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The Truth About Credit Scores

Have you ever wondered what your credit score is? Or, do you have a pretty good idea of what your score is, but have no idea how to improve it? Or maybe you're one of the few people that know what your score is, as well as the basics of improving, but have no idea how the score is actually calculated? The truth is, the actual formula for calculating your credit score is a closely guarded trade secret, the credit bureaus are protecting their business by not disclosing precisely how your credit score is determined. However, understanding what goes in to a credit score can be the first step to repairing your credit report and improving your score.

Understanding what your credit score is

First, it's important to understand what a credit score is and how it affects you. For years, lenders and creditors have been using the same basic credit-scoring concept to help them make good decisions on whether or not to approve you for mortgages, auto loans, credit cards or other financing. A low score generally means a higher interest rate, and if it's too low you risk not being approved at all.

How your credit score affects your life

Recently, employers have begun using credit reports and the information contained in them to pre-screen applicants and potential new hires. In fact, without a good credit score you may not be eligible for many government jobs and other jobs that require security clearance or access to sensitive and proprietary information. Add to this the fact that most insurance companies are starting to use the information contained in your credit reports to determine whether to offer you coverage and what premiums you'll pay for auto insurance, and you start to get an idea of just how much your credit score is affecting your life. But what is a credit score? In the simplest terms, a credit score is a snapshot of you as a consumer, and a number that represents you as a credit risk, the higher the number, the less risky you are, and the more likely you'll be approved at better rates. There are a variety of factors that figure into the overall score, and it's important to understand how each of these factors affects your credit.

The five areas of your credit score

There are basically five types of information on your credit report, and they are all used to calculate your overall score. These five areas are payment history, amounts owed, length of credit history, new credit applications, and types of credit. Here's an explanation of what each area really is, and how much it affects your overall score:

Payment History (35% of overall score)

We all know it's important to make payments on time, and this particular area makes up the biggest part of the credit score. In addition to items like late payments, collection accounts, charge-offs and bankruptcies all fall under this heading. Knowing that your payment history makes up 35% of your overall score, it's pretty clear why you should make every effort to ensure your creditors are paid in a timely manner.

Amounts Owed (30% of overall score)

Scoring models that the credit bureaus use evaluate how much you owe in relation to your credit limits. High balances and limit overages translate into lower scores. However, it's not always wise to carry a zero balance, either. The credit bureaus like to see that you're actually using the credit you've been extended. So the question is, where do you keep your balances? The magic number seems to be right around 35% of the available balance. Keep your balances fairly low, but make sure you're still using them, and you're on the right track to rebuilding your credit score.

Length of Credit History (15% of overall score)

A short credit history can negatively affect your score, the creditors and lenders may view you as an unproven risk. That's why it's a good idea to keep your oldest lines of credit open, rather than paying them off and closing them.

New Credit Applications (10% of overall score)

Applying for several new lines of credit within a short time frame can adversely affect your score as well. Use your best judgment in applying for new lines of credit, and don't be too eager to take advantage of an extra 10% savings on your purchase if you apply for an in-store credit card.

Types of Credit (10% of overall score)

Major credit cards will have a much greater impact on your score than department store cards. Auto loans and mortgages are also more likely to impact your score.

How to find out what your score is

Knowing that these five areas of information are what make up your credit report is the first step in understanding how to repair and manage your credit reports. But what's the score, and what does that three-digit number really mean? Under the Federal Fair Credit Reporting Act, you're entitled to one free credit report from each of the three major bureaus each year. The score is another matter entirely, and it'll cost you to find out what it is. If you purchase your credit score from each of the three bureaus individually, you'll pay around $15 each, but if you buy the score from www.annualcreditreport.com, where you can also get your free credit report, you'll only pay $6-$8.

What the score means

But what does this number mean, and how do you know if you have good credit or not? Well the credit score scale ranges from 300-850. Lenders consider anything below 620 to be high risk, and you may want to consider repairing your credit and taking action to boost your score. On the other end of the scale, anything above 720 is considered to be good credit, and in general qualifies for better financing rates. If you're anywhere below this, you may want to consider some sort of action plan for repairing any damage you may have done to your score.

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