Credit Scores

What You Don't Know CAN Hurt You!

You probably assume that if you pay your bills on time, you will automatically have a high credit score. Unfortunately, that's not always the case. There are numerous misperceptions about how scores are calculated and many people's scores are lower than they expect.

 Why does it matter?

Credit scores are used by financial institutions to determine whether they should lend money to a potential borrower and, if so, what interest rate to charge. A higher score means an applicant is statistically less likely to default on the loan, so that person gets a lower interest rate. Ignoring credit scores can be a costly mistake for buyers. Even a small increase in a mortgage rate can add up to a large sum in additional interest payments over time. There are many credit scoring systems available to lenders, but FICO scores are by far the most commonly used. The system was developed by the Fair Isaac Corporation back in the 1960s. Technically, each person has three different FICO scores - one for each of the three major credit reporting agencies (Equifax, Experian, and Trans Union). Knowing how FICO scores are calculated can help you make better decisions about your credit.

Here are five of the most common misperceptions.

• I always pay my bills on time, so I must have a high credit score. Paying bills on time is clearly a critical factor, but it only accounts for 35% of a person's overall FICO score. The FICO score also takes into consideration four other components: the amount of debt owed (30%); the length of the person's credit history (15%); the number of credit accounts recently opened (10%); and the types of credit used (10%).

• Consolidating multiple credit cards will increase my score. Consolidating credit cards could make it easier to pay down debt, but the FICO score could actually decrease when someone consolidates to fewer accounts with balances that are closer to the maximum available credit.

• I don't have any credit cards or other major debt, so I can't have a low score. The FICO score will be lower if the borrower hasn't established a long-term borrowing history with multiple creditors.

• I shouldn't shop around for a mortgage or other large loan because credit inquiries hurt my score. A large number of credit inquiries will lower a buyer's score, but FICO is sophisticated enough to take into account when someone is rate shopping. Inquiries for similar types of credit are bundled if they're made within the same brief period of 14 days or so.

• I shouldn't check my credit report more than once a year because credit inquiries hurt my score. Checking credit reports does not affect a person's score, so consumers should check them as many times as they'd like. If you want to learn more about how FICO scores are calculated, there are many sources you can access, including Fair Isaac's consumer Web site, MyFICO.com. The site offers a host of informational materials and credit-score tips. Visitors can also order their three credit scores for a fee.