For today’s edition of “back to basics” month at Get Rich Slowly, we’re going to talk about credit scores. What is a credit score? Why should you care?
As you go about your life, you leave a trail of transactions. You take out a mortgage, you buy a new car, you use your credit card to buy new clothes and your debit car to purchase groceries.
Every month, your creditors — the companies to which you owe money — send info about your recent activity to a variety of credit reporting agencies (commonly referred to as credit bureaus). Each agency collects this info into a file called a credit report.
Your credit report is a history of how well you’ve managed your credit. It contains info about where you’ve lived, how much you’ve borrowed, and whether you tend to pay your bills on time. It also notes if you’ve ever filed for bankruptcy.
The credit bureaus — Equifax, Experian, and TransUnion — sell your credit report to other businesses so they can decide whether to lend you money, sell you insurance, rent you a home, or give you a job.
Credit reports may be boring, but they’re vitally important because they provide the basis for your credit score.
How to Get Your Free Credit Report
The U.S. government has mandated that consumers be allowed to view their credit reports from each of the three major reporting agencies once every year. This is easy to do via the free AnnualCreditReport.com website. (Beware of scammy lookalikes. This one is the official government-sanctioned site.)
To get your report, you need to provide some basic info like your Social Security number. You might also need to answer some questions about current and/or past accounts. Sometimes these questions get tricky if you don’t have quick access to your files. (When Kim had to check her credit report recently, she couldn’t remember the amount of her mortgage payment from 2005. Her request was denied.)
If you’d like, you can obtain reports from all three credit reporting agencies at once. Or, you can stagger your requests, possibly requesting one report every four months from a different agency.
Your Credit Score
While your credit report collects info about your debt history, your credit score is a single number that summarizes all of that data.
Credit scoring has been around for decades in one form or another. It only became widely used during the 1980s after a fim called Fair Isaac (now known as FICO) developed a new type of credit score called a FICO score. The mortgage industry recognized the usefulness of credit scores, widely adopting them in the mid-1990s. Other industries followed suit.
To generate your credit score, FICO takes bits of data from your personal credit report and compares this info to similar data from millions of other people. FICO then uses secret formulas to squeeze all of this information into a single number, which can range from 300 to 850. This number is a measure of risk. It gives lenders a good idea of how likely you are to pay them back. They use it to decide how much to lend you, what interest rates to charge, and what terms to set.
Although the FICO score is the most widely used credit score — used in over 90% of U.S. lending decisions — it’s not the only credit score. Other companies offer competing credit scores, and FICO (the company) offers a variety of specialized scores to measure things like how likely you are to declare bankruptcy, close an account, and so on.
Take a company like Credit Sesame, for instance. Credit Sesame offers a variety of credit-monitoring tools including a free credit score. But Credit Sesame does not use a FICO score. The company uses the VantageScore, which was developed by the three major credit bureaus as an alternative to the FICO score.
Confused? Don’t sweat it. The important thing to remember is that we often talk about “your credit score” like it’s just one thing when it’s actually many credit scores.
“A bad or even mediocre credit score can easily cost you tens of thousands and even hundreds of thousands of dollars in your lifetime,” Liz Weston writes in Your Credit Score. “You don’t even have to have tons of credit problems to pay a price. Sometimes all it takes is a single missed payment to knock more than 100 points off your credit score and put you in a lender’s high-risk category.”
A high credit score will get you the best interest rates on credit cards and loans, including mortgages. With a low score, you’ll pay higher fees and interest rates.
Here’s an example from FICO:
Bad credit can cause a downward spiral. One money mistake leads to bad credit, which costs you more money and leads to more debt, which drops your credit score…and so on. But your credit history doesn’t just affect your ability to borrow money. Nowadays, it’s used by insurance companies, landlords, and even employers.
- Some insurance companies use a specific credit score (known simply as your insurance score) — combined with other info — to gauge how likely you are to file a claim. A lower score can lead to higher insurance premiums.
- When you try to rent a home, your prospective landlord may run a credit check. If your credit score is low, she may see you as a high-risk tenant and ask for a larger security deposit — or simply turn down your application.
- Current and potential employers can pull your credit report if you grant them written permission. This is especially…
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