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WIKI ANALYSIS
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This article is a part of Wikinvest's Personal Finance section and Guide to Investing. Please contribute or edit to improve it. |
The FICO score is a measure of a borrower's credit worthiness --the likelihood that he or she will pay back his or her loan. Consumers with higher FICO scores are considered to be less risky by lenders. The FICO score is derived from a formula that was created in the 1950s by Fair Isaac and Company as a way to help lenders to more accurately and more consistently measure the credit risk associated with borrowers. The formula takes into account factors like number and recency of late payments, total debt and length of credit history. This formula was then adopted by the three major credit bureaus- Equifax, Transunion and Experian- which collect information from thousands of lending institutions throughout the U.S. in order to calculate a comprehensive score for each borrower.
Credit Ranges
| Poor | Good | Excellent |
| <620 | 620-720 | 720-850 |
FICO scores range from 300-850, with a median score of 723, according to Fair Isaac and Company [2]. Different lenders have their own cutoffs for scores. In general, a a score above 720 is considered excellent and is eligible for lenders' best rates. A borrower with a score from 620 to 720 will have to pay more, but generally won't have trouble getting credit. Borrowers with scores below 620 are considered subprime or highly risky and typically can only get credit if they pay relatively high interest rates.
Why your credit score is important
Lenders such as credit card companies, banks and car companies use FICO scores to determine how risky a loan to a particular borrower would be. FICO scores along with other factors like income are used by companies decide not only the amount that they are willing to loan to a borrower but also interest rate that the borrower will have to pay. For instance, two people might have the same income but two different FICO scores. If borrower A has a score of 800, he or she may be offered a credit card with a 20,000 line at an interest rate of 7.5%. Borrower B on the other hand who has a credit score of 550 may only be eligible for only a $1,000 card with an interest rate of 19%. In the grand scheme of things, a higher FICO score means greater access to capital and tens of thousands in savings over a lifetime.
How FICO's scores are calculated
The Credit Bureaus
The calculation of the FICO score starts with the credit report. Each of the three credit bureaus put together a credit report on each borrower. They get their data from credit card companies, banks, and other lenders that voluntarily report payment history and other information about their borrowers. Since each of the three credit bureaus collects information separately, the credit file for any one person often varies by bureau. The different bureaus also use slightly different formulas.
Factors affecting FICO Scores
The FICO formula is fairly complex. As a result, the impact of any one element of the formula will vary depending on other elements. For instance, a late payment can actually affect the score of a borrower who has a history of making payments on time more than an individual who has several more recent, late payments. Moreover, the FICO score used from one bank to another can vary dramatically from that supplied by the three credit bureaus because lenders often add or change the weight assigned to some variables to better reflect their own priorities. For instance, one of the credit bureaus may decide that the fact that a borrower has consistently made on time payments on his or her mortgage for the last 20 years as being worth 30 points, whereas the bank that the borrower goes to for a loan to purchase a second property may calculate this as being worth 60 points. In general, however, FICO scores are determined by a several basic factors.
- Payment History (35%)- Late payments can dramatically affect a borrower's score. Lenders typically report a payment as late if it has not been received within 30 days of the due date. A payment that is 30 days late will impact your credit score less than a payment that is 60 days or 90 days late. The impact of a late payment also differs based on its recency. A late payment that was missed 3 years ago, will affect an individual's score a lot less than a late payment that occurred last month. The amount of the late payments also plays an important role. Was the borrower late on a $30 payment or a $100 payment.
- Public Records - Public records such as bankruptcies and collection negatively impact your credit score. Bankruptcies which can take as much as 7 years to remove can be especially damaging.
- Amount Owed (30%) - How much debt has an individual incurred? Perhaps more importantly, what is the ratio of his or her debt to his or her total available credit? Are any of his or her cards near their limits? Even if a borrower's overall ratio is low, having a single credit card has a balance of more than 50% can hurt his or her score.
- Length of credit history (15%) - The credit bureaus typically look more favorably on credit histories that are more established. In other words, having made payments on time consistently for 10 years is better than only having done so for 5 years. This criteria takes into account the average age across all of an individual's credit accounts, acctivity (when was the last time the borrower used his account) as well of the age of account by type of account.
- New Credit (10%) - Applying for new credit can lower your score in the short term. New accounts reduce an individual's average account age. Moreover, each time a borrower applies for credit, the lender pulls their credit report . This is called an inquiry. The number of new inquiries, as well as the time between inquiries can also affect your score.
- Diversity of Credit Lines (10%) - The Fico formula also takes into account the diversity of a borrowers credit lines. For instance, a borrower who has had a car loan, a mortgage and several credit cards, scores better than one with only credit cards. It is not necessary that a borrower hold multiple types of credit at any one given time, but only that he or she has had them at some point.
- Score Cards - Depending on the above factors, borrowers are assigned to one of 10 score cards or scoring groups [4]. For instance, borrowers with bankruptcies on their credit reports are grouped with other borrowers who have filed for bankruptcy. An individual's FICO score is influenced in part by how he or she compares with other people in their same score cards.
References
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