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We all look forward to those big purchases in lifea car, house, and even a college education. But, one three-digit number stands between us and those very things: our credit score.

What is a credit score?

A credit score is a number based on a statistical analysis of a person’s credit files or borrowing history, which in theory represents the creditworthiness of that person, which is the likelihood that people will pay their bills.

The score is primarily based on credit report information, typically from one of the three major credit bureaus: Experian, TransUnion, and Equifax. Each bureau has several different methods of calculating credit scores.

How is it calculated?

FICO, the most widely known type of credit score, is developed by FICO, previously known as Fair Isaac Corporation. It is used by many mortgage lenders as a risk-based system to determine the possibility that the borrower may default on financial obligations.

The credit bureaus also all utilize their own credit scores: Equifax’s ScorePower, Experian’s PLUS score, and TransUnion’s Transrisk, and each also sells the VantageScore.
All have slightly different criteria and weights assigned to them, in general the scores average out to be fairly close when using the same scale or relative adjusted scale.

30% of the score is based on outstanding debt. How much you owe on car or home loans, and how many credit cards do you have that are at their credit limits. The more cards you have at their limits, the lower your score will be. The rule of thumb is to keep your card balances at 25% or less of their limits.

15% of the score is based on the length of time you’ve had credit. The longer you’ve had established credit, the better it is for your overall credit score. Why? Because more information about your past payment history gives a more accurate prediction of your future actions.

10 % of the score is based on new credit. Opening new credit accounts will negatively affect your score for a short time. This category also penalizes hard inquiries on your credit in the past year. Hard inquiries are those you’ve given lenders permission for, as opposed to soft inquiries, which include looking at your own score which have no effect. However, the score interprets several hard inquiries within a short amount of time as one way to account for the way people shop around for the best deals on a loan.

The final 10% is based on the types of credit you currently have. It will help your score to show that you have had experience with several different kinds of credit accounts, such as revolving credit accounts and installment loans.

Why are there so many different scores and how do they differ?

Tracking people’s credit is a business. They accumulate and analyze massive amounts of data to spit out a number that can be used to base high risk decisions upon. Each company claims to have a more accurate way of determining risk. Lenders generally pull your credit score from more than one source to ensure checks and balances.

For example, VantageScore is a collaborative effort between Experian, Equifax and TransUnion launched in 2006 which uses the same formula across the board. All three bureaus sell this product but the score can still vary slightly between them since the data being collected is not 100% consistent.

Many financial institutions are starting to migrate to using the VantageScore. The biggest challenge is that the scale is different than the others, thus it takes some readjustment in reasoning to map credit buckets to risk.

How do you monitor and improve your score?

Monitoring can be quite tricky at times. Remember when I said that credit scores are a business? Everyone wants to sell you access to it. The government has stepped in and has passed legislation as recent as July 2010 whereby a consumer is entitled to receive a free credit score if they are denied a loan or insurance due to their credit rating.

However, if you are not too keen on waiting to be denied for a loan to monitor your score, try CreditKarma.com. It’s a totally free way to obtain and monitor your credit score. They provide you with TransUnion’s TransRisk and VantageScore scores. They also do an excellent job of breaking down the specifics of how your score was calculated and where you should improve.

CreditKarma partners with many companies (ours included) to provide financial offers which will reduce your costs. Think of it as highly directed advertising similar to how Google AdWords works. They make money by saving you money, which is the true definition of a win-win.

Why is a credit score so critical?

Since your credit score determines your risk level, it’s used to determine how much you’ll end up paying for a car, house or any large purchase for that matter. It’s also used as a basis for determining how much insurance will cost you, and it’s now even being used during the applicant screening process when you apply for jobs. The thinking there is that better credit will translate into a more responsible employee.

So next time you’re at a store and they ask you to sign up for their card to receive 10% off your first purchase, hold off on the discount. Youre credit score always has priority over cute shoes, since your future of purchasing what you truly need, depends on it.

Similar Posts:

• Debunking Credit Scores
• The Two New Credit Scores You Must Check
• The Other Magic Number: Your Credit Utilization Rate
• The New Free Credit Score: What it Means for You
• Joe Nocera’s Terrific Report on the Tyranny of Credit Scores