By: David K. Carboni, Ph.D.,CFPⓇ
Credit scores are increasingly important to our financial lives and yet many of us don’t realize it. Our financial transactions are closely monitored by the credit bureaus and used to determine our credit risk, otherwise known as our credit score.
A credit score affects how much interest we pay on mortgages, consumer loans, credit cards and more. The difference between a good score and a bad one can be tens or even hundreds of thousands of dollars over our adult lives. A credit score can also affect your ability to get a job, a cell phone contract, rent an apartment, or even how much we pay for insurance.
All of us must becoming an educated consumer about our credit score. A bad credit score can block you from buying a home or a car, or finding a job.And yet, the credit scoring system seems such a mystery because there’s so much confusing information out there (bad and good) that it’s hard to sort whats real from the myths.
Facts about Credit Scores:
1. All credit scores are not created equal.
2. Pay attention to the credit score called the FICO score.
Major lenders use the FICO score and about 90% of the top 100 financial institutions in the U.S. The score, based on a formula developed by the Fair Isaac Corporation, is the gold standard for measuring credit risk. FICO scores range from 300 to 850, the higher the better
The best place to get our FICO score is directly from the company at myFICO.com. If you have applied for a loan your lender can give it to you. Under federal legislation, every credit bureau is required to give consumers one free credit report per year (visit annualcreditreport.com), but not a free credit score. The major credit bureaus sell credit scores based on their own models. The closest to FICO of the three is Equifax.
Check Your Credit Score
Lenders will obtain your FICO score which rely on the credit reports from each of the big three bureaus. Your credit reports may vary somewhat with each bureau as they may not have identical data. Also, 85% of credit reports have errors, with many serious enough to affect your credit score. Unless you find these errors and take action to remove them from your credit reports, they will remain there.
That’s why its wise to check your credit reports annually because you never know when you might have to borrow money and it’s best to be prepared. If you aim to buy a house in the near future, its vital. By the way, it can take months to raise your credit score.
For most of us, buying a home is the most expensive purchase we will ever make. Getting a preferred interest rate will make a huge difference over the mortgages life. Heres an example from a year ago that shows how a credit score impacted the interest rate available on a 30-year fixed rate mortgage:
4.750% (and likely not able to be done)
Other Impacts of Your Credit Score
To get the best terms from a credit card company, you need a high credit score. Likewise, a bad credit score can get you turned down from renting an apartment or force you to pay more money up front to the landlord. Now, only seven states restrict the use of credit scores to screen job applicants. States that restrict this practice are: California, Hawaii, Oregon, Connecticut, Illinois, Maryland and Washington.
In addition to credit card records, consumer loan and mortgage payments, and collections, charge-offs and bankruptcies are also tracked by the major credit bureaus. Many of our financial dealings that used to go under the radar are now being captured by a fourth credit bureau: CoreLogic. CoreLogic tracks evictions, child support payments, payday loan applications and property tax liens. It’s being offered to mortgage and home equity lenders to screen applicants for credit risk.
How do you maintain a good credit score? The single greatest factor is payment history, which makes up 35 percent of a credit score. So pay your bills on time. The amount of debt you have is the next most important factor, making up 30 percent of a credit score. Work to keep credit balances at zero. But if that’s not possible try to keep the balance owed at no more than 30 percent of whats available.
The other factors include length of credit history, which makes up15 percent of your credit score, types of credit (10 percent), and inquiries for new credit (also 10 percent).
A few pitfalls to avoid include:
Don’t close an inactive credit card account as it could raise your overall debt-to-credit ratio and lower your credit score.
Don’t co-sign a loan unless you are prepared to risk lowering your credit score should the other person default.
Don’t max out or exceed credit card limits.
Understanding and tracking your credit score doesn’t have to be difficult. But it can reap great rewards for your financial life.