Demystifying Credit Scores

One of the few positive outcomes of the 2008 financial crisis was that it helped shine a light on the importance of understanding and staying on top of your credit profile. Along with that heightened visibility, however, has come a great deal of confusion and misunderstanding – particularly around the all-important credit score.

"The consequences of not maintaining a sound credit score can be very costly," says Anthony Sprauve, senior consumer credit specialist at FICO. "A low score can bar you from getting a new loan, doom you to higher interest rates and even cost you a new job or apartment."

Five factors are used to determine your credit score: payment history (usually around 35 percent of your score), amount owed (30 percent), length of credit history (15 percent), newly opened credit accounts (10 percent), and types of credit used (10 percent).

Fortunately, if your credit score has taken a hit, you can initiate several actions that will begin improving it almost immediately. Just be aware that it can take many years to recover from events like bankruptcy or foreclosure.

First, find out where you currently stand by reviewing your credit reports from each major credit bureau (Equifax, Experian and TransUnion). Look for negative actions your creditors might have reported as well as errors and fraudulent activity, which you can challenge through the bureau's dispute resolution process. You can order one free report per year from each bureau through the government-authorized site, www.AnnualCreditReport.com; otherwise you'll pay a small fee.

You might also want to order your credit score. Lenders use credit scores to supplement their own selection criteria to determine whether you are a worthy credit risk. Several types are available, including FICO® Score, VantageScore (a competing model jointly created by Equifax, Experian and TransUnion) and proprietary credit scores from each of the three bureaus, among others. Scores typically cost from $15 to $20 each.

Note: You may see offers for free credit scores, but they're usually tied to expensive ongoing credit-monitoring services you may or may not want. Read the contract carefully.

Here are a few tips for improving your credit history:

• Always pay bills on time and catch up on missed payments.
• Set up automatic payments for recurring bills and automatic minimum credit card payments if you often miss deadlines.
• Sign up for text or email alerts telling you when your balance drops or payments are due.
• Never exceed credit card limits.
• Monitor your credit utilization ratio (the percentage of available credit you're using). Try to keep your cumulative utilization ratio – and the ratios on individual cards or lines of credit – below 30 percent.
• Transferring balances to a new card for a lower rate will slightly ding your credit score – although it won't take long to recover. But be careful the transfer doesn't increase your utilization ratio on the new card.
• Make sure that card credit limits reported to the credit bureaus are accurate.
• Don't automatically close older, unused accounts; 15 percent of your score is based on credit history.
• Each time you open a new account it slightly impacts your score, so avoid doing so in the months before a major purchase.
• Pay off medical bills, as well as parking, traffic and even library fines. Once old, unpaid bills go into collection, they'll appear on your credit report.

"Bottom line, don't lose hope," says Sprauve. "The negative impact of past credit problems will gradually fade as recent good payment behavior begins to show up on your credit reports."