It can cost you anytime you apply for a mortgage, rent an apartment, buy homeowners insurance or even interview for a new job.
It's your credit score, yet most people don't understand what it measures or how it works, according to a recent survey by the Consumer Federation of America of Washington, D.C., a nonprofit association of some 300 consumer groups.
Only about one-third of consumers correctly understand what a credit score does, the survey found.
Simply put, a credit score is your probability of repaying a loan.
It is a predictor of your credit behavior, spun from a complex computer model and based on your credit history. That history is stored and constantly updated by the nation's top three credit reporting agencies: Equifax(EFX), TransUnion and Experian, a subsidiary of the U.K.'s Gus Plc(GUSSF).
The best-known credit score is the FICO from industry pioneer Fair Isaac(FIC). FICO scores range from the poorest rating of 500 to a top of 850, with 723 as the nation's current median score, according to the company.
The higher the score, the more credit is available to you at lower interest rates. A borrower seeking a $300,000 mortgage with a score below 559 would pay about 9.234% interest on a 30-year fixed mortgage, or $2,465 a month, according to Fair Isaac, while the same loan would cost a borrower with a FICO above 720 just 5.515% interest, or $1,706 per month.
"Ignorance about your credit score can cost you," says Liz Pulliam Weston, author of the new book Your Credit Score: How to Fix, Improve, and Protect the 3-Digit Number that Shapes Your Financial Future and syndicated newspaper columnist. Usually people with bad or mediocre credit "get all the loans they want," she says, "but they don't realize the high price they're paying."
The use of credit scores exploded in the mid-1990s, when the nation's biggest mortgage-financing companies, Fannie Mae(FNM) and Freddie Mac(FRE), began requiring them, while lower interest rates prompted millions of homeowners to refinance their mortgages, according to Weston. "Once the refi boom took off," she says, "more people got obsessed with controlling and improving it."
Credit scores have helped make massive amounts of credit available to consumers. Americans now owe trillions of dollars in records amounts of debt on credit cards, auto loans and home-equity lines of credit. The ratio of household debt to disposable income has risen considerably, from 1.01 in January 2000 to a current high level of 1.20, according to the latest U.S. Commerce Department reports.
Although it's widely used, credit scoring is poorly understood and has generated a number of myths, says the author. Some of the most common are spread by well-intentioned mortgage brokers and auto lenders. And, unfortunately, there's no way to know exactly how any one credit action taken will change your score because it's based on a number of constantly changing variables.
At the top of the myth list, says Weston, is the notion that closing some of your credit accounts will help improve your score. This can backfire, resulting in a lower score for two reasons. First, a major portion of your score is based on how much of your outstanding credit you are, in fact, using. If you reduce the amount of credit available by closing accounts, you could be scored lower for using too much credit in the accounts you've left open. And second, you get positive points for having a long history of good credit. If you shut down one of your older accounts, that can also reduce your score.
"Closing an account will never help your score," says Ryan Sjoblad, public relations manager for Fair Isaac's online service www.myfico.com. "More than likely, it will hurt your score. You're closing the door on credit history."
The only time to even consider closing an account, says Weston, is when you're seeking a large loan like a mortgage and a lender asks you to close it to reduce the chances that you'll become overextended.
Here are some of the other common myths, according to Weston, the Consumer Federation and Fair Isaac:
Checking on your own score will lower it. Not so, say the experts. In fact, you should check your score at least once a year (myfico.com charges $12.95 to obtain a FICO score that is based on any one credit bureau and $38.85 to get FICOs from all three reporting services).
What can downgrade your score, notes Weston, is having a friend or family member who works at a bank or mortgage company pull it for you. That counts as a "hard" inquiry from a lender, and too many of those can hurt.
Shopping around for the best loan rate can count against you. Fair Isaac recognizes that smart consumers do this and therefore doesn't penalize them. So the company lumps together as one all inquiries on mortgages or auto loans made within 14 days before the score is created. Also, any inquiries you make 30 days before the score is drawn up are automatically ignored.
Marrying someone with a good score will improve yours. More than half of those surveyed by the Consumer Federation believed that a married couple has a combined score, not individual ones. In fact, each spouse has an individual credit score, but these will be similar if they share most accounts.
It's important to keep in mind, however, that each person has more than one score. That's because each of the three credit bureau biggies keeps somewhat different information, leading to three different scores.
Checking your score is something only lenders do. In fact, scores are used routinely by landlords screening tenants and auto and home insurers because it's been shown there's a high correlation between poor scores and a tendency to file claims.
Some employers also require it, particularly for high-level managers dealing with finances and for government jobs that require security clearance, says Weston. But no one is supposed to obtain your credit score without seeking your permission first.
Fixing bad credit history can be accomplished quickly. You can't erase negative information, such as late payments and collections, which can remain on your record for as long as seven years. But you can improve your credit score by correcting errors that reflect badly and by paying down outstanding debts. The myfico.com site offers those who purchase scores the use of a simulator that tells them, within a range of scores, how certain actions would improve or hurt their ratings.
Weston says that most of the mail she receives from readers about credit scores comes from consumers struggling with credit mishaps and wanting advice on how to improve their standing. But she also gets a surprising number from people at the other end of the scale, those with nearly perfect credit. "They have a 780," she says, "and demand to know why they don't have an 850."
For more information visit www.experian.com, www.transunion.com and www.equifax.com.