The mighty FICO score can influence how much your pay for insurance, the interest rate on a mortgage, credit card interest rates, and even whether you will be hired.  But exactly what is a FICO score?

First, what does FICO stand for anyway?  FICO is an acronym for the Fair Isaac Corporation which is the company that calculates the scores.  By the way “Fair” is not a reference to the score being unbiased, but rather the last name of one of the founders, Bill Fair.   The other founder was Earl Isaac; hence, the name Fair Isaac Corporation.

How is a FICO Score Calculated?

FICO uses a mathematical model to predict whether you will default on a loan based on your credit history.  This is done by comparing your credit profile with a historical database of over a million borrowers.  The result is a number from 300-850 which lenders use to assess the risk of extending credit.

What Factors go into the FICO Credit Score Calculation?

FICO scores are based on five factors which are weighted to reflect their importance in determining the risk of default.  Although there may be instances when a different weighting model is used, the chart below shows how the score breaks down for the typical consumer.

35% – Payment History

30% – Total Amount Owed

15% – Length of Credit History

10% – New Credit

10% – Types of Credit Used

Payment History

This is the most important factor in determining credit worthiness.  Basically, if you’ve paid your bills on time and in full in the past, you are likely to continue to do so in the future.  The components of payment history include whether you have defaulted on a loan, as well as, whether you have been late with payments, not paid the minimum due, etc. Pretty much any loan that you’ve had during the last seven years will be evaluated such as credit cards, department store cards, mortgages, car loan, loans from a finance company, and other installment loans.

If you’ve filed for bankruptcy, your credit score will be adversely affected for 7-10 years.  Defaulting on a loan, having your wages garnished, or having your house foreclosed are all events that will have a strong negative effect.

The impact of having some late payments on your record will vary based on how late the payments were and how much money was owed.  So, if one month you forgot to pay the bill for a $3 toll, don’t panic.  It’s not the same as missing mortgage payments.

Total Amount Owed

The FICO score attempts to determine whether you owe too much money already.  Since credit reports do not include information on your income, the amount owed versus available credit is the primary factor used to determine whether a borrower is overextended. If you are maxed out on all of your credit cards, you will not be as attractive to lenders.  Having numerous credit cards with a balance can also be a negative.  Even if you pay your bill in full each month, the balance is taken as the amount owed on your last statement so you will still be considered to have a balance. (One “trick” that people employ to improve their credit score is to request a higher line of credit on their existing cards.)

It’s not all about credit cards.  The percentage owed on installments loans is also a factor.

Length of Credit History

This refers to how long you have had credit accounts.  The ages of the oldest account and newest account are taken into consideration along with the average age of all accounts.  That is why it is not recommended you close older accounts.

New Credit

New credit refers to new credit accounts that you have opened but also includes recent credit checks by lenders.  So, if you apply for a credit card or loan and are denied, this will event will still be factored into the new credit component of your score because the lender will have checked your credit report.  This is why it is not advisable to apply for several credit cards in a short period of time.  Don’t worry though about checking your own credit score since doing so won’t count against you.

Types of Credit Used

The score also looks at your portfolio of credit and takes into account the number of accounts and their type.  Having a lot of accounts won’t necessarily have a negative impact if you are managing them well by paying your bills on time.

Where Does the Data Come From and Why do I seem to have Different Scores?

There is a key point that many people are not aware of which is that there is no single FICO score.  The FICO scoring system relies on credit history which is collected by three main credit reporting agencies: Experian, Equifax, and TransUnion.  Since the three agencies will not necessarily have the same information on file for a particular consumer, which credit reporting agency your lender uses will determine the FICO score that they receive for you.

For instance, I recently applied for a home equity loan from Wells Fargo.  To evaluate the risk of lending to me and the interest to charge, they use Experian FICO score, meaning that the credit history that Experian has for me in their database was used in the determination of my FICO score for the purposes of evaluating my credit-worthiness.  A different lender may choose to use Equifax or TransUnion.  (In addition there are alternatives to FICO for determining a credit score, but that will be covered in a later blog.)

To make matters a bit more complicated, FICO also produces credit scores tailored to specific industries so if you are applying for an auto loan, a slightly different model may be used in determining your score.

What Factors are NOT Included in the FICO Credit Score Calculation?

The score does not consider demographic information such as race, religion, marital status, where you live, or age.  It also does not include employment information or any other information that is not present on a credit history report.

Keeping Tabs on Your Score

Consumers are able to get one free credit report from each credit reporting agency (Equifax, TransUnion, Experian) per year.  The report does not include your credit score, but it is important to make sure that the data going into your score calculation is accurate so it is important to review your credit history.  Remember, that the agencies won’t necessarily have the same information, so it is important to check all three.  Currently, you have to pay to receive your FICO score but legislation is pending to make this information available to consumers for free once each year, and some credit card companies have started providing free credit scores as a service to its customers.

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