Personal Finance

Your Spending Habits Could Be Increasing Your Auto Insurance Rates

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If you caused a three-car pile up last year or if your teenager has a penchant for speeding, you shouldn't be surprised when you have to pay high auto insurance rates. But what about the amount of credit card debt you carry? Did you know that can affect your insurance rates, too?

A lot of drivers are surprised to find out that their credit report makes a significant impact on their auto insurance rates. After all, what does your current debt amount have to do with your ability to follow traffic laws?

Legislators and insurers have debated for years over whether a person's credit legitimately indicates their ability to drive, and whether the use of credit further compounds the financial disparity between various demographics. However, insurance analysts insist there's a statistically relevant correlation between peoples’ credit-based insurance scores and the amount of risk they pose to their insurance companies, and the Federal Trade Commission has substantiated these claims.

The use of credit information helps to prevent cross-subsidization, according to James Whittle, chief claims counsel for the American Insurance Association (AIA), "so that good drivers do not pay for the behavior of bad drivers." Why more bad drivers tend to come from groups with poor credit isn't fully understood; it's simply borne out by the data.

To date, only three states have banned the use of credit information in setting insurance rates—California, Hawaii and Massachusetts.

It's important for policyholders with poor credit to understand the factors that affect their rates and what they can do improve these rates if they're struggling to afford their car insurance.

What's the difference between a credit score and a credit-based insurance score?

Both your credit score and your credit-based insurance score are based on your credit report. Your credit report outlines the amount and types of debt you carry, how long you've carried it, whether you're timely in your credit card and loan payments, and other information pertinent to a person's financial history.

But while both scores are based on the same report, the specific data points and algorithms used to generate them are different.

Your credit score indicates your creditworthiness. Lenders, landlords and other groups use this number to assess how likely you are to keep up with or default on your monthly payments. A poor credit score may disqualify you from obtaining a loan, or it could simply land you a higher interest rate.

Your credit-based insurance score indicates how risky you are to insure. Insurers don't use this score to determine how likely you are to pay your premiums on time. Rather, they use it to calculate how likely you are to file a claim, or how much that claim might cost. The higher your score, the lower your rates will be.

Here's a breakdown of the components that determine an average person's credit-based insurance score, according to FICO.

FICO credit-based insurance score components

However, which data points are used and the weight they're given could fluctuate if your credit history falls outside the average parameters of the general population—such as if you've just begun using credit.

What should I do if I have poor credit?

If you have poor credit and high home or auto insurance rates, your financial history is probably playing a role. There's no immediate fix for this, but over time you can increase your score.

Follow steps to improve your credit, such as diversifying the types of credit you carry and always paying debts on time. Gradually, both your credit score and credit-based insurance score will rise. If you have improved your credit, ask your insurance company to reassess your credit-based insurance score to see if you qualify for lower rates.

Everyone should work to improve and maintain their credit. However, those still paying down their debts can also find cheaper rates by comparing quotes from a few different insurance providers. While most insurers do consider credit when setting their rates, they don't all calculate it in the same way. It's possible you may find rates by switching to another insurer.

Is the use of credit reports discriminatory?

Critics of the use of credit information claim that it gives insurers a roundabout way to discriminate against some demographics.

Although it varies by state, insurers are banned from using certain criteria, such as race or level of education, to determine their rates. But lower-class communities typically have less money and less education on how to manage it, resulting in worse credit reports. It seems unfair to further punish these groups with higher insurance rates because their finances are tight, but the statistical correlation between a person's credit-based insurance score and their likelihood to file a claim can't be denied.

Whether it seems fair and whether it's statistically significant are separate issues, and one might argue that when it comes to setting actuarial rates, the latter is more meaningful. The data shows that people with a poor credit history are going to file more claims than people with a good or excellent history. If insurers are expected to manage their losses and maintain solvency—their mandate to all policyholders—then they have to set accurate rates.

The article, Your Spending Habits Could Be Increasing Your Auto Insurance Rates, originally appeared on ValuePenguin.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.