ajc.com 2008 Holiday Guide

Holiday shoppers will inevitably face this question in the coming days: "Would you like to save 10 percent today by opening a charge account with us?"

Customers are easily tempted by an offer of a 10 percent discount, or interest-free financing for a year or more, especially when buying a big-ticket item.

But in the long run, credit experts say, that decision could cost more than it saves. Simply opening an account will lower your credit score, the three-digit number that credit bureaus use to rate virtually every consumer.

Credit scores affect a wide range of everyday transactions — from interest rates and the price of insurance to whether you can rent an apartment or get a discount on cellphone service.

Why does an extra charge account matter? "Statistically, you have become a slightly riskier borrower," said Craig Watts of Fair Isaac Corp., the Minneapolis-based company that developed the computer models used to calculate the scores.

A consumer who has applied for credit six times or more within the last year is eight times more likely to declare bankruptcy than somebody who applied for no new accounts, Watts said.

Opening four or five new accounts while Christmas shopping may not make you a riskier borrower. But it will lump you in with consumers who been have proved by computer models to be less than ideal.

Paying bills not enough

Who knew?

Most consumers understand that paying bills on time and avoiding bankruptcy help to build a healthy credit score. But many do not realize that payment history makes up only about a third of their score.

A credit score is derived from information about a consumer's loans and charge accounts. A complex mathematical model calculates the score, which rates consumers by analyzing how similar consumers have performed in the past.

A flurry of holiday shopping can quickly ding a consumer's score, even if every bill is paid on time.

"People have no idea that the balance on their credit cards, even cards in good standing, has a huge impact," said Ed Mierzwinski, director of the consumer program at the advocacy group U.S. PIRG, the federation of state Public Interest Research Groups.

Consumers whose balance exceeds 50 percent of their credit limit will definitely take a hit on their credit score, he said.

Some consumer advocates suggest never topping 30 percent of the limit. "The lower the balance shown on your credit report, the better," said Watts, of Fair Isaac.

Consumers who pay their balances every month might think they always look good. That's not necessarily so.

Credit card companies take a snapshot of customers' accounts and forward them to credit bureaus. If the snapshot is taken before the bill is paid, that balance will be figured into the credit score.

Credit bureaus historically have been hesitant to tell consumers too much about how they calculate credit scores.

The three national credit reporting companies — Experian, TransUnion and Equifax — have begun to let consumers view their credit scores, although the companies charge a fee. Federal law requires the credit bureaus to provide consumers with free copies of credit reports every year. Credit scores are calculated from the information contained in credit reports.

But the details of the models that compute the scores are still closely guarded.

"These people pretend they have the Coca-Cola formula," Mierzwinski said. "They won't release anything about what is under the hood or in the black box."

The scores determine how much consumers pay for a mortgage or auto loan. A willingness to extend "subprime" home loans — many with high fees and adjustable rates — to borrowers with low credit scores fueled the ongoing mortgage meltdown.

Credit scores also can determine whether you can open a bank account, rent an apartment or turn on the electricity without posting a deposit. If your score dips, some credit cards will automatically charge you higher interest, even if you always pay on time.

Credit scores play a major role in determining how much consumers pay for auto and homeowner's insurance. Many employers routinely review credit reports to decide whether to offer someone a job.

The trademarked FICO score produced by Fair Isaac is the most widely used score. But most consumers have many different scores for different purposes. A score used to set auto insurance rates, for example, differs from a score used by lenders.

Some consumer strategies backfire

The industry guards the details of its credit scoring models, but it does disclose the factors that influence scores. The factors that Fair Isaac considers are:

• Payment history.

• Amounts owed and relationship to credit limits.

• How many years you have used credit.

• How often you apply for credit and open new accounts.

• Types of credit, such as a mortgage, auto loan, finance company accounts or retail accounts.

Some consumers try to help their score by closing unused accounts. But that can backfire because reducing credit lines and eliminating a long-term account can be seen as negatives.

"There are counterintuitive drivers of credit scores," said Allen Fishbein, a credit scoring expert at the Consumer Federation of America.

Managing credit for a long time is considered a positive — so having had the same credit card for years can help. That's why it's often a bad idea to roll balances from one card to another.

Even the type of credit card can matter. Bank cards can help your score more than those from a department store or gas station.

"You make perfect payments to a Visa gold card, and I make perfect payments to Acme gas card, and you get more points," said Mierzwinski of U.S. PIRG.

Accounts with some types of lenders, such as finance companies, are also viewed as less attractive than others.

Scoring system is here to stay

What's the profile of a person with a near-perfect credit score?

"If we're talking about predicted credit risk, the ideal consumer is a very conservative money manager," Watts said. "It's somebody who has two or three accounts that have been open as long as the U.S. has been a country, they have never ever been late, they do use the credit occasionally, but they always pay it down to zero or to low balances."

Why do people like this get the highest scores?

"They are almost guaranteed to pay all their creditors on time," Watts said.

Consumer advocates vigorously object to the use of credit information for purposes beyond lending, but federal law allows it.

"The industry says there is a relationship between one's score and the likelihood that someone will file a claim for auto or homeowner's insurance, but they have never demonstrated why that relationship exists," said the Consumer Federation's Fishbein.

The scores may be good predictors, consumer advocates say, but some consumers with low scores do not deserve them.

Nonetheless, most experts expect that the three-digit numbers will continue to have more leverage in the average consumer's life.

"This credit-scoring system is here to stay," said Evan Hendricks, the editor of the Privacy Times newsletter and the author of a book about credit scoring.