When it comes to calculating your insurance rate, insurers want to answer one question: are you a risky person to insure? To answer this, they’ll look closely at your claims history, your driving record, your age, your credit …
Wait, wait, hold up—your credit? What does paying bills on time have to do with driving a car or managing a home?
It’s surprising, sure, but according to many insurance companies, credit is one of the best ways, if not the best, to predict your level of risk. But how exactly does that work? And what can you do if your credit score is low? Let’s break it down and find out.
How Do Insurance Companies Use Credit Scores?
First, it’s important to note that insurance companies don’t use traditional credit scores to set your rate. Instead, they use something called a credit-based insurance score.
Read: How an Insurance Company Decides to Insure You
What’s a credit-based insurance score?
Like credit scores, credit-based insurance scores are three-digit numbers based on your history with credit. But unlike a credit score, which measures the likelihood you’ll pay off debt, credit-based insurance scores are designed to measure the likelihood you’ll file an insurance claim. For example, life insurance companies in Massachusetts and Philadelphia can use your credit score to determine your premium rates.
How are they calculated?
While each insurance company has a different method for calculating your score, many use some form of FICO’s insurance score, which is composed of these factors:
- Payment history (40%)
- Current levels of debt (30%)
- Length of credit history (15%)
- New credit/pursuit of new credit (10%)
- Credit mix (5%)
Again, your insurance company may score differently than this, so it’s a good idea to reach out to your insurance agent to better understand their method.
How do credit-based insurance scores affect premiums?
First off, remember that a credit-based insurance score is only one factor affecting your insurance rate. That being said, it can have a major impact on how much you pay for insurance.
According to a recent study by the Zebra, the difference between someone with great credit and someone with poor credit is as much as $784 for a six-month policy ($634 for great credit, $1,418 for poor). Factor in other things, such as poor driving experience or a long claims history, and you could face a pretty hefty premium.
Read: The Top 5 Factors that Affect Your Auto Insurance Premium
Which kinds of insurance are impacted by credit?
Credit affects car and home insurance rates above all others. In fact, according to FICO, around 95% of auto insurers and 85% of home insurers use credit-based insurance scores in their underwriting.
In addition to these, credit can also affect your life insurance policy, especially if you’ve had a bankruptcy in the past. Your health insurance premium is probably the least affected by credit, though if your policy is through a private insurance company, your insurer may run a soft check on your credit history.
Can you get declined because of your credit?
If your credit is really bad, you may get declined, though rarely does an insurance company deny your application on poor credit alone. It’s usually a combination of factors with poor credit being one of them. Most of the time, your application will be accepted, but you’ll pay more for your policy.
Why do insurance companies trust credit-based insurance scores?
It all goes back to two big studies, one by the University of Texas, the other by the Federal Trade Commission.
Both studies found that a correlation exists between credit-based insurance scores and loss rate. In general, drivers with lower credit scores file more claims than drivers with better scores. On top of that, drivers with bad credit generally file more expensive claims than drivers with good credit.
In other words, the more policyholders with low scores, the more money an insurance company can expect to lose.
Though these studies have numbers to back up their claims, what’s missing is a compelling reason for why the correlation exists. Some, including FICO, speculate that people who care about their finances are also people who care about their cars, homes, and health, though, to this day, no data substantiates this.
This lack of a reason behind the numbers has led to a major dispute over credit-based insurance scores. In fact, three states—California, Hawaii, Massachusetts—have outlawed the use of them, and some insurance companies, especially those that offer usage-based car insurance, are starting to move away from them.
Read: The Top 5 States with the Lowest Car Insurance Rates
If you have a low credit score, what can you do?
First off, don’t panic: you got this. Though a low credit-based insurance score can be a major inconvenience, you still have options. Here are just three:
1. Look for car insurance companies that don’t check credit.
One way to skirt a credit check is to look into usage-based insurance. Instead of estimating your driving skills, these policies use in-car devices or apps to monitor your acceleration, braking, mileage, and even cell phone use in the car to set your insurance rate. For example, Travelers (a popular car insurance company in Philadelphia), takes a fair approach, not heavily weighing any factor against another, resulting in very competitive rates for all drivers.
Read: An Intro to Usage-Based Auto Insurance and Telematics.
2. Talk to your insurance company.
Sometimes, your insurer will negotiate your rate if you can provide evidence your credit was negatively affected by a major life event, such as a medical crisis, job loss, family emergencies, or identity theft.
3. Improve your credit score.
If all else fails, shift your focus to the long-term and work on improving your credit score. Yes, your credit-based insurance score is scored a bit differently. But the factors that make them up are usually identical. Just paying your bills on time, which makes up 40 percent of your credit-based insurance score, and paying off your debt, which is 30 percent of your score, can have a major impact on your credit.
In the eyes of an insurer, a poor history with credit indicates you’re more likely to take on risks, meaning you’ll probably file more claims than someone with a higher score. To balance out this added risk, you’ll most likely have to pay a higher premium. Conversely, good credit means you’re less likely to file claims, which means you’ll be rewarded with a lower premium.