Lenders profits make money by charging you interest and lose money when borrowers default. Because of the risk of a loss, lenders generally charge higher rates to those borrowers who they view as being risky.
In the old days, lenders made loans to people they knew or they called your other creditors to see if you were responsible and paid your bills on time. Nowadays, banks have turned to a numeric estimate of your credit worthiness—your credit score.
Since your credit score determines how much you’ll be charged for a loan, it’s important to know how it’s calculated.
Each of your creditors reports information about your loan and payment history to a Credit Bureau that tracks this information. Banks buy this historical information and use a credit scoring model like FICO to make predictions about your performance by comparing you to the payment history of people who are similar key credit dimensions.
In general, credit models look at five factors to determine your grade:
- Payment history (35% of your score)
- How “maxed out” you are on your credit lines (30%)
- How long you’ve managed credit (15%)
- The types of loans you have (10%)
- New credit or credit inquiries (10%)
Not all lenders report to all bureaus, and there can be significant errors or omissions. Recent studies have determined that up to 25% of credit files have errors sever enough to impact the interest rate.
Since your information may be different or incorrect in each of the Credit Bureaus, you should monitor your report and score at each of the bureaus. You get a free credit report (but not credit score) from each credit bureau once a year at AnnualCreditReport.com. If you wish to more closely monitor any changes to your credit report or score, you can sign up for a subscription credit monitoring service (usually around $15/month) through one of the bureaus or an independent provider like PrivacyGuard.com or SmartCredit.com.
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Scott Crawford founded www.debtgoal.com, the leading online do-it-yourself debt payoff solution that helps members build a personalized "debt-loss" plan and stick with it. Described as "Weight-Watchers for debt," DebtGoal.com has helped thousands of people pay off over $1.3Bn in debt. Leveraging the success of the DebtGoal program, the company has now expanded to offer free content and tools via www.oweing.com and www.debtscore.com
Scott holds an MBA from Stanford's Graduate School of Business and a BA in economics from UCLA. He has been a featured expert for top media outlets including US News, Readers' Digest, Yahoo Finance and Bankrate.com.
Scott's family has (only somewhat) jokingly given him the superhero nickname of ThriftyMan.
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