Ever wonder why you can go online & be approved for credit within 60 seconds? Or get pre-qualified for a car without anyone even asking you how much money you make? The answer is credit scoring.
 

Your credit score is a number generated by a mathematical algorithm based on information in your credit report, compared to information on tens of millions of other people. The resulting number is a highly accurate prediction of how likely you are to pay your bills.
 

If it sounds arcane & unimportant, you couldn’t be more wrong. Credit scores are used extensively, & if you’ve gotten a mortgage, a car loan, a credit card or auto insurance, the rate you received was directly related to your credit score. The higher the number, the better you look to lenders. People with the highest scores get the lowest interest rates.
 

Scoring Categories

The scale runs from 300 to 850. The vast majority of people will have scores between 600 and 800. A score of 720 or higher will get you the most favorable interest rates on a mortgage, according to data from Fair Isaac Corp., a California-based company that developed the credit score.
 

What’s the big deal?

The difference in the interest rates offered to a person with a score of 520 & a person with a 720 score is 3.45 percentage points, according to Fair Issac’s website. On a $100,000, 30-year mortgage, that difference would cost more than $85,000 extra in interest charges, according to Bankrate.com’s mortgage calculator. The difference in the monthly payment alone would be about $235.
 

Key factors of you score

Just what goes into the score? Pretty much everything in you credit report, with different kinds of information carrying differing weights, says Fair Isaac consumer affairs manager Craig Watts. The model looks at more than 20 factors in five categories.
 

1. How you pay your bills (35 percent of the score): The most important factor is how you’ve paid your bills in the past, placing the most emphasis on recent activity. Paying all your bills on time is good. Paying them late on a consistent basis is bad. Having accounts that were sent to collections is worse. Declaring bankruptcy is worst.
 

2. Amount of money you owe & the amount of available credit (30 percent): The second most important area is your outstanding debt – how much money you owe on credit cards, car loans, mortgages, home equity lines, etc. Also considered is the total amount of credit you have available. If you have 10 credit cards that each have $10,000 credit limits, that’s $100,000 of available credit. Statistically, people who have a lot of credit available tend to use it, which makes them a less attractive credit risk. Carrying a lot of debt doesn’t necessarily mean you’ll have a lower score. It doesn’t hurt as much as carrying close to the maximum. People who consistently max out their balances are perceived as riskier. People who never use their credit don’t have a track history. People with the highest scores use credit sparingly & keep their balances low.
 

3.  Length of credit history (15 percent): The third factor is the length of your credit history. The longer you’ve had credit – particularly if it’s with the same credit issuers – the more points you get.
 

4. Mix of credit (10 percent): The best scores will have a mix of both revolving credit, such as credit cards, & installment credit, such as mortgages & car loans. Statistically, consumers with a richer variety of experiences are better credit risks. They know how to handle money.
 

5. New credit applications (10 percent): The final category is your interest in new credit – how many credit applications you’re filling out. The model compensates for people who are rate shopping for the best mortgage or car loan rates. The only time shopping really hurts you score is when you have previous recent credit stumbles, such as late payments or bills sent to collections.
 

What doesn’t count in a score?

Age, race, job or length of employment at your job, income, education, marital status, whether or not you’ve been turned down for credit, length of time at your current address, whether you own a home or rent.

A lender may consider all those factors when deciding whether to approve a loan application, but they aren’t par of how a FICO score is calculated.

Credit scores are not perfect

The major drawback to credit scoring is that it relies on information in you credit report, which is quite likely to contain errors. That’s why it’s critical that you check your credit reports annually, or at the very least three to six months before planning to buy a house or a car. That will give you sufficient time to correct any errors before a lender pulls your scores.

Four Credit-Scoring Myths
By Liz Pulliam Weston

Looking to buy a home, condo or homesite? Make sure you know what will truly hurt and help your case with lenders -- and don't fall for the misinformation mortgage lenders can spread.
 

There's a lot of misinformation being propagated about what does and doesn’t hurt your credit score, and much of it is coming from sources who should know better: mortgage lenders.

Now, let me say first that I’ve worked with several excellent lenders who really knew their stuff and kept up to date, not only on loan trends but on the information that’s available about credit scoring. That’s important, because the FICO credit score, in its various permutations, is used in three-quarters of all mortgage lending.

But what I heard from several lenders responding to my recent column, “8 big mortgage mistakes and how to avoid them,” was the kind of bad advice that can cost you money and keep you from getting the best loans.Check out your options. Record low rates could save you a bundle. So if your mortgage broker gives you any of the following advice, take a tip from me: Find a new broker.

Closing accounts can help your credit score

No, no, no. For the umpteenth time: Closing accounts can never help your credit score, and may hurt it.
 

Every time I write this, I get more e-mail from people who say their mortgage lenders told them exactly the opposite. It’s true that having too many open accounts can hurt your score. But once you’ve opened the accounts, you’ve done the damage. You can’t repair it by shutting the account, and you may actually make things worse.
 

The credit score looks at the difference between your available credit and what you’re using. Shut down accounts, and your total available credit shrinks, making your balances loom larger, which typically hurts your score.

The score also tracks the length of your credit history. Shutting older accounts can also make your credit history look younger than it actually is, which can hurt your score.

Rather than closing accounts, pay down your credit card debt. That’s something that actually can and usually will improve your score.

Checking your FICO score can hurt your credit

Unfortunately, I heard this one from a mortgage broker who is otherwise pretty smart. He was confused about which type of inquiries hurt your score and which don’t.

Applying for new credit is generally what hurts your score. Ordering a copy of your own credit report or credit score doesn’t count. Those mass inquiries made by credit card lenders, who are trying to decide whether to send you an offer for a pre-approved card, also aren’t going to hurt you, either -- unless you actually take them up on their offers.

If you want to minimize the damage from credit inquiries, make sure that when you shop for a mortgage you do so in a fairly short period of time. The FICO score treats multiple inquiries in a 14-day period as just one inquiry and ignores all inquiries made within 30 days prior to the day the score is computed.
 

For most people, one inquiry will generally knock no more than 5 points off a score (and scores typically run from 300 to 850, so that’s not a big percentage).

Credit counseling will hurt your score as much as a bankruptcy

The current FICO formula ignores any reference to credit counseling that may be in your file. That’s been true for the last three years, after researchers at Fair, Isaac, the company that created the FICO scoring system, noticed that people getting credit counseling didn’t default on their debts any more often than anyone else.
 

Your ability to get a loan could still be hurt by credit counseling, however. Your current lenders may report you as late, because you’re not paying what you originally owed or because your credit counselor isn’t sending your payments in on time. Late payments do hurt your credit score.

Lenders consider other factors besides credit scores in making their decisions, as well. The factors they look at can vary widely. Most want to know your income, for example. Some want to know how much savings you have or whether you’re a homeowner. Some will find credit counseling disturbing, while others see it as a good sign.

The mortgage lenders who don’t like credit counseling generally treat its enrollees the same as if they had filed for Chapter 13 bankruptcy. Chapter 13 is the kind of bankruptcy that requires a repayment plan and is looked at somewhat more favorably than Chapter 7, which allows you to erase many of your debts. You might still be able to qualify for a loan from one of these lenders, although your interest rates will almost certainly be higher than if you had perfect credit.

If you plan to get a mortgage soon, and you’re not already behind on your debts, it’s probably smart to steer clear of credit counseling. If you’re already in trouble, however, a good credit counseling agency might be able to help you get back on track.

Your FICO isn’t the only score you need to check
This came from lenders who thought the FICO score is offered by only one of the three credit bureaus: Equifax.

In reality, all three of the bureaus offer FICO credit scores using the formula developed by Fair, Isaac, but they each give the scores a different name. At Equifax, the FICO is known as the Beacon credit score. At TransUnion, it’s called Empirica. At Experian, it goes by the unwieldy title of “Experian/Fair, Isaac Risk Model.”

Complicating matters further is that you’ll probably have three different scores from the three different bureaus, largely because the bureaus don’t all share the same data. One bureau may list more accounts for you than another, for example, and the differences (in types of accounts, payment histories, credit limits and balances) will be reflected in the score that bureau computes for you.

Because of those differences, it does make sense to pull and examine your credit reports from all three bureaus before you apply for a big loan like a mortgage. Many mortgage lenders take the middle score from the three bureaus when making their decisions, so fixing errors in all three reports before you shop for a loan is smart.

When it comes to comparing your scores, however, you may be stuck. Equifax is so far the only bureau that makes it easy for consumers to get the same FICO score that lenders see. (You can order your Equifax FICO score on MSN Money here.) The scores typically provided to consumers by Experian and TransUnion aren't FICO scores, and they're different from the scores these bureaus provide to lenders.

But the ways you improve your credit score are the same in any case: Correct errors. Pay your bills on time. Pay down your debt. And apply for credit sparingly.

Liz Pulliam Weston's column appears every Monday and Thursday, exclusively on MSN Money.