The Importance of Your Credit Score

Your credit score is important if you care how much you pay for big things like houses and cars. It’s important if you care how much life insurance costs. It even matters indirectly, through your credit report, if you care whether you get a job.

In a Yahoo Finance article Barrett Burns, CEO of VantageScore Solutions said, “A lower credit score can result in a borrower paying more than $5,000 for a $20,000, 60-month auto loan.”

Even more troubling than that fact is the fact that nearly 80 percent of respondents to a survey by the Consumer Federation of America said they did not know a low credit score could cost them money.

Credit scores are tied to interest rates based on the theory that the lower your score, the bigger risk you are when it comes to borrowing money. The bigger the risk, the more the lender charges to offset the chance you may default on your loan.

Conversely, the higher your score, the lower your interest rate, the lower the risk, and the less the lender feels they have to charge to extend credit.

Buying a House or Car

To illustrate the difference in cost of a large purchase with different credit scores, MyFico has a Loan Savings Calculator you can use to compare loan rates at various FICO score levels.

For example, a 30-year fixed-rate mortgage of $200,000 would cost $901 a month if your FICO credit score were 760 or higher. It would be $947 if your FICO score were 680 to 699.

That extra $46 a month becomes a net difference of $552 a year – a nice recliner or HD television. Over the life of the loan, you would pay an additional $16,000+ - or about the cost of new appliances for the kitchen.

Getting a Credit Card

As you might imagine, your credit score affects other forms of credit – such as obtaining a credit card. ScoreMatch allows you to plug in your approximate FICO score and locate credit cards for which you qualify.

The differences can be striking. For example, with a score considered excellent (over 720) you can qualify for credit cards with a regular APR as low as 10.9 percent, sometimes even lower. A poor credit score will put you in line for an APR approaching 25 percent. If you carry a balance on your credit card, this interest rate difference can be worth hundreds, even thousands of dollars over time.

Buying Insurance

Many people don’t realize it, but the Federal Trade Commission makes it clear – your credit score can be a factor when it comes to automobile, homeowners, even life insurance.

Once again, it all boils down to risk. A higher credit score means you keep your financial house in order, which makes you a good risk. A low score means you have struggled or worse yet – are irresponsible.

Mint.com points out the additional fact that credit scores used by insurance companies are not the same as credit scores used by financial institutions.

Insurance companies use what are called Insurance Credit Bureau Scores or Insurance Risk Credit Scores. The main difference is that these types of scores consider both credit information and previous insurance claim information.

Getting a Job

What does your credit score have to do with getting a job? Plenty, it turns out.

CBS MoneyWatch stated that credit reports are a regular part of hiring decisions. While it is true that your credit report is not your credit score, your credit score is calculated based on information in your credit report.

Amy Traub, senior policy analyst with nonprofit advocacy group, Demos said, “We know that about half of employers look at credit reports as part of the hiring process." Elaborating, Traub pointed out that those with poor credit need a job. Unfortunately that road is blocked by their poor credit, something Traub calls a “Catch 22."

As with insurance, not all employers check credit reports and not for all jobs. Eight states - California, Illinois, Connecticut, Washington, Hawaii, Maryland, Vermont and Oregon - restrict the use of credit reports in hiring. Others are considering such restriction.

How Credit Scores are Calculated

Having established the importance of your credit score, it might be helpful to understand how that score is calculated.

FICO, the Prime Poobah of credit scores considers its scoring formulas “proprietary information” and something it will not share.

However, much is known, as reported by CreditCards.com. There are, for example, five elements to your credit score:

• Payment history
• Debt amounts
• Length of credit history
• New credit
• Credit mix

The two most important elements are payment history and debt amounts. FICO representative Craig Watts said, "Those two factors contribute roughly two-thirds of a typical person's FICO score."

Watts breaks that down to 35 percent for payment history and 30 percent for Debt. Length of credit history comprises 15 percent. New credit, i.e., applying for loans or credit cards, accounts for 10 percent of your score, as does Credit mix, which refers to the mix of loans, credit cards, and other types of credit you have.