By FPA member Leslie T. Beck, CFP®, MBA

Last Updated: December 20, 2010

Although the term “credit score” can be frequently found in articles on managing your finances (a recent Google Search produced 93 million hits), many consumers remain in the dark about what a credit score actually is (and isn’t), and how to maintain their own score in the “healthy” range.

Why is this important? A low credit score can cost you substantial money over time, and you may not even know it. While many consumers realize credit scores are used to determine loan rates and eligibility (such as for credit cards and mortgages), few realize they are also commonly used to determine how much you’ll pay for things as diverse as auto insurance and cell phone plans. In addition, employers and landlords often check the credit scores of those applying for jobs or apartments. So knowing what goes into a credit score, and how everyday actions can affect it, is just being a smart consumer.

What is a Credit Score?

In 1956, a mathematician and an engineer joined forces in order to develop analytic models that could predict human behavior. Their early work eventually developed into the most common credit score in use today, known as the FICO® score (named after their company, Fair Isaac). Importantly, the FICO® score is based solely on information maintained at credit reporting agencies such as Equifax, TransUnion and Experian. So it should be no surprise that reviewing your credit report for accuracy is a big part of maintaining your credit score.

Which brings me to another point — a credit score and a credit report, while related, are actually two different things. Your credit report (which can be obtained free of charge by law only at www.AnnualCreditReport.com) is a history of all your credit transactions, including mortgages, credit cards, auto loans, student loans, installment loans, etc. Your credit score is a mathematical analysis of all those transactions, used to determine how likely it is you will repay a loan on a timely basis. And unfortunately, in most cases you will have to pay a fee to obtain that score.

Tips for a Healthy Score

Now that we know what a credit score is, let’s examine what goes into it (more information on FICO® can be found at www.myfico.com). The majority of your score (35 percent) is comprised of your payment history.

• Tip #1: Always pay your bills on time. Late payments will lower your credit score — period. However, establishing (or re-establishing) a track record of timely payments will slowly raise your score.
• Tip #2: Thirty percent of your score is based on the amount you owe your creditors. The amount is not an absolute number — it’s viewed as a percentage of the amount of credit available to you as reflected on your credit report. Say you have one credit card with a total credit limit of $10,000. Avoid having a balance over 50 percent (or $5,000 in this example) on that card. What if you have multiple credit cards? Avoid having an individual balance more than 50 percent on any one card, as well as staying below the 50 percent level for all combined cards. Going above that level will reduce your score. And remember, even if you pay off your credit cards every month, your credit report will still report the latest balance.
• Tip #3: The remaining parts of your score concern your length of credit history, types of credit in use and new credit applications. So don’t close credit cards, even if you rarely use them (unless there is a hefty fee involved). Keep credit cards active by using them occasionally for small purchases. Having different types of credit (credit cards, a mortgage, an auto loan) can be an advantage, as long as you can afford the payments and make them in a timely fashion. And don’t go on a credit binge by opening up multiple accounts in a short period of time — this will definitely hurt your credit score. By the same token, shopping for the best rate (say, on a mortgage or auto loan) will not hurt your score, as long as it’s done within a relatively compact time frame (typically 14 days).
• Tip #4: While negative items can have a quick, and large, impact on your score, it usually takes much longer to improve your credit score, which is why it’s important to plan ahead for any major credit applications. The number one action you should take is to review you credit reports for any inaccurate information. And unfortunately, this involves reviewing all your credit reports, as many creditors rotate which credit reporting agency they use for their credit scores. If you see something that is incorrect, dispute the information with the credit agency.

Another action you can take is to pay off large credit card balances — note that due to reporting lag times, this action can take up to two months to flow through to your credit score.

Some things what won’t help include closing unused credit accounts (this might actually hurt your score); shifting balances around credit cards; and opening new accounts just to increase your amount of available credit.

Managing your credit score might sound intimidating, but you’ve already taken the first step by reading this article. Putting this information to use can help you make better decisions regarding your use of credit, which will ultimately put more money in your pocket. Learn more about managing your credit score.

FPA member Leslie T. Beck, CFP®, MBA, is one of the founders of Compass Wealth Management LLC, a fee-based financial planning and advisory firm based in Maplewood, NJ. Leslie is also the in-coming president of the Financial Planning Association of New Jersey.