How Credit Scores Work

By: Lee Ann Obringer

What Your Score Affects

If you aren't careful about your credit, you could end up paying dearly for a low credit score. Not only can a low score stand in the way of getting a loan for your dream home or dream car, but even if you do get the loan, a less-than-stellar score will make it expensive.

As your credit score decreases, you become more of a credit risk in the eyes of lenders. This means they'll attach a higher interest rate to your loan, and your monthly payments will jump. On the other hand, a high score will lower that interest rate. Consider this pie chart, which illustrates the relationship between credit scores and interest rates:


This next chart shows an example of how interest rates for a car loan can vary based on your credit score:

 chart on how interest rates for a car loan can vary based on your credit score

Although the score has a big impact, keep in mind that there are other factors that influence the interest rate you get for a loan besides your credit score. These might include things like the type of property you are using the loan to buy, how much of your own money or equity is going into it, the costs the lender pays to make the loan and so on.

In addition to banks and lenders, there are landlords, merchants, employers and insurance companies jumping on the credit score bandwagon. Of all of these, the fact that insurance rates are being determined by credit scores is causing consumers the most alarm. To most, it seems that your credit history and your driving record have little in common. Insurers, on the other hand, have found that credit scores help them predict how likely someone is to file claims. The rule of thumb is the lower the score, the higher the likelihood of filing claims. ­They don't use the same score that banks and lenders use, however. They use a slightly different formula for their calculations and actually call it an insurance score.

Insurers' use of credit histories to determine rates is under scrutiny nationwide. Many states are passing laws restricting this practice. In a few states, insurance companies can't make decisions based solely on credit. In some others, if an insurance company makes a decision that negatively affects your policy based on your credit, it must disclose to you the reasons behind the decision [source: CreditInfoCenter].

Another practice that particularly upsets consumers has to do with credit card companies' policy of universal default. Although we've already learned how a credit score can determine your interest rate, in the case of credit cards, your interest rate can change at the drop of a hat -- or rather, at a drop in your score. Even if you always pay your credit card bill on time, if you default on a completely separate loan, your the interest on your credit card debt could rise dramatically.

All this adds up to say that credit scores are enormously important. So putting a little thought into improving your score could prove a good investment.