What is a Credit score?

Your credit score is a three-digit number generated by a mathematical algorithm based on information in your credit report, compared to information on tens of millions of other people. The credit scoring concept is based on boiling down a borrower's entire credit history into one objective number. The resulting number is a statistical prediction of how likely you are to pay your bills. Your credit score will determine if you get credit at all and the interest rate on that credit. The higher the score the lower the interest rates, and that can save you a ton of money -- the difference can mean hundreds of thousands of dollars in interest. The system was first developed in the 1950s, but has come into widespread use in just the last couple of decades. The formula for the credit score takes into account how you've been paying your bills, how much you owe, the length of your credit history, how much new credit you have and what kind of credit (mortgage, credit cards, installment loans) you use.

Credit scoring models are developed by analyzing statistics and picking out characteristics that are believed to relate to creditworthiness. Although many different formulas are used to calculate credit scores, the most widely used credit score by lenders is the FICO score, provided by Fair Isaac & Co. A FICO score can range from 300 to 850.

The FICO score model takes into account five factors when evaluating your credit worthiness:

Payment History (35% of score) Amounts Owed (30% of score). Length of Credit History (15% of score). New Credit (10% of score) Types of Credit in Use (10% of score)

Lenders Use Credit Scores for Quick and Fair Evaluation of Creditworthiness

The growth in use of credit scores has dramatically increased the speed at which many credit decisions can be made. Especially for consumers with relatively good credit, approvals for loans can be given in a fraction of the time previously required, without any manual review of the information.

Your credit scores provides lenders with a quick, objective method to assess your credit worthiness. Before credit scores, lenders physically looked over each applicant's credit report to determine whether to grant credit. Not only was this time consuming, but human judgment was prone to mistakes and bias.

The advent of credit scores simplified the credit review process. Lenders use credit scores to quickly summarize a consumer's credit history, saving the need to manually review an applicant's credit report and provide a better, faster risk decision. The higher your credit score, the easier it will be for you to receive an automated loan approval.

Many lenders consider your credit score in conjunction with other factors, such as your annual income and how long you've held your current job.

The Big Difference on Interest Payments

Lenders usually reserve the best interest rates for borrowers with solid credit, or scores of about 720 or higher. Borrowers with scores in the low 600s, on the other hand, are considered risky investments and warrant higher rates. A few points of credit scores can make a huge difference because interest rates are tied to specific point ranges on the scale. If their best rates are offered to borrowers with a score of 700 or higher and yours is a 698, those two points could cost you thousands of dollars.

For example, a score of 720 to 850 would pay 5.78 percent for a 30-year mortgage, while someone with a score of 620 to 674 would pay 7.59 percent, according to myfico.com, a division of Fair Isaac.

On a $150,000 mortgage, that's the difference of $180 per month and about $65,000 in additional interest payments over the life of a 30-year mortgage.

FICO Score Distribution

Fair Isaac reports that the American public's credit scores break out along these lines:

How to Check Your FICO Credit Score

You can access credit scores from all three bureaus at myFICO.com, which is run by Fair Isaac. WIth your score analysis, you'll get an explanation of how your score is likely to affect your credit, information about what is helping and hurting your score and a snapshot of your credit history. The three major credit reporting agencies (Equifax, Experian and Trans Union) use a slightly different system to arrive at a credit score.