FICO is a company that uses statistics and mathematical formulas called algorithms to determine a person’s credit score. A FICO score is the most common credit score used to determine loan eligibility and the interest rates a person pays. A credit score is a person’s financial history packed into a three-digit number which indicates a person’s credit risk.
Your credit score is compiled of information found in your credit report. A credit report is a loan and bill payment history kept by a credit bureau. Financial institutions and other potential creditors use credit reports to determine the likelihood of debt repayment. Credit scoring companies use statistics to determine the risk associated with lending.
They do not use data such as sex, age, race or religion to determine the likelihood of repayment. FICO and other credit scoring companies are always updating their formulas but here are the categories that FICO generally includes development of its credit scores, with a rough estimate of the emphasis they place on each category.
Payment history accounts for roughly 35% of the credit score. The amounts owed relative credit limit accounts for roughly 30%, length of credit history accounts for about 15%. Frequency of new credit accounts for roughly 10% and types of credits used accounts for about 10%. Let’s quickly break down each category. Payment history takes into account any bills paid late including how many are late, how late they are, how recent any delinquencies are and the total amount owed.
This is where people can sometimes find themselves in trouble with credit. The good news is that over time, older entries including negative entries disappear from your credit report. Typically, seven years for late payments and ten years for bankruptcy filing. Amounts limit is your debt’s to credit ratio.
Say you have five credit cards, each with a $20,000 credit limit. That means you’ve got a $100,000 credit limit. You may only be using 10% of that and that’s positive. However, if that means you’ve maxed out on one card, that’s negative. It’s best to keep your debt to credit ratio below 50%. Length of credit history takes the average length of time you’ve had your credit card accounts into consideration.
The longer history you have on making payments on time, the better your credit score. Frequency of new credit is important because if you have a lot of newly issued credit in your credit history, whether new loans or new credit cards, lenders may be concerned about your ability to repay all that in your debt.
Therefore, they will be less likely to lend you money. While examining types of credit used, lenders prefer to see that you’re capable of handling different types of credit. So someone who only has credit card debt would probably not have as good a score as someone who has demonstrated good payment habits on installment loans, mortgage loans, and student loans as well as credit card debt.
All of this is important because your credit score affects your ability to rent an apartment, a car insurance at lower premiums, and obtain credit of lower interest rates. That’s right, a good credit score will save you money. Here’s an example. [xx] and [xx] are applying for $10,000 loan, both look like qualified candidates.
They both live in the same city and work at the same company. Let’s see if their FICO score tells the same story. [xx] pays all of his bills on time and in full. He usually uses about 10% of his total credit limit, and he’s had the same credit card since college. [xx] on the other hand frequently forgets to pay her bills on time.
She uses over 50% of her credit limit, and when she maxes out her credit card she opens a new account. Who do you think would have a higher credit score and as a result be more likely to obtain a loan with a better interest rate? That’s right, [xx] would. Because his credit score is closer to 800 while [xx] is closer to 600.
Suppose that [xx] received a 5% simple interest rate on the $10,000 [xx] received an 8% simple interest rate. Over the course of a year many of you will pay $500 an interest. [xx] would pay $800 in interest. That’s $300 more interest than [xx]. She could have saved or used that $300 to purchase something else.
So your credit score does matter. Let’s recap. To maintain a good credit score, pay all bills on time and in full. This way you avoid late bills. Avoid opening new credit card accounts or installment loans. Keep your debt to credit ratio low, don’t cancel your oldest credit cards as credit history is important.
And remember, monitor your credit reports. By law, each of the three product bureaus TransUnion, Equifax, and Experian must provide you with a free credit report every year. You can obtain these three copies by visiting www annualcreditreport.com Remember each of these reports may vary slightly from the others, so it’s important to check all three.
Now you understand a little more about how a FICO credit score is determined. Visit saintlouisfed.org and education resources or more information on credit and other topics.
“’Let them eat credit’ could well summarize the mantra of the political establishment in the go-go years before the crisis” — Raghuram G. Rajan
“Life was a lot simpler when what we honored was father and mother rather than all major credit cards” — Robert Orben