Your credit score has far-reaching effects beyond the amount you pay for your mortgage and credit card interest rates.
While people are usually aware that their credit score can effect the amount they pay for loans, they are often unaware of the other areas it impacts. In fact, a poor credit score can cost you well over $1 million during your lifetime.
Recently Congress has been looking into the insurance industry's use of credit scores to help determine rates. The industry defends this practice, stating that insurance scores based on credit ratings are an accurate predictor of risk. In the long run, this helps insurers better determine each person's risk profile and helps keep down insurance costs for everyone, the industry argues.
On the other side, consumer and civil rights groups believe credit scores don't reflect a person's responsibility in relation to insurance. They argue it is unfair that "consumers with spotless driving records can be penalized with higher premiums just because of their credit score." They also posit that using credit scores means that certain minority groups pay more for insurance, no matter how well they drive.
How They Size You Up
As the use of credit scores expands outside of the lending industry to help other businesses and organizations determine a variety of risks, the health of your credit becomes an even more important factor in your personal finances.
The first thing you need to understand is how your credit score is determined. General information is available from Fair Isaac, although the exact algorithm used to determine your credit score is a secret closely guarded by each credit agency. The general guidelines about how your credit score is compiled are broken down into five main categories, with the following percentage weight for each:
- 35% payment history (only includes payments later than 30 days)
- 30% debt-to-credit ratio
- 15% length of credit history
- 10% new credit
- 10% type of credit in use (installment, revolving, consumer finance)
Common Mistakes to Avoid
Once you see how the scores are determined, it is easier to see how people make common mistakes that can affect their credit score. Here are few things to avoid:
1. Cancelling old credit accounts: Many people who have credit problems end up cancelling their credit cards after they have paid them off, to avoid future problems. If these happen to be the cards that you have had open the longest, cancelling them will shorten your credit history, which makes up 15% of your total score. Thus, canceling older cards inadvertently reduces your credit score. If leaving the account open is not costing you money in the form of annual fees, storing the card in a place where you will not use it, or even destroying the card without closing the account, will keep the length of your credit history intact without tempting you to use the card again. In addition, if you have balances on some of your other cards, keeping accounts open will give you a better debt-to-credit ratio.
2. Choosing specific payments: When people are trying to pay off debt, they sometimes decide to pay off specific debts first and leave others until later. While done with good intentions, this can be a huge negative on your credit score, as it often means all but one of the debts will be late. While there is a 30-day grace period before late payments will affect your credit score, this is also the area that has the most impact on your score, at 35%. Even a single payment that exceeds the 30-day period can significantly lower your credit score. You want to pay at least the minimum payment on all your debts each month. If you do end up having to make a late payment, make sure the payment doesn't exceed the 30-day limit.
3. Maxing out credit cards: Maxing out your credit cards is a warning sign that you aren't dealing with your credit well and hurts you in the debt-to-credit ratio. If you have $2,000 in credit card debt, your credit score will be better if you have several cards with the $2,000 in debt spread among them than all the debt on a single card with a $2,000 limit. While this is better, you don't want to open a lot of credit cards in a short period of time to accomplish this. Applying for a lot of credit in a short period indicates that you may be having financial troubles and will affect the 10% of the score that looks at new credit.
4. Avoiding all credit cards: Many people try to avoid credit card pitfalls by paying for everything in cash. The problem is that by doing so, they end up with no credit history -- and no credit score is the same as having a lousy credit score. Since it is likely that there will be a time when you need to borrow money -- such as for a home mortgage -- it is best to keep at least one credit card and make a purchase every now and then on it to keep your credit score active.
5. Not checking your credit report: If you have not checked your credit report, you may be surprised at what is in there. According to a U.S. Public Interest Research Group study a few years ago, 79% of all credit reports contained some type of error. These errors can make a big difference on your credit score, so you should check your credit report from all three credit agencies on a yearly basis to make sure that all the information is accurate. You can do so at Annual Credit Report (do not use freecreditreport.com, which is anything but free). In addition to making sure your credit information is accurate, checking your reports on a yearly basis will also help you detect possible identity theft issues.
The best thing you can do to keep your credit healthy is to pay all your bills and loans on time. But if you are trying to raise your credit score, be sure not to accidentally make one of the above mistakes that could, unintentionally, damage your score.