Why Credit Scores are Important

Today’s economy has everyone thinking about their financial standing. Along with having enough capital on hand to pay living expenses, stash some away for savings, plan for college, and hope to have a retirement fund, making sure that your credit score is in good condition almost gets lost in the shuffle. In fact, with all of this fancy financial footwork going on, it’s easy to forget how important having a good credit score really is.

What Does my Credit Score do, Again?

Credit scores, or FICO scores, are a calculated measurement of how likely an individual is to pay off a loan, and range from 300 to 850. Basically, money lenders use this number to decide how risky it is to loan you money. Those with higher scores are safer to loan to because in the past they have a solid history of paying loans back on time and in full, while those who have lower scores have had problems with complying with loan repayments in their credit history, making them riskier to loan to. Again, this risk is defined as the likelihood of the borrower paying back the amount in full.

Based on your riskiness—measured by your credit score—money lenders decide first if they will loan to you or not. If they decide to loan money to you, they go back and consult that credit score again to determine how high of an interest rate to charge you. Again, the higher the credit score, the lower the interest rate and the lower the score, the higher the interest rate. The reason for this is because the lender is taking on more risk by loaning to those with lower credit scores, and the return on a higher interest rate is their reward for assuming that additional risk.

Why do I care about an Interest Rate?

Borrowers should care about the interest rate they receive on a loan because this is the amount of money they will pay to the lender for the privilege of borrowing the money. The higher the interest rate, the more it will cost the borrower to borrow the money; the lower the interest rate, the less it will cost the borrower to borrow it. For example, a let’s say a person with a high credit score—700 or above—goes to the bank to borrow $1,000. The bank looks at their FICO score and sees that they are in excellent financial health and the likelihood of them getting their money back is very high, so this individual is a very low risk. As a result, they issue this customer the line of credit at 3%. This means that it will cost this customer $30 to borrow $1,000; a very good deal indeed. Next, another person walks into the bank looking to borrow $1,000. The bank pulls this person’s FICO score also, and finds that their number is very low—620 or lower—signifying to the bank that there are most likely going to be problems getting their money back. Even though this customer is risky, they decide to lend the money, but do so at a significantly higher rate: 10%. This means that it will cost this individual $100 to borrow $1,000. The bottom line here is that individuals should care about their credit score because it can save them money at a time when they probably need it the most—when they go to borrow money.

How can I Improve my Credit Score?

The number one way to improve your credit score is to make your payments on time; even if all you are doing is making the minimum required payment, do so on time. This shows potential creditors that you favorably abide by your financial contractual obligations.

The next piece of advice is don’t take too much credit out, or apply too often for credit. If you take too much credit out you run the risk of not being able to pay it off, which will hinder your progress towards the first point here. If you apply too often for credit, this lowers your credit score because research has shown that those who open a large amount of credit within a short period of time are less likely to pay any or all of it off.

Check your credit score often. You can check it yourself without injuring the score, so do so frequently. This will allow you to make corrections if errors appear, and keep you informed to your general creditworthiness. To do so, contact one of the three credit rating bureaus:

• Equifax. P.O. Box 740241, Atlanta, GA 30374-0241; (800) 685-1111
• Experian. P.O. Box 2002, Allen, TX 75013; (888) (397-3742)
• Trans Union. P.O. Box 1000, Chester, PA 19022; (800) 916-8800