It is common to assume that paying bills on time automatically means having a high credit score. Unfortunately, that's not always the case. There are many misperceptions about how scores are calculated -- and yours could be lower than you might expect.
Credit scores are used by financial institutions to determine whether they should lend money to a potential borrower and, if so, what interest rate should be charged. A higher score means an applicant is statistically less likely to default on the loan so they get a lower interest rate.
Ignoring your credit score could be a costly mistake. As an example, let's say you bought a $400,000 house with a 30-year fixed-rate mortgage at a 6-percent interest rate. Over the term of the loan, you would pay interest charges of $463,354. If, however, you had a lower score and your bank bumped your interest rate up to 8 percent, you would pay interest charges of $656,619. That's a hefty difference of $193,265.
There are many credit scoring systems available to lenders, but FICO scores are by far the most commonly used. The system was developed by the Fair Isaac Corporation back in the 1960s. Technically, you have three different FICO scores -- one for each of the three major credit reporting agencies.
Knowing how FICO scores are calculated can help you make better decisions about your credit. At a minimum, you should be aware of some of the most common misperceptions:
I always pay my bills on time so I must have a high credit score.
Paying your bills on time is clearly a critical factor, but it only accounts for 35 percent of your overall FICO score. It also looks at four other components: the amount of debt you owe (30 percent), the length of your credit history (15 percent), the number of credit accounts you've recently opened (10 percent), and the types of credit you use (10 percent).
Consolidating multiple credit cards will increase my score.
Consolidating credit cards could make it easier to pay down debt, but your FICO score could actually decrease if you consolidate to fewer accounts with balances that are closer to the maximum available credit. FICO considers you a lower risk if you have multiple credit accounts, keep the payments up-to-date, and maintain balances between 25 percent and 35 percent of the available credit.
I don't have any credit cards or other major debt so I can't have a low score.
Your FICO score doesn't take into account your net worth or your income level -- it only looks at your past borrowing history. Your FICO score will be lower if you haven't established a long-term borrowing history with multiple creditors.
Closing a credit card is better for my score than keeping it open.
Closing a credit card will not necessarily hurt your score in the short term, but you will eventually lose the positive effects of the long-term credit history that you've established with that lender.
I shouldn't shop around for a mortgage or other large loan because credit inquiries hurt my score.
A large number of credit inquiries will lower your score, but FICO is smart enough to know when you are rate shopping. Inquiries for similar types of credit are bundled if they're made within the same 14-day period.
I shouldn't check my credit report more than once a year because credit inquiries hurt my score.
Checking your own credit report does not affect your score, so feel free to check it as many times as you'd like.
If you want to learn more about how FICO scores are calculated, visit Fair Isaac's web site at www.myfico.com. They offer a host of informational materials and credit score tips. And while you're at it, you can also order your three scores for a small fee.
Becoming more knowledgeable about FICO scores could help you to keep those pesky interest rates at a minimum. With just a small investment of time, you will be able to make smarter credit decisions and take proactive steps to increase your score.