Understand How FICO Credit Score Works

Sunday, February 22, 2009, 12:41 AM | 2 Comments

Up until, perhaps 2006, credit was in abundance. You went to the bank, someone would be waiting for you, would even open the door for you.

Credit from the credit card companies was rushing towards you like a mountain stream, fresh untainted. In some communities, at times, there is shortage of water.

The credit back then was better, as in plentiful, than water.

Even if you didn’t need money, they would give it to you.

But it was not free money. You borrowed it, better yet rented it, and then after using it, you had to return it to the owner.

A lot of folks messed up those days. They, probably, thought it was free money and that they didn’t have to return it. Those were the good old days.

Those days are gone. We must wake up to the reality of the current situation.

If you borrow lawnmower from your neighbor, you damn make sure, you return it. If you break it, make sure you fix it and then return it.

Many folks screwed up because of their mindset and then the bad economy played a big part.

We cannot do anything about the lousy economy, but we sure can change our mindset about our personal finances – credit, debit, debt and the like.

What’s a FICO score?

Your credit score is used by lenders and credit card companies to make decisions about your livelihood and your financial life itself. They must have a means of determining whether you are at high or low risk.

If you have a better than average credit score, they can extend you a line of credit or issue you a mortgage or auto loan or business loan.

Creditors also use your credit score to figure out how much interest to charge on a loan.

FICO scores are usually intended to show the likelihood that a borrower will default on a loan; a separate score, the Bankruptcy Navigator Index (BNI), is used to determine the likelihood of a borrower’s declaring bankruptcy.

Each credit bureau also calculates a credit score (not a FICO score) using its own proprietary model which differs from the model used by Fair Isaac Corporation.

It is not unusual for these scores to differ – by 50, 100 or more points – for the same borrower.

For the three types of credit for which a FICO score is generally used (mortgages, automobile loans, and consumer credit), lenders usually establish different cut-offs for lending.

Before you go ahead and screw up your credit score, try to understand the chart from FICO – Fair Issac Corporation – and see how you can avoid worsening your ratings.

FICO Scores are calculated from a lot of different credit data in your credit report.

This data is grouped into five categories as outlined in the chart.

The percentages in the chart reflect how important each of the categories is in determining your FICO score.

Warning

It’s important you read the warning down below to understand fully how FICO treats each category.

The warning on FICO website states that

• A FICO score takes into consideration all these categories of information, not just one or two.

• The importance of any factor depends on the overall information in your credit report.

• Your FICO score only looks at information in your credit report.

• Your score considers both positive and negative information in your credit report.

1. Payment History

   FICO gives it the most importance. All kinds of credit is included here, namely, credit cards, store cards, mortgage payment, various installment loans, etc.

   35% importance for this category is a lot, better than one-third. So try your utmost to make your payment before the due date and never be late or miss a payment. The rest of the categories combined are less than two-thirds of the whole chart.

2. Amount owed

   The next big category is 30% of the whole chart. That is a little less than one-third. The important thing to remember is to keep

   • Total credit on your account as high as possible
   • The amount owed as low as possible
   • The number of accounts where you keep the rented money as low as possible

3. Length of Credit History

   The third big category is 15% which is at least half of each of the first two, but important nonetheless. That is a part of the history since when you opened a certain account for renting other people’s money.

   So if you have always returned the rented money to its proper owner, on time and in full, you should be doing OK.

4. New Credit

   If you have applied to new credit, or someone has made an inquiry to your credit account, you get penalized by 10%. So if your credit is excellent to the tune of, let’s say, 750, a 10% penalty will bring it down by 75 and that is a lot.

   So put a break on the temptation when a store offers you 10% discount on merchandise if you open up a store account, try to say NO and again NO.

5. Types of Credit Used

   Number of recent information on various types of accounts – credit cards, retail accounts, installment loans, mortgage, consumer finance accounts, etc.

   Any or all of these items will have a 10% effect on your credit score. So the 10% on the chart in this category goes to

   • Number of accounts you have recently opened
   • The proportion of new accounts to total amounts
   • Number of recent credit inquiries
   • The time that has passed since recent inquiries or newly opened accounts.

In a Nutshell
Take good care of your credit. You can get a credit report three times a year, one after the other, from the three major credit agencies. Those three reports from each are free of charge.

Get in control of your finances. You can only get a loan at lower interest rate if your score is high. If it is excellent, such as 800 or better, you will be able to get the loan at an even lower interest rate.

So don’t lose your livelihood and get into the habit of starting to improve your credit score. Do it for yourself and your family. Show them that you care.

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