Dollars & Sense (Part II) - Understanding Your Credit Score

Understanding the importance of managing your credit and debt is vital, but how important your personal credit score is and how it relates to you is something we should all be aware of. It’s important to us personally and equally important to us as a nation.

This week we reached our national credit spending limit, but the Treasury Department has once again found a way to borrow from Peter to pay Paul and has now pushed the debt ceiling limit further back to August. When the U.S. credit is finally ‘maxed out’ our ability as a nation to borrow funds to pay for essential programs will no longer exist; and the very same applies to us personally.

It’s not a phenomenon that talk about credit scores seems to be everywhere, and the reason for this is that many Americans don't really understand their credit scores. It’s certainly not overrated and at the very least by understanding the basics, can save you thousands of dollars.

Why a Credit Score?

A credit score is a tool to help lenders assess an individuals' risk of not repaying a loan. It is not to assess borrowers' knowledge of consumer credit, their attitude toward consumer credit, their amount of consumer debt or the financial resources they have to repay a loan.

In factoring your credit score – specifically you’re ability to borrow, lenders look at five things:

1. Payment History: Do you pay your bills on time? If not, how late are you, and how often are you late?
2. Amounts Owed: How much total credit do you have available, and what percentage of it are you using?
3. Length of Credit History: When did you first start using credit, and what is the average age of all your credit and loan accounts?
4. New Credit: How much credit have you applied for and taken on recently?
5. Types of Credit in Use: Do you have a mix of different types of credit?

Your age, marital status, gender, race, nationality or state of residence, are not included in your credit score. Most of this information doesn't even appear on your credit report and is prohibited from being used for credit considerations under the Equal Credit Opportunity Act.

Who Checks Your Credit and Why:

Anyone you want to borrow money from is going to check your credit, this includes mortgage lenders, credit card issuers and car dealerships. Creditors use your credit score to determine whether to lend you money and if so, and at what interest rate you will get. The higher your credit score, the lower the interest rate you will qualify for, and the less you will pay to borrow that money. It follows, of course, that the lower your credit score, the more interest you will pay, if you can even get a loan or a credit card at all.

But did you know that home insurers, landlords, cell phone companies and electric utilities may also use your credit score? It can be used to determine whether you can get insurance and at what cost, whether to rent you a living space and at what price and whether to require a deposit when you establish cell phone or utility service.

Your Credit Score is really a blend of Three Scores:

There are three major credit bureaus that monitor your credit--Experian, Equifax and Transunion. Each one calculates your score somewhat differently, giving you three somewhat different credit scores. Ideally, you'd like each of those scores to be at least 720 as this is the score that will usually qualify you for the best interest rates in today's market.

Learn More about your Credit Score:

You are entitled to one free copy of your report every 12 months from each of the three credit bureaus (the easiest way to get it is through www.annualcreditreport.com). Looking at your credit report will help you understand what is on your report and what isn't. It will also allow you to check for any mistakes that could be harming your credit score and check for any signs of possible identity theft (like accounts you don't recognize).

The free credit report does not include your credit score, but unless you're planning on making a major purchase that requires credit (like a mortgage or a new car) in the next six months, or you're having trouble getting approved for a credit card, you don't particularly need to know your score. If you do want or need to know your score, you'll have the option to purchase it while you're obtaining your free report.

You may be able to obtain your score for free by signing up for a credit monitoring service that offers a free trial (though it won't be free if you forget to cancel before the end of the trial period) or by applying for a loan and obtaining your score from the lender. If you don't need to know your actual score and just want to get a general idea, there are Web sites that will help you estimate it. Should you find yourself in a position of seeking out one of those 'credit repair' companies, be aware that all they’ll help you do is renegotiate your obligated payments. Consequently this will have a negative impact on your credit and will ‘bottom out’ your credit score, and could take years to re-establish.

The Bottom Line:

No matter how much those credit score commercials might irritate you, their underlying message is sound: understanding the basics of credit scoring is essential to managing your finances well. Without that understanding, you could end up wasting money on high interest rates or miss out on achieving goals like home ownership.

Next up: Slip ups That Won't Hurt Your Credit Score