If you’re like any other good young professional, you would have noticed a particular type of commercial at three in the morning. Their tag lines may include the following:

“Bad Credit Score? No Problem!” — “Low Credit Score Okay!” — “No FICO Score Required!”

Just what is this magical credit score that’s often mentioned in these entertaining and informative late-night infomercials?

In the United States, a credit score is a number usually between 300 and 850. These numbers are generated based on an analysis of a person’s credit history, and are thus a representation of your creditworthiness (or put more simply: are you going to pay the man or not?). The higher the number, the higher your creditworthiness and thus the lower the risk you are to lenders. Having a high credit score is one of the best money saving tips we can stress.

Because of their use as a measurement of creditworthiness, credit scores can affect your ability to acquire many things: from an auto loan, a mortgage loan, insurance, to even a potential job. Whether you like it or not, you will most likely have your credit score examined and prodded at some point in your life.Besides the ability to acquire credit, credit scores can also affect your interest rates — especially that of your mortgage loan. For example, a high credit score that obtained a low rate of 5% versus a low credit score that obtained a high rate of 7% will amount up to thousands of dollars in extra interest (and monthly payments) over the course of a mortgage term.

Example of buying a $300,000 on a 30-year loan at different interest rates:

Total Interest Cost: 7% = $418,526.69 vs. 5% = $279,767.35

Obviously then, it’s crucial to get a clear understanding of how credit scores work, what general factors make up a credit score, and how you can improve your scores (if necessary). Hopefully you can see why we stress this money saving tip.

The Low Down

Credit scores are based on credit histories that are derived from the three major consumer credit reporting agencies: Equifax, Experian, and TransUnion. Because your credit history may differ from one credit reporting agency to the next (yes, maybe one of them just doesn’t love you as much), your credit score may vary depending on the agency it’s coming from.

Example: Your credit file from Experian includes an account that has had a few late payments; for whatever reason, this particular account isn’t reported on the credit file from TransUnion. Thus, your credit score on Experian is lower than that of your score from TransUnion (because the negative implication doesn’t appear on the TransUnion file).

If you thought that was a headache, consider this fact: a credit score from one source can be vastly different from another source. In fact, some credit score may be worthless (in relevancy), depending on its source.

IIn general, what’s available to the consumer are their FICO credit scores and their recent VantageScore credit score. There are also the NextGen and CE Scores. These scores can be wildly different from one to another due to the fact that they all use different types of formulae to compute their scores. Even if both use the 300 to 850 rating system, a FICO doesn’t have to correlate to another type. To keep things simple and relatively sane, we’ll focus on the more widely-used FICO scores.

FICO Who?

As mentioned, FICO scores are a type of credit score. They are computed by the Fair Issac Corporation (hence FICO — yeah, really original). Like other credit scores, FICO scores can vary depending on the credit report it’s based on. You can purchase your official FICO score at myFICO.com.

Just as you can’t compare an ACT score to an SAT score (although both are a measurement of your academic performance), you cannot compare a FICO score to other types. After all, they’re computed by different companies, with different formulae and with different information.

Although how FICO scores are computed is a closely guarded secret, Fair Issac has given a general guideline to the make-up of a FICO Score.

Here’s a break down on factors of a FICO Score (and generally, other types of credit score):

35% - Payment History: In short, how you pay your bills significantly affect your credit score. So paying on time and paying the required amount is imperative! The difference between paying them off 60 days late versus 90 days late can also have an effect. Your number of past-due accounts versus your number of on-time accounts all fall into this category.

30% - Types of Credit Used: The types of credit you have on file is also important. Examples include credit cards, installment loans (student loans fall into this category), mortgages, consumer finance accounts, and so on.

15% - Amounts Owed: A bit self explanatory. Your proportion of used credit line and proportion of installment loan still owed also fall within this category.

10% - Length of credit History: Also self explanatory. The length of time to your various accounts will fall into this category.

10% - New credit: Your brand-new Hello Kitty credit card will fall into this category. The credit inquiries made on your credit files will also affect your credit score (inquiries being whenever you give permission for a third party to check your credit history in order to obtain credit or service).

Other factors that aren’t listed: bankruptcy, foreclosure, and judgments. These usually affect scores significantly, and most won’t be removed from your report until well over 7 years.

Things that are NOT in the score: Your employment history and your income (So yes, you might have better credit score than Bill Gates. Of course, he probably doesn’t need consumer credit).

Although your income and your employment history aren’t factors in a FICO score, they may still come into play when you’re applying for credit; after all, banks generally enjoy lending money to people who has a job to repay the loan.

Upping Your FICO Score So You’re Better than Your Friends

Now that you know what makes up a FICO score (and generally, most credit scores), you most likely have a good guess on how to make sure your FICO score is in the best shape possible.

Let’s run it down by percentages:

1. Pay on time. As mentioned, paying your credit bills on time is important! Even if you can’t afford to pay in full, you should at the very least make a full effort to pay the minimum on time. Don’t just pay the minimum, though, or you’ll never get anywhere.
2. Vary your types of credit, and limit unnecessary credit accounts. Let’s face it, 100 credit card accounts opened and no mortgage loan may look a bit sketchy. A “healthy” credit report will have a good mix of revolving accounts (credit card accounts) and installment accounts.
3. Don’t max out your credit card. Maxing out your cards fall into the “amounts owed” category. When you use up your credit limits and affect the available credit ratio, your score will be affected negatively. Thus, putting in an effort to pay off your balance will not only reduce the interest incurred, it will also improve your credit score.
4. Another reason not to open up too many new accounts. As you open up new credit card accounts, you will be lowering your average account history length. Generally, the longer you have a positive account, the better it is for your credit score. Thus, you should never close a credit card account unless it is costing you money (such as a high annual fee credit card).
5. Opening up too many credit card accounts can also affect your credit score negatively. That’s due to the large number of credit inquiries being placed on your account. You should note, however, that when you shop for a mortgage loan, inquires made by mortgage lenders within a 30 day period will all be counted as one inquiry (a good thing too, since most people should carefully select their mortgage loan).

The Ever-Changing Scores

Credit scores change daily, as information on your credit report is updated daily. Generally, you will see more changes from month to month, as your account balance update, and various information gets computed into the score (e.g, an inquiry or late payment falls off the credit report).

Although credit scores are a good gauge of where you stand in terms of creditworthiness, they’re not the only measurement lenders use to provide you with credit. Still, it’s important to understand the factors that affect a score, as the same factors also affect your overall credit picture to a lender. After all, paying on time, keeping balances low, and being responsible with your accounts are all things a lender considers when they check for your credit history.

Even if you have bad credit or a low credit score right now, fear not. With due diligence and time, you can improve your score by making sure you follow the steps outlined above. Just starting out? Even better. Take the proper step now to ensure you don’t damage your credit.

Remember, it takes months and years to build up a good credit — but it can take as little as a day to ruin a credit history and score.

More FICO Goodies:

• Understanding Your Credit Score PDF (Fair Isaac / MyFICO)
• Your Credit Scores PDF (Fair Isaac + Consumer Federation of America)
• myFICO promotional code (Personal Finance Blog)

This post was written by Cap of StopBuyingCrap.com.

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