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Understanding your credit score
There are three credit-reporting bureaus – Experian, Equifax and TransUnion. They've been creating reports on people's credit for many years. Lenders would review these reports and then make subjective judgments about people's creditworthiness. However, in 1958 the company now known as FICO created the concept of a credit score. According to the online encyclopedia Wikipedia, “A credit score is a numerical expression based on a statistical analysis of a person's credit files, to represent the creditworthiness of that person. A credit score is primarily based on credit report information typically sourced from credit bureaus.”
How your credit score is calculated
Nobody outside of FICO knows exactly how credit scores are calculated. This is a carefully guarded and proprietary algorithm. However, it is known that credit scores are composed of five components – credit history or on-time payments, capacity used, length of credit history, types of credit used and credit applications. Of these five components, the first two are the most critical because it is believed that they account for 65% of your credit score.
Credit score ranges
Credit scores are grouped into ranges. They are as follows.
Between 700 and 850 – Very good or excellent credit score.
Between 680 and 699 – Good credit score.
Between 620 and 679 – Average or OK score.
Between 580 and 619 – Low credit score.
Between 500 and 579 – Poor credit score.
Between 300 and 499 – Bad credit score.
People who have scores above 700 are considered to be "golden" and can get just about any sort of credit that they would apply for. Conversely, if you have a score of 580 or less, you’ll have a tough time getting credit and if you do get new credit, it will come with a high interest rate.
Why it's become king
There is a simple reason why credit scores have become king. Credit reports are usually very long and complicated. Few lenders are willing to invest the time required to wade through the 12 or more pages of a report when they can just check your credit score instead.
An example of how credit scores affect interest rates
Here, courtesy of Bankrate.com, is an example of how your credit score would affect the interest you would pay on a mortgage.
760 to 850 tier 5.780% 620-659 tier 7.096%
700-759 tier 6.002% 580-619 tier 8.583%
660-699 tier 6.286% 500-579 tier 9.494%
As you can see from this table, it is much better to have a credit score of 760 or above vs. one of less than 580 as this could mean a difference of more than 3.5 points. And this would translate into thousands of dollars more you would pay over the life of a 30-year mortgage. Of course, the example of what you would pay if you had a credit score of less than 580 is relatively hypothetical as the odds are you wouldn’t even be able to get a mortgage.
What to do about a low credit score
Unfortunately, there's not much you can do short term about a low credit score. If you have a score of 620 or lower, it's probably because you've made some serious mistakes in in the way you’ve handled your credit. You've probably missed payments or even defaulted on a loan or a credit card. Worse yet, those bad items will stay on your credit report and continue to affect your credit score for seven years. This means you'll just have to slog it out, take care of any unpaid balances or defaults and be sure to make your payments on time every time until those bad items fall off your credit report.