The Importance of the FICO Score

What is a FICO score and why is it so important? For those in the credit industry, knowing what a FICO score is can help a lot in maintaining a healthy lending business. That is because the FICO score is being used in order to assess a person's credit worthiness. Lending money to people is always a risky endeavor. Lenders always have the fear of never ever getting back the money that they have loaned. And because it is a business, lending institutions can only make a profit if borrowers actually make the payments on the money that they loaned. For them, it is very important to know about an individual's borrowing as well as debt payment behavior before they can ever decide on handing out the money in the form of a loan or other types of credit.

Creditworthiness of an individual is something that lending institutions really want to know before they ever want to decide of loaning any amount of money. And the best way to do that is by knowing the FICO score and what it represents in terms of an individual's credit behavior and pattern. And just what is a FICO score? It is simply a way of being able to measure an individual's creditworthiness without requiring the lending institutions access to an individual's income history or employment status and, in a way, being able to maintain a person's privacy in some way.

What is a FICO score and how did it come to be? It was originally developed by the Fair Isaac Company in order to help the credit industry assess individuals applying for credit. The FICO score is calculated taking into consideration certain factors that determine one's credit behavior. Such factors included in calculating for the FICO score include one's credit history, current credit owed, the length of the credit history, recent loans applied for as well as the various types of credit each individual has obtained. The FICO score is now widely used by major credit reporting agencies in providing lending institutions with a credit report on individuals applying for a loan, getting a mortgage or trying to get approved for a credit card. Credit card providers and banks also use the FICO score in order to determine credit limits and the setting of interest rates.

Before an individual's FICO score can be calculated, he or she must at least have one credit account open and active for a minimum of six months. This is the bare minimum of information that is needed for calculating an individual's FICO score, although it would still be a long way from being considered credit worthy. Most lenders prefer to see an individual having minimum of three or four credit accounts that have been maintained for at least 12 months. This is what banks look for in providing large lines of credit and mortgages to its clients.

What is a FICO score in terms of your credit worthiness? A FICO score is rated at scale from 300 to 850. The accepted median for the FICO score is around 720. FICO scores that are 725 and above are considered good scores while those found below 600 are considered bad. Making sure that one keeps his or her FICO score high would ensure that lenders would approve of credit or loans being applied for.

Improve Your Credit

Your credit score is a very important number. It will decide many things in your future, including whether or not you will qualify for auto loans, credit cards, and mortgages; what interest rate you will have to pay, and many other credit limits. But many people do not really know what affects their credit ratings, nor do they know how to improve their credit ratings. It is not just about paying your bills on time. There are many other factors the the credit reporting agencies consider when determining an individual's credit score.

Credit Score Composition

Punctuality of Payments (35%) - The single largest portion of the credit score is punctuality of past payments. Credit score is affected only by payments more than 30 days late.

Available Credit (30%) - Almost one third of a credit rating is calculated by the ratio of debt to available credit for revolving accounts, such as credit cards. This is the amount of credit that is available to be used.

Length of Credit History (15%) - This is portion of the credit rating is determine by how long your credit history goes back. When determining your credit rating, the age of your oldest account, and the average age of all your accounts are taken under consideration.

Types of Credit Accounts (10%) - All three credit reporting agencies like to see a mixture of different types of credit accounts, including installment, revolving, and consumer finance.

Recent Credit History (10%) - One tenth of the credit score is calculated by recent credit searches and recently obtained credit. This includes financial institutions running your credit with or without your consent, as well as if a new credit account was recently opened.

Tips to Improve Your Credit Rating

- Pay all bills on time. One late payment
could take your credit score down up to
100 points. Try to use automatic payment features if possible.

- Try to keep balances for accounts such
as credit cards under 60% of total available credit.

- Open non credit accounts, such as savings and checkings accounts.

- Don't close older unused credit accounts. This will lower both your level of available credit, as well as the average age of your accounts.

- If you can afford to, do not declare bankruptcy. Most people with accounts that are in delinquency or collections will suffer an ever greater deduction from their credit ratings if they file for bankruptcy.

Breaking Your Credit Score Down Into Its Components - Part 1

To best understand how the score is computed you need to understand that the FICO score is made up of 5 main factors that are all weighted differently. This means that some factors like payment delinquency is weighted more heavily than say, inquiries for new credit. While this makes common sense, by understanding how the computer scores different factors you will have a better shot at making the changes that will have the maximum impact to your score.

Factor 1: Payment History - 35% of Score

It is easy to understand why your payment history is weighted so heavily as it is this information that tells a prospective creditor what your history has been paying your other creditors. This information gives prospective lenders insight as to how you will likely treat their account based on your previous payment history.

When it comes to derogatory credit information (often referred to as "dings") the assignment of weight (how much your score will decline) is based on three factors:

• Recency

• Frequency

• Severity

Recency refers to how recent (from the time of credit report being pulled) the "ding" was reported. For example, if you had a 30-day late on a credit card only one month ago, this would score more heavily (more negatively) than a 30-day late that was reported last year. As far as regular payment "dings" (30, 60 & 90 day lates) the time scale is 24 months. This means that the more recent the "ding" to the date that the report was pulled, the more it hurts your score. The closer the "ding" to the 24 month (back) date, the less it will impact your score negatively. And when the standard 30, 60, or 90-day late becomes over 2yrs old it is NO LONGER PART OF THE SCORE! While you can still READ the information on the report (for up to 7 years) the "ding" is no longer being calculated as part of your score. This is important, because for most people, if you start doing the right things with your credit and pay your bills on time, you can go from bad credit to good credit, even great credit within 2 years.

Frequency refers to how often you have payment "dings". If you have one 30-day late in the last 24 months, this will hurt your score less than if you had 2 or more late payments in the last 24 months. So the fewer the late payments within a 2 year period, the better!

Severity refers to the type of derogatory information or "ding". A 30-day late is worse than past-due. A 60-day late is worse than a 30-day late and a 90-day late is worse than a 60-day late. Nothing is worse than a 90-day late because credit card companies have determined that most 90-day late accounts end up having to be "charged off" and end up in collections. In fact the true definition of the original FICO score was "What is the likelihood that a borrower will have a 90-day late in the next 24 months?" Try to avoid 90-day lates at all costs as this type of "ding" is weighted the most heavy and negatively affects your score more than the others. However, as with 30-day and 60-day lates, after the "ding" is over 24 months old, it is no longer part of the active score.

Factor 2: Balance of Available Credit - 30% of Score

The second largest factor affecting your credit score, next to your delinquent payment history is related to your balances relative to your credit limits. It is important that you understand how this works. Let's say you have a VISA card with a $10,000 limit. If your balance on that credit card is $6,000, although you are not maxed-out...you will suffer a "ding" to your credit. Fair Isaac will not release the details of exactly how much it hurts your score, but it is generally accepted that like the rest of credit scoring, it is based on a sliding scale.

The closer to maxed-out the worse the "ding" to your score. Again, although Fair Isaac has not released the details, many industry experts believe that the optimal ratio of balance to available credit is 30%. It is also generally assumed that the "ding" becomes more severe as you cross the 50% line and head towards the max. This ratio is applied per card not against your total credit limit across all cards. For example, if you had 4 credit cards each with $10,000 limits, the system will look at the balance ratio on each card and then assign a point value. The reason that this is important is that many people might have several credit cards that have no balance and that they rarely, if ever use. Then they have one or two cards that they use all the time. Let's say that out of the 4 cards I mentioned previously, Jane only carries a balance on one the cards and leaves the other three with no balance. If card one had a balance of 8,000, although that only represents 20% of her total available credit ($40,000) it actually represents an 80% ratio for that specific card, and that is how the system is looking at that. So Jane would be better off (from a credit score perspective) to spread $2,000 onto each card thereby reducing her ratio to only 20% per card. The reason is that there is NO positive points awarded for carrying no balance, only negative points for the 80% ratio on the one card that Jane uses.

So she was "dinged" for the one card she uses, but received no compensating positive points for the three cards that she carried no balance. An important distinction to make is that credit scoring decisions may be counter to financial decisions. For example, if Jane only used card #1 because it had a very low interest rate compared to her three other cards, this would be a good financial decision. However, as we have just learned this will cost her in FICO points. So you need to make your decision based on what your goal is. If you have excellent credit and have points to spare (i.e. 750) then you may choose to use Jane's strategy and save money on interest charges. If on the other hand you are trying to improve your credit while you apply for a loan or a new credit card, you would want to spread the money to all the cards to avoid the "ding" from the 80% ratio on card #1.