Credit scores: What's in them, their importance, their effect

By Ben Woolsey

What is a credit score?
You’ve heard of a credit report, but you don't understand what a credit score is. Furthermore, you're unsure as to how this affects you when applying for a new credit card. A credit score is a sum that is determined by lenders using a mathematical formula and is derived from information taken from your credit report. This sum is an indicator of how likely you are to repay your loans. In other words, this is how lenders determine if you are a risk for lending money to or if are going to be an ideal creditor who will pay your bills on time and in full.

Lenders have been using credit scores as part of the lending decision for over 20 years. There are several factors the can influence your credit score:

• How you paid previous debts
• How much you still owe to other creditors
• How long you have had credit (length of credit history)
• Number of bankruptcies, charge-offs, and collections
• Current available credit

When all this information is factored together, the lenders determine your overall credit score.

How does my credit score affect me?
A credit score is just a number; however, it is a very important number. It is a vital indicator of your financial health, in the same way that your cholesterol number is just a number until you realize the significance that number has on your overall health. To avoid a financial heart attack, it is important to become familiar with your credit report and to rectify any mistakes or errors that could negatively impact your credit score.

Lenders use credit scores to:

• Determine creditworthiness (whether they will give you the loan)
• What Annual Interest Rate (APR) to charge on credit cards

A good credit score can help you get prime rates that will save you money over the long run. A not so good credit score, on the other hand, could cause you to receive an APR that is a couple of points above the prime rate, which will cost you a lot more money over the long haul.

What is a "good" credit score?
Generally, the higher the score, the better. Each lender determines what their “good” credit score range is and what constitutes a risk. Therefore, it is best to discuss with the lender what their criteria for credit scoring is and how this could affect your application.

If you have additional questions about credit scores and how they relate to your personal financial situation, contact a financial adviser or a loan professional.

Published: April 22, 2006

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