January 30, 2007 > Understanding credit scoring can save you money, hassles
Understanding credit scoring can save you money, hassles
By Jason Alderman
There's a lot of confusion around credit reports and credit scores - what they're used for, how they're calculated and why they're so important if you want to buy a car or house. Lenders, insurers and even employers review your credit history to decide if you're a worthwhile risk, so here's some background information that may help demystify the whole credit scoring process:
Credit bureaus. There are three major credit bureaus: Equifax ( www.equifax.com ), Experian ( www.experian.com ) and TransUnion ( www.transunion.com ). Each tracks how many and what types of credit cards and loans you have, how long your accounts have been open and whether you've paid your bills on time.
Credit report. Upon request from you or a potential lender, a credit bureau will compile a credit report - basically a snapshot of your credit history at that moment. You can order one free credit report a year from each of the three bureaus. (Order through www.annualcreditreport.com; otherwise you'll pay a small fee.) They are required by law to investigate any disputed item and correct inaccuracies.
It's wise to order a free report from one of the bureaus every four months; that way, you'll keep regular, year-round tabs on what's being reported about you. Another tip: If you're planning to borrow to make a major purchase, order your credit reports beforehand so you'll know what lenders will see about your credit history.
It's vital to know what's in your credit reports so you can spot fraudulent activity or errors before they damage your credit standing. For more information on what to do if you suspect identity fraud, go to Practical Money Skills for Life, a free personal financial management site sponsored by Visa USA (www.practicalmoneyskills.com/security).
Credit scores. Credit bureaus use information in your credit report to create a three-digit credit score. The higher your score, the better your credit rating is. The most commonly used credit scores are called FICO scores, named for Fair Isaac Corporation (FICO), which developed the proprietary software.
Five factors are used to determine your FICO score: payment history, amount owed, length of credit history, newly opened credit accounts, and types of credit used. Scores take into consideration information in all five categories, both positive and negative, but may weigh them differently depending on your individual circumstances.
When you apply for credit or a loan, lenders evaluate one or more of these bureaus' scores along with their own criteria (which may include income, length of employment or other factors), to determine if you are a worthy credit risk. Your overall credit score may affect not only whether or not you get the loan, but also the amount, term length and interest rate.
The differences between excellent, good, fair and poor credit scores can really add up. For example, someone with a top-notch FICO credit score - say above 720 - might qualify for a mortgage rate one or more percentage points lower than someone with poor credit. For a typical 30-year, $200,000 mortgage, this could add up to an extra $50,000 in interest payments over the life of the loan.
For more information on how credit reports and credit scores work - and to purchase a copy of your score - go to www.myfico.com. Remember, it's always a good idea to know what's in your reports ahead of time so you can correct errors before they harm your credit rating.
Jason Alderman directs the Practical Money Skills for Life program for Visa USA. Further information on credit reports and repairing bad credit can be found at www.practicalmoneyskills.com. As always, consult a financial professional regarding your particular situation.