In the olden days, if the store manager didn't like your face, the price of your lay-away might mysteriously go up. Today, you can be as good-looking as Brad Pitt and still pay through the nose for a new car loan -- if you happen to have an ugly credit score.
Credit scores are a form of financial profiling lenders use to predict the statistical likelihood of a buyer not keeping up with his payments -- or going bankrupt altogether.
They are based on things like your income, employment history, length of time at your residence, buying patterns, history of credit applications, repayment of loans, revolving debt (credit card balances, etc.), record of defaults, bankruptcy proceedings and so on.
All this data is monitored and recorded by the three major credit reporting bureaus -- Equifax, Trans Union and Experian. The info is fed into a mathematical equation developed by the finance/lending industry to assign you a "risk profile" relative to past experience with people who have similar records of income, debt payment and so on. All this is ultimately reflected as a number ranging from 300 on the "homeless and hopeless" end of things to 800 (perfect credit) on the other.
The higher your score, the better your credit -- and the lower your interest rate should be.
Here's how it breaks down:
About 35 percent of your credit score is derived from your payment history -- how well (or not) you keep up with your current obligations. Any record of late/missed payments, etc. will negatively affect your score -- even if it happened several years in the past and you've had no incidents since that time. (Credit records typically go back seven years.)
Another 30 percent of your score is based on the amount of money you owe to various lenders -- everything from your monthly mortgage payment to outstanding credit card balances. If the proportion of your debt relative to your income is too high, your score will be lower.
15 percent of your score is based on the length of your credit history -- the more established you are, the better your credit score will generally be.
10 percent of your score is based on recently applied-for/new credit applications -- the more such applications, the more it hurts your score.
10 percent is based on the types of credit you have and are using -- is it a "healthy mix"? (Excess revolving/credit card debt is "unhealthy," as an example.)
Your credit score will also change from year to year as new information about your income, current spending patterns, recent payment history and so on are factored into the mix.
Basically, if you don't spend more than you can repay -- and your record shows a steady track of responsible conduct with money matters -- you should have no trouble getting loans at favorable rates.
It seems pretty straightforward -- and for the most part, it is. However, there are some things to be aware of that may have nothing to do with how well you manage your finances as such. People who are very conscientious with their money are sometimes surprised to discover their credit's not as good as they might have imagined. And folks who assume their number's got to be really low based on their high debt load may have higher-than-expected credit scores.
Absence of payment history -- Some people think it's smart to avoid credit card and other debt entirely, preferring to pay for things as they go with checks or cash in order to avoid living beyond their means. This is prudent in terms of keeping within one's limits -- but as far as your credit score goes, it leaves a black hole on your record that can be just as lethal as having too many cards or getting in over your head with debt. The problem is that without a paper trail, no one really knows how good -- or bad -- a risk you really are. Having a Visa or Mastercard creates that paper trail for you. It also shows that you can handle credit -- and that's ultimately what it's all about. This is especially important for young people just entering the work force.
Too many cards -- Even if you never carry a balance (or always make your minimum monthly payment) having too many credit cards can hurt your credit score as badly as having too few (or no) credit cards at all. The assumption is that with access to all those potential lines of credit, you might over-spend yourself into the poorhouse without realizing it until it's too late. It's easy to fall into the trap of having too many cards given the weekly deluge of offers most of us get in the mail each week -- but to keep your credit score healthy, avoid having more than 3-4 credit cards in your wallet.
Too many credit inquiries -- If you're thinking about a car (or other loan) avoid applying for new store cards, a home equity line or other forms of credit during the weeks/months prior to applying for your loan. Each time an inquiry is made into your credit history during the application process, it is reported -- and that can negatively affect your overall credit score. Again, the assumption (as far as the credit equations go) is that you're too extended, or in danger of becoming over-extended.
Finally, everyone should periodically check their credit report for accuracy -- and immediately contest any erroneous information that may have found its way onto your record.
Contact info for the three major credit bureaus is as follows:
Equifax (www.equifax.com or call 800-685-1111)
Trans Union (www.transunion.com or call 800-888-4213)
Experian (www.experian.comor call 888-397-3742)
For more information on this topic, visit our Car Loans center.