similar to cumulative grade point averages. Initially, values are somewhat shifty and respond quickly to new incoming data. Over time, as a financial track record begins to emerge and harden, the overall average becomes steadily and progressively more difficult to change. This makes intuitive sense. After all, will a student starting the first semester of their senior year in high school be able to meaningfully change their cumulative GPA 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 over a long period of time, it becomes harder to change. This is why, when you’re establishing a credit history, it’s important to pay your debts 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, upon request, legally obligated to provide at no charge once a year, it’ll cost 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 scores are, this site is still worth perusing because it’s loaded with useful content. Last time I checked, myfico.com featured a handy chart illustrating 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 in no position to establish and build a credit history 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 credit history that will be useful to you later on. Luckily, FICO reversed an earlier ruling to drop the so-called piggy-back clause on authorized user accounts. 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 leery of unproven borrowers. Sure, people with no credit or even awful credit can still get a loan. Typically, 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 origination fees and interest rates. Nevertheless, the additional money that banks collect on these types of loans don’t necessarily translate into a more profitable transaction for lenders. Why? Because the additional revenues that are collected from sub-prime borrowers are understandably offset by disproportionately higher overall default rates. After all, a higher percentage of sub-prime borrowers will not repay their loans in full. Interestingly, the minority of debtors who struggle under difficult loan terms and avoid outright default pay for the majority of those who do. But, in exchange for paying their economic penance, so to speak, such borrowers benefit from higher credit scores and the prospect of lower future borrowing costs. You see, like any other profit driven enterprise, financial firms pass their cost of doing business onto their customers. Ultimately, this explains why individuals with a flawless credit history enjoy better loan terms in a crowded and fiercely competitive lending market. Creditors know that (based on a careful analysis of their own loan loss histories) money lent to risky borrowers is less likely to be recovered in full. Naturally, creditors compensate themselves for this added economic risk by assigning higher interest rates to less creditworthy 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 commodity. Of course, just as you’d expect to pay for using a truck that’s not yours, you’ll have to pay for borrowing someone else’s money when 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 you’ve got a shabby driving record, a few fender benders and perhaps a DUI, this will adversely affect your chances of being able to borrow a vehicle. To offset the perceived risk of loaning a vehicle to such a reckless driver, U-Haul would understandably jack- up the price of the rental. Similarly, if you’re shopping for a loan and have a terrible credit score, brace for rough economic sledding. While it’s true that those who don’t repay their debts will walk away with a bit of extra pocket change on a strictly one-time basis, they’ll end up paying many times the amount taken 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 obtaining this report online requires navigating an endless maze of diversional pop-up menus 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 periodically inspect your credit report is to alert yourself to identity theft. If your credit report contains lots 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 portrayed 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 catalogs—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, good credit is worth establishing and protecting 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 Management, 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 obligations 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 plenty of heartache–later in life.

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