SALT LAKE CITY — Experts say maintaining a good credit rating is always critical. From buying a home to obtaining a credit card or purchasing a vehicle, almost any major purchase involves a consumer’s creditworthiness.
Unless you can pay cash for everything, living with poor credit can be very expensive. How much consumers pay for credit is heavily dependent upon their credit score.
In the U.S., a credit score is a number representing the creditworthiness of a person — the likelihood that the individual will repay his or her debt obligations. In general, lenders such as banks and credit card companies use credit scores to evaluate the potential risk posed by lending money to consumers.
The most prevalent metric in use by most financial institutions is the classic FICO score. Originally founded in 1956 as Fair, Isaac and Co. by engineer Bill Fair and mathematician Earl Isaac, FICO is a measure of credit risk that is available through all of the major consumer reporting agencies in the United States, including among others Equifax, Experian and TransUnion.
The company debuted its first general-purpose FICO score in 1989. The credit score range for the standard (classic) consumer FICO score is 300 to 850.
Credit scores are designed to measure the risk of default by taking into account various factors in a person's financial history, explained Murray-based mortgage adviser Al Bingham, who is also the author of “The Road to 850: Proven Strategies for Improving Your Credit Score.”
According to Bingham, a good credit score today is above 740, which is higher than it used to be because of more stringent standards imposed by lenders. After the financial crisis, what many creditors now consider as “good” credit is a bit higher than the traditional 720 benchmark that was accepted for so many years in the past, he said.
For perspective, Bingham described a 720 score as the lower edge of the “above average” range, which would still result in consumers paying slightly higher interest rates on loans and credit cards. In prior years, such scores would have qualified for the best interest rates available, indicative of stellar creditworthiness.
In the current credit environment, more consumers are falling into categories that end up costing them thousands of dollars in added interest costs over the long run, Bingham said.
"The actual cost from a decent-to-lower credit score has jumped substantially over the last few years," he said. "This can be attributed primarily to the fallout from the financial crisis."
Even though that period is mostly in the rearview mirror, credit requirements generally continue to be held at high levels in order for consumers to qualify for the best terms, interest rates and insurance premiums, he explained. Having an acceptable credit score in the high 600s or the low 700s is no longer the minimum desired score; it is approaching the upper 700s, he said.
Establishing a solid credit history is important in today's credit-driven society, and there are literally hundreds of strategies for maintaining or improving one's score, he added, with making on-time payments and reducing debt as common themes. But there is much more to it, he said.
"No matter what your credit score is, create a viable plan. Identify and work with a reputable credit expert, or with a credit counseling agency that has experienced counselors, to create a successful plan," Bingham advised. "A plan should correctly answer the four critical questions to credit score improvement: What accounts to keep open and use, what accounts to close, what accounts to pay down with your resources, and account activity. Failure to correctly answer these four questions will lower your scores."
He also advised that developing multiple golden accounts — those accounts open for at least 10 years — is a critical strategy.
"If possible, avoid high levels of debt on credit card, auto and home loans," he said. "Consumers never know what tomorrow brings, and one small financial hiccup can topple an excellent credit rating for years to come. That one small hiccup can easily cost a consumer tens of thousands of dollars."
The changes in the current credit market are forcing many consumers to take a more informed approach to credit management, one analyst said.
“People are becoming smarter in regard to what their credit score means,” said John Potter, senior vice president and credit administrator for Zions Bank. “(That’s) pushing the scores up and interest rates lower for customers.”
He said that as consumers become more aware of how to manage their credit and improve their overall score, the number of people with higher FICO scores is increasing. He also noted that many consumers learned some valuable — sometimes difficult — lessons as a result of the economic downturn.
While the financial crisis was challenging, the “silver lining” may be that lenders are much more careful about whom they approve, and consumers are more knowledgeable about the consequences of poor money and credit management.
Becoming educated as soon as possible is the best way to develop into a savvy consumer, said Ann House, coordinator of the Personal Money Management Center at the University of Utah.
“It’s really important for students to start early,” she said. “It’s important to get going and start to build a credit history.”
While FICO has not released the exact formulas for calculating credit scores, the company has disclosed the various components, she explained.
The largest proportion of the formula — payment history — is 35 percent, she noted, with debt burden comprising 30 percent, length of credit history at 15 percent, the kind of credit used (installment, revolving, consumer finance or mortgage) at 10 percent, and the final 10 percent based on recent searches for credit, which happen when consumers apply for a new credit card or loan.
She recalled helping her daughter launch a credit history as a teenager by putting her on her personal credit accounts at local department stores. Even though her daughter wasn’t necessarily making purchases, she was benefiting from her mom’s usage and meticulous payment habits.
“Had she needed a student loan (for college), she probably could have gotten one on her own because she would have had those years behind her of a good credit history,” House explained.
She recommends that young people obtain a credit card to help them learn how to be responsible and become financially competent.
“The best thing for parents to do is to put kids on a credit card to start showing lenders that (they) can handle a loan,” she said. “If the child is still living at home, then the parent can monitor and help and teach (them) how to use a credit card responsibly.”
On the contrary, if the parent waits until their children are out of school, they have wasted a significant opportunity to impart critical knowledge about sensible credit management, House added.
Using a single credit card for everyday purchases and paying it off in full each month can help build a strong credit history that shows creditors that you are a good risk, she said.
“It doesn’t mean piling on debt,” she said. “It just means using a credit card to pay your bills. You’re using it to build good credit.”
The more consumers learn about developing strong credit, House said, the less fearful they will become and the more they will be able to work within the system.
Visit MyFICO.com to learn more about bolstering an individual's credit score.