Why it’s important to know your score

One number could make the difference between being able to buy the house of your dreams or having to settle for something less, maybe not being able to qualify for a mortgage at all. It could make a difference of thousands of dollars in interest over the life of your home loan. Given the importance that number could have in your life, shouldn’t you know the score?

Credit scores, known by a number of different names depending on the particular model being used, were developed in the late 1950s to assist lenders in processing credit applications more quickly and objectively. They are a statistically valid means of using a person’s credit history, as shown in their credit report, to predict their likelihood of default on a new loan.

Mortgage lenders use credit scores to reduce their risk. They might require a minimum score in order to qualify for a loan, or they might charge higher up-front fees and higher interest rates to people with lower scores in order to compensate for the greater risk of default.

What determines your credit score? According to MyFico.com, a Web site operated by Fair Isaac Corp., which developed credit scores and provides them for the three national credit reporting agencies, scores are calculated from a lot of different data in your credit report.

In general, 35 percent is based on your payment history. This includes public record information, such as bankruptcies or liens, as well as late payments, amount and number of past due items, and length of time since any adverse information was reported. Even if you’ve had payment problems in the past, a year or two of timely payments will improve your score.

Roughly 30 percent is based on amounts owed, balances, and types of accounts. This includes a comparison of your current balance to your high credit amount on a given loan, so an installment loan with little paid off or a maxed out credit card will tend to lower your score.

Closing unused accounts, a step often recommended by consumer advocates, can actually lower your credit score by increasing the proportion of available credit that you are using. Some types of loans are viewed more favorably than others. If you like to take advantage of those “Don’t pay any interest for a full year” or “six months same as cash” offers, you should know that those consumer finance company accounts could lower your credit score, even if they’re paid as agreed.

About 15 percent of your score is determined by the length of your credit history and the length of time you have held specific accounts. If you’re one of those people who can’t resist the great introductory rates on new accounts, transferring balances and closing old accounts as you go, be aware that you are probably lowering your credit score in the process.

Another 10 percent is based on the amount of new credit you have, so again, chasing better rates can result in a lower score. This is also where the number of inquiries on your account is considered, so even applying for a lot of new credit can create a problem.

The final 10 percent of your credit score is related to the types of accounts you have and the number of each.

Your credit score is based entirely on the information in your credit report, so inaccurate information can lead to an unfair score. It is up to you to check your credit reports to be sure the information they contain is accurate. The three national credit reporting agencies — Equifax, Experian, and TransUnion — are competitors, not partners, so information contained on one report may be very different from that on the other two. New legislation allows you to get a free copy of your report every year from each of the three credit reporting agencies.

An important thing to remember is that a credit score represents a snapshot of one moment in time. It changes as each of these factors change, so a bad score will not haunt you for life, but can be improved if you make an effort to change the way you use credit.

Who benefits from credit scoring? We all do. Using credit scores makes the credit granting process more objective and allows lenders to extend credit to more people while minimizing losses. While a credit score is just one factor that a lender looks at in deciding whether or not to grant a loan, it is a tool that makes the decision faster, more efficient, and more fair.