Why are Credit Scores Such a Mystery?

Do you know how your credit score is calculated?

Most people don’t because it’s a trade secret, and the private firms that collect credit data are poorly regulated. You have better chance of reading classified U.S. State Department cables on Wikileaks.

It’s troubling that your so-called “FICO” score, which measures your ability to pay back loans and maintain credit, is such a black box. This one number can determine not only your ability to get a mortgage or installment loan, but how much interest you’ll pay over time.

How important is your FICO score? Some 90% of banks use it in determining your finance charges. The lower your score, the higher the interest rate. (The highest-possible FICO score is 850, but even people with stellar credit don’t tend to exceed 825.)

On a four-year, $20,000 auto loan, a 740 FICO means you’ll pay $139 less each month over someone with a 620 score. Over the life of the loan, that’s real money: $6,672, according to myfico.com, which can send you your free score.

Potential employers and insurance companies also check credit scores, so your FICO is a keystone to your future security as well.

How is your FICO determined? Only a handful of employees at the Minneapolis-based Fair Isaac Corp. know and they won’t tell you — or government regulators. Then how do you know you’re getting a fair assessment of your credit practices? You don’t. You have to trust them.Generally, your score is an amalgam of how much credit you use, whether you pay on time and use of credit cards. If you’re generally current on your bills and have a mortgage, chances are your score is fairly good. But if you spend to the limit, pay late fees and are behind on your mortgage, that will depress your score. Foreclosures, bankruptcies and other major deficiencies are the blackest marks.

Of course, this is not a foolproof formula. If your credit record contains mistakes — loans that you’ve paid off that falsely appear to be outstanding — that will hurt your score. Under federal law, you have a right to correct your record, although first you have to check it (do it at least once a year).

The major reporting services are Experian, Transunion and Equifax. You can correct your record for free. What if your score isn’t fair? After all, those who don’t use credit much at all can potentially get a lower score than someone whose wallet is loaded with credit cards.Neither the Federal Trade Commission nor banking regulators have much power over the credit-rating industry, which largely escaped close scrutiny under the Dodd-Frank financial reform law passed last year.

“Consumer groups also complain that without knowing how the formula is put together, there’s no way to be sure it’s reasonable or accurate,” writes Amy Biegelsen for the iWatch News. (Disclosure: I am researching a piece for iWatch’s parent, the Center for Public Integrity on politics and financial reform)

The new Consumer Financial Protection Bureau, which is slated to be up and running by July 21, is taking a close look at the credit-scoring business. Although its mission has been attacked by the banking industry and GOP Congressmen, the agency hopes to produce a report that will examine whether the credit agencies are complying with the law and treating consumers fairly.Do you think that your credit score isn’t fair? Tell the CFPB. Go to their website and tell the agency your concerns. You also can scour your own credit report for free and challenge anything in it. Caveat: Make sure to avoid “credit repair” clinics or services that sell you regular access to your credit record.

Most errors are easily fixed and there are any number of free services that can tell you how to boost your score.

Ironically, one of the better tipsheets on credit score improvement is available from the FICO folks at myFico.com. Also get a hold of credit guru Liz Weston’s new book The 10 Commandments of Money. Whatever you do, always check your credit record before you apply for a loan or line of credit. Clear up any problems, which will make that new vehicle or installment loan a lot more affordable. It’s no mystery that clean credit opens up a lot of doors.