What is a Credit Score and How Does it Affect Me?

What is a Credit Score?

You’ve heard of a credit report, but you don’t understand what a credit score is. Furthermore, you’re unsure as to how this affects you when applying for a new credit card. A credit score is a sum that is determined by lenders using a mathematical formula and is derived from information taken from your credit report. This sum is an indicator of how likely you are to repay your loans. In other words, this is how lenders determine if you are a risk for lending money to or if are going to be an ideal creditor who will pay your bills on time and in full.

Lenders have been using credit scores as part of the lending decision for over 20 years. There are several factors the can influence your credit score:

• How you paid previous debts
• How much you still owe to other creditors
• How long you have had credit (length of credit history)
• Number of bankruptcies, charge-offs, and collections
• Current available credit

When all this information is factored together, the lenders determine your overall credit score.

How does my credit score affect me?

A credit score is just a number; however, it is a very important number. It is a vital indicator of your financial health, in the same way that your cholesterol number is just a number until you realize the significance that number has on your overall health. To avoid a financial heart attack, it is important to become familiar with your credit report and to rectify any mistakes or errors that could negatively impact your credit score.

Lenders use credit scores to:

• Determine creditworthiness (whether or not they will give you the loan)
• What Annual Interest Rate (APR) to charge on credit cards

A good credit score can help you get prime rates that will save you money over the long run. A not so good credit score, on the other hand, could cause you to receive an APR that is a couple of points above the prime rate, which will cost you a lot more money over the long haul.

What is a "good" credit score?

Generally, the higher the score, the better. Each lender determines what their “good” credit score range is and what constitutes a risk. Therefore, it is best to discuss with the lender what their criteria for credit scoring is and how this could affect your application.

If you have additional questions about credit scores and how they relate to your personal financial situation, contact a financial advisor or a loan professional.

What Makes Up Your Credit Score?

If you have ever wandered how the credit bureaus come up with your credit score you are not alone. It is one of the more arcane things in shadows of the financial world. You may have heard about how certain actions or behaviors, like being late with a credit card payment or having too many cards in your wallet, can negatively affect scores. But, that's only a small piece of the puzzle.

There is, in fact, a very definitive algorithm that goes into making up a credit score or “Fico” score. Even the term Fico is enigmatic, for that matter. But it actually is just an acronym that stands for “Fair Isaac Company”, the company that originally developed the credit scoring methodology.

While the exact recipe of the credit score is a tightly guarded trade secret, there are some general guidelines that comprise the final numbers. Listed below are the financial behaviors and related factors along with the percentage weighting that each contributes to an overall credit score:

• 35% - An individual's history of making credit payments on time
• 30% - The total amount of debt being carried along with available credit
• 15% - The age of an individual's open credit lines (more history is better)
• 10% - The frequency with which someone applies for new credit
• 10% - Wild card factors such as the types of credit lines

In general, most of the factors that influence credit scores are within the power of consumers to change for the better. All it takes is a consistent dose of financial self-discipline to always make payments on time, not carry too much debt on any one credit card, don't close older accounts unless absolutely necessary and use discretion when applying for new credit.

If you are curious about your current credit score, you can obtain a free copy once per calendar year. Simply click here for articles about obtaining your credit report or click here to order your free annual credit report.

Credit Scores For Dummies

If you are somewhat or completely confused by credit scores (often called FICO Scores), you are not alone. In fact, you are probably part of the majority that finds themselves befuddled by how credit bureaus compile, calculate and use these scores to determine your creditworthiness - often with the input of credit card companies and other creditors.

A credit score is simply a numeric value that has been assigned to your historical credit habits. The original company that pioneered the creation of this score is called Fair Isaac and Company, which forms the acronym "FICO".

The combination of credit bureaus, credit card issuers and massive databases that warehouse consumer data means that virtually every American now has a FICO score. And, this score is vital to determining whether a person can access low-cost credit, something more expensive or even not being able to get new credit at all.

In general, the higher the score, the lower the interest rate a person will have to pay on a new credit card or consumer loan. Conversely, a lower score will translate to higher interest and less desirable terms.

FICO credit scores can range anywhere from a low of 300 all the way up to 850. Lenders generally segment scores into six ranges for the purpose of determining to whom they will make credit offers and at what terms. Anyone below the sixth tier can usually only obtain credit from a sub-prime credit card lender at very high interest rates. Listed below are the six average credit score ranges used by many of the nation's largest credit card, mortgage and auto lenders:

• 720 – 850
• 700 – 719
• 675 – 699
• 620 – 674
• 560 – 619
• 500 - 559

Individual banks solely determine the credit terms that they offer to each FICO score tier, but in general the best offers go to the top tier. Many of the top credit card issuers specialize in super-prime lending, meaning they target consumers with these tier 1 credit scores. However, competition among the largest issuers could allow those in lower tiers to be considered for leading offers, like those that feature 0% APR introductory rates.

Credit Card Users Need Not Strive for Perfect Credit

Most consumers probably know that credit card applications are approved or denied on the basis of their credit score, that all-important number with a huge bearing on your ability to borrow money. While many of us wish our credit score was higher, experts suggest there is not much reason to concern yourself with striving in vain for a perfect score, particularly if your credit score is already excellent.

For starters, even those people who are exposed to lots of credit scores have to admit perfect scores are very, very rare -- if they are ever seen at all. With the popular FICO score, the range goes from a very poor 300 all the way up to a perfect 850. But even the vice president of public education at Experian, one of the three major credit bureaus, acknowledges that she has never seen an 850.

Rather, she notes that the majority of high scores peak at about 825. As a result, your time may be better spent looking for the Loch Ness Monster or Bigfoot rather than hoping to catch a glimpse of a perfect credit score.

Another reason why credit card users need not struggle to hit the top end of the credit score range is practical -- they just aren't going to see much benefit going from excellent to perfect. Washington, D.C.-based advocacy group Consumer Action explains that consumers who improve their credit score from a 775 to an 850 will not see a difference in their rates.

Therefore, if you are able to get a fair interest rate and enough credit when you apply for credit cards, there are other things to focus your energies on as opposed to battling to get your credit score even higher. For example, try alphabetizing the items in your refrigerator.

However, for those of us who have been denied a credit card or loan due to credit scores below the high 700s, there are ways to get your score up that you may or may not have heard before:

Don't go overboard with your use of credit. Even those consumers who pay off their credit card balance every month could still show debt on the day their credit history gets pulled, explains FICO-score developer Fair Isaac Corp. By always using credit carefully, you can be confident that you credit use will appear sensible no matter when your lenders look at your credit history. Aim to use about 25% of your available credit.

Keep credit card applications to a sensible number. While it may be tempting to fill you wallet with the great variety of credit cards available through CreditCardXPO.com, if you want to emulate those people with the highest credit scores, it might be better not to. That is because those consumers with the top credit scores tend to apply for credit much less than the average of twice a year. And, having an excellent credit score means you are more likely to get approved for those credit cards you really want.

Keep your creditors honest. Even if you always pay your bills on time, it won't do your credit score much good if creditors don't report how dependable you are. If a creditor mistakenly hits you with a fee for late payment, be sure to call them and get the situation resolved quickly. Otherwise, you may be not only end up paying unnecessarily, but your credit score may take a hit unfairly.

Don't be afraid to look at your credit report. Like taking a look in your basement, it may be scary to discover what is actually contained in your credit report. Additionally, some consumers may worry that pulling their own credit history could hurt their credit score. But this is not the case. In fact, purchasing or taking a free look at your credit history could actually help your credit score, if you use the supplied information to correct any mistakes in the report and to improve your credit use. While you may not end up with perfect credit by following these recommendations, you can still be content knowing that your improved credit score is the best it can be.

Pay by Credit Card to Help Your Credit Score

You might think that just because you are financially responsible, with no debt and a responsible borrowing history, that your credit score would undoubtedly reflect that. But you may actually not be providing the credit bureaus with enough information to help your credit score if you do not use your credit card.

That lack of credit card use could leave your credit report "unscoreable." In fact, some 50 million Americans have too little credit activity to qualify for the most commonly used credit score.

If you do not use any credit for six months, the credit bureaus may be unable to calculate your credit score. While you should still be able to borrow money under these circumstances, any approvals will take longer and you might end up paying a higher interest rate.

Even positive information only stays on your credit history for so long, so it is important to show that you have paid off recent debts. As older auto loans and mortgages disappear from your credit history, replace them with an ongoing display of responsible use of credit cards.

Just a little credit card use is enough to keep your credit score up-to-date. All it takes are some charges on your plastic, and then the quick payment of your credit card bill. These charges could be as small as using your credit card for groceries or gas -- which could also earn you a little something in return if you pay with cash back credit cards or reward credit cards.

You may wonder why credit scores matter if you do not plan to borrow any money. But should you find yourself in an emergency and needing a home-equity line of credit immediately, or you buy a second home and require a mortgage, a solid credit history is crucial. Additionally, the rate on your homeowners and auto insurance could be influenced by your credit history.

As a result, it is a smart move to stay aware of your own personal credit history, which is used to calculate your credit score. You can order a free credit report every 12 months from the three major credit bureaus -- Equifax, Experian, and TransUnion.

Meanwhile, it is not only people who prefer paying by cash, check or debit card that may find themselves without a credit score. If you have lived abroad for some time and have not used a U.S. credit card while overseas, you could find yourself without a credit score on your return home.

Therefore, many Americans will see their credit histories benefited by consistent use of a credit card and prompt repayment of their bills.