Review: Your Credit Score

Every Sunday, The Simple Dollar reviews a personal finance or other book of interest. Also available is a complete list of the hundreds of book reviews that have appeared on The Simple Dollar over the years.

Your Credit ScoreI was about to review the third edition of Liz Pulliam Weston’s Your Credit Score several months ago when I found out that a fourth edition was forthcoming, so I waited until this new and updated edition was released to write this review. What I found was that the book remained a detailed and useful resource concerning how credit scores work in America.

Part of the challenge of credit scores is that the exact formulas for calculating them remain trade secrets. At best, companies like Fair Isaac issue guidelines on how to improve your credit score, but they don’t tell you exactly how they’re calculated.

Unsurprisingly, this can result in some serious confusion. Even worse, these scores are used for all kinds of things, from determining how trustworthy you are during a job interview process to determining your rates when you buy insurance.

Weston has written a pretty solid concise guide to understanding and navigating this minefield.

Why Your Credit Score Matters
If your credit score is good, banks will want to do business with you. They’ll provide you good rates on things like mortgages and car loans. If your credit score is bad, banks will pretty much avoid you because, to them, you’re not worth the risk. Even if you don’t really care about such things, it’s important to keep tabs on your credit score because it’s often the first way you find out that your identity has been stolen. People open up lines of credit in your name, use them for purchases, and you’re the one holding the bill – not something you want to have happen to you.

How Credit Scoring Works
Your credit score is calculated based on your credit report, which is a compiled document about you listing all of the sources of credit you have, such as student loans, credit cards, car loans, mortgages, and so on. You can get your credit report from the federal government at annualcreditreport.com. Generally, five factors make up your credit score: your payment history (have you been making payments?), how much you owe (do you owe a lot?), how long you’ve had credit (longer is better), your last application for credit, and how many different types of credit you use, and all of these pieces are obtained from your credit report.

FICO vs. “FAKO” – Competitors to the Leading Score
The primary formula used for calculating a credit score is called FICO (short for Fair-Isaac Corporation) and it’s the general formula that’s used for calculating your credit score. Unfortunately, the FICO formula is a trade secret, meaning we don’t know exactly how it works. Some companies offer alternatives to FICO, but none of them have caught on.

Improving Your Score the Right Way
How do you improve your credit score? First, get your credit report, as mentioned above, and then make sure you know what every entry on that report is and that it’s correct. Next, make sure to pay all of your bills on time, and then pay down your debts. Also, if you’re trying to improve your score and you’re carrying any debt at all, it’s probably not a good idea to close any of your credit cards or lines of credit.

Credit Scoring Myths
The biggest myth that goes around about credit scores is that your score will be helped by closing old credit cards or having your credit limits reduced. This actually can hurt your score if you’re carrying any debt because it alters the “how much you owe” element of your credit score, which is based on a comparison of your actual debt versus your credit limit. The closer you are to your credit limits on the whole, the worse off you are. So, if you have a $2,000 debt on a card with a $2,500 limit and another card with $0 debt with a $2,500 limit, you’re utilizing 40% of your credit limit. Not bad. But if you cancel that $0 debt card, you’re suddenly using 80% of your credit limit – not good.

Coping with a Credit Crisis
Many people tend to retreat into their shell when things get financially bad, but that usually just makes things worse. A much better approach is to handle it head-on. Look for ways to free up some cash by selling off things in your closet. Prioritize your payments so that you’re not going to lose your home or your car. Contact some of your lenders and discuss the crisis you’re going through – some lenders will put your debts into forbearance during a job loss or other such situations. Weston discusses credit counseling (and doesn’t give it much of a thumbs-up) and bankruptcy as final options after you’ve tried everything else.

Rebuilding Your Score after a Credit Disaster
Much like dealing with a bad situation, recovering from it also requires you to be proactive. Check your credit report regularly and make sure it’s correct with regards to your current situation. Resolve the bad spots still left on your report. Also, if you have the opportunity, make sure that you get positive things about yourself added to your report. If you have a line of credit that’s not being reported that’s in good shape, try to get that to appear on your report by contacting the company who is offering that line of credit.

Emergency! Fixing Your Credit Score Fast
It’s difficult to get changes made immediately to your report and your score. If you do try this route, you need proof of what you’re saying or else you’re just wasting both your time and their time. A much more reliable route is to focus on the positive change you can make over a month or two by doing things such as paying off as much of your credit cards as possible (improving your ratio, as described above), using your credit cards very lightly, and trying to get positive things added to your credit report.

Insurance and Your Credit Score
Insurance companies use your credit score as an element of determining how much to charge you for insurance, so one of the best things you can do to improve your insurance rates is to improve your credit score. Of course, that’s not the only factor in determining your insurance rates, as things like your deductible amount also influence how much you pay.

Can Bad Credit Cost You a Job?
Employers often use credit scores to help winnow down applicants for an open position, particularly in a poor job market. If an open position has a deluge of reasonably qualified applicants, employers are going to look for reliable and trustworthy people, and like it or not, credit scores are often used as a quick thumbnail to check how reliable and trustworthy people are.

Keeping Your Score Healthy
Pay your bills. Pay down your debts. Have an emergency fund. Have adequate insurance (for example, life insurance for you and your spouse). These things all go a long way toward ensuring that your credit score is healthy for the long haul.

Is Your Credit Score Worth Reading?
Weston’s book focuses in on credit scores like a laser beam. If you ever had any interest in understanding how credit scores work and how they affect your life in more detail, this is absolutely the book to pick up.

Keep in mind, though, that this book hits a home run with the topic at hand, but doesn’t really address much else in terms of personal finance (outside of issues directly connected to the topic), so if you’re looking for more of a full picture, you might want to pick up a different book and look at this one as a supplement.

Check out additional reviews and notes of Your Credit Score on Amazon.com.

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  1. Valleycat1 says:

    Add: pay your bills on time is the minimum rule. But be aware that paying early ( as the bills arrive) instead of near the due date, is even better. Some companies will list you as a slow payer if you routinely wait for the due date and that dings your score.

  2. Johanna says:

    “So, if you have a $2,000 debt on a card with a $2,500 limit and another card with $0 debt with a $2,500 limit, you’re utilizing 40% of your credit limit. Not bad.”

    Is this an example that Weston uses, or is it one of your own invention? I’d always heard that you want to keep your debt-to-credit ratio below 30%, maximum. 40% is better than 80%, but calling it “not bad” may be misleading.

  3. SLCCOM says:

    Credit scores are NOT a reliable indication of how good a potential employee will be, particularly in this economy.

  4. deRuiter says:

    Another thing insurance companies look at is how many claims you have put in for payment. This means if you have a claim that is only a few hundred dollars more than your deductible, you are better off paying the extra yourself and not turning in a claim for insurance. When you make claims, your rate goes up. It’s also important to re shop for insurance every couple of years or oftener. Just because you’ve been with one company for homeowners since 1986 and never put in a claim, doesn’t mean you are getting the best rate although you should be. Shop around and often a new company will give you a better rate because you have a fine track record of not making nuisance claims. Also do what you can to reduce rates. With rental housing, the person doing the inspection will make a positive note if you do not allow tenants to keep dogs. They know that dog bite is one common, expensive claim they will not have to defend, so they will score your property higher positively, your rate will not go up, same with building hazzards, neat clean property vs ill kempt and cluttered with junk. To keep your identity from being stolen, have a credit freeze put on all three accounts at the credit reporting agencies and no one will be able to steal your identity. Just don’t lose the passwords! This is cheap, fool proof, and secure.

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