Credit scores are an important fact of life: they dictate whether you can borrow funds, and what interest rates you'll be offered for credit you qualify for. But, how does your credit rating affect your life without you knowing - and should it scare you? (For more, find out What Credit Score Should You Have?)
Your credit rating, or FICO score, is based on information in your credit report. You probably know that your credit score comes into play when you apply for a credit card, loan or mortgage but it impacts your life in other significant ways:
TUTORIAL: Credit And Debt Management
When you apply for an insurance policy, your credit score and credit report do play a role in determining your risk, but it's one small part of a much larger scoring system. Ultimately, whether an insurer decides to extend coverage to you depends on your credit-based insurance score. Every insurer uses a different formula to arrive at the insurance score, but it is essentially a statistical analysis tool that calculates risk based on lifestyle, location, employment and many other factors. From that analysis, insurance premiums (or, what you pay for coverage) are determined.
Employers sometimes use credit reports when making hiring and promotion decisions, especially for positions that involve financial transactions. However, the Fair Credit Reporting Act (FCRA) mandates that employers obtain written consent from the employee or prospective employee before checking your credit rating. If the employer does pull your credit rating, he or she must provide you with written notice that it has been accessed. If the employer decides not to hire or promote a candidate based on information in the credit report, he or she is legally required to notify the candidate of the "adverse action," either verbally, electronically or in writing. The candidate then has the legal right to request a free copy of the credit report within 60 days. (To help you get a job, read Job Hunting: Higher Pay Vs. Better Benefits.)
Pre-Approved Offers of Credit
If you've received mail telling you that you qualify for a specific credit card, personal loan, mortgage, offer to refinance or switch insurers, you're credit rating has likely been scanned by the person sending you the offer. How does a company you've never done business with know so much about your finances?
The practice of "pre-approval screening" is perfectly legal and not at all uncommon. According to the Federal Trade Commission (FTC), you end up on the sender's list because they have identified a minimum credit score prospective customers must meet and had a consumer reporting company provide a list of customers who meet that criteria, or they provided a prospect list to a consumer reporting agency and asked who on it matched certain criteria.
Though prescreened offers don't impact your credit score, you will see inquiries that were made and by whom, when you review your credit report. If you don't like the idea of a company snooping around in your credit, "opt out" of prescreen offers at optoutprescreen.com. (For more, see Pre-Qualified Vs. Pre-Approved - What's The Difference?)
Knowledge Is Power
The best way to ease fears about your credit rating is to educate yourself on how credit works. By law, you have the right to access a free copy of your credit report once every 12 months at annualcreditreport.com.
It's also important to understand what behaviors and events positively or negatively impact your credit. FICO scores are based on this simple formula:
- Your payment history makes up 35% of your credit score. If you have ever had late or missed payments, or account delinquencies, they'll influence your score the most. Instances that happened two years ago or less drag your score down the most.
- The amount you owe compared to your credit limits dictates 30% of your credit rating. Stay away from charging balances that are close to the credit limit even if you pay your credit card bills in full each month. For example, if your credit limit is $6,000 and you're charging $4,000 each month, from a credit rating standpoint, you're 80% utilized in your credit at any given point in time, even if you pay the balance in full.
- Your credit history length is determines 15% of your score. There is a false belief that closing accounts will raise a credit score. In fact, doing so might lower the score.
- New credit is 10% of your score. Avoid applying for too many cards, even if you intend to use it only once for a discount and destroy it. According to Credit Cards Canada, a card is recognized on your credit report when the issuer approves it, even if you never use it again.
- The number of credit card accounts is 10% of your rating. Store-issued credit cards do less to boost your credit than a Visa, MasterCard, American Express or Discover Card.
The Bottom Line
While your credit rating can make or break your life, it isn't something to fear. When you understand how to use credit responsibly, you'll eventually earn a solid credit score and save yourself precious percentage points in interest payments. (For more tips on improving your credit score, see 5 Keys To Unlocking A Better Credit Score.)