Understanding Your Credit Score (FICO®)

Fair, Isaac and Co. is the San Rafael, California Company founded in 1956 by Bill Fair and Earl Isaac. They pioneered the field of credit scoring for financial companies. They have expanded their enterprise to cover decision systems, analytics and consulting. Every credit agency, and most lenders, calculate your credit score using software from FICO® (Beacon) or in house software based on the FICO® rating system.

What does your score mean?

This rating system is meant to develop a snapshot of the risk you currently represent to a lender. Several parameters in your credit file, including length of credit history, number of open accounts, loans, mortgages, public records, and others are formulated to produce a three-digit score between about 300 and 950. There are other scores used by lenders and insurance companies (some of which are developed by FICO®) such as Application and Behavior scores. These other scores take other information into account. Usually a lender will use a combination of your credit score with other factors when determining your risk. They all have the same objective, to determine the borrower’s potential risk. Regardless of whether the score was generated by FICO® or a system based on FICO® parameters, they all yield an industry standard three-digit score. This score places the borrower in one of three main categories (we named the third one ourselves.)

Prime, Sub-prime, and Poor

Prime  If your credit score is above 680, you are considered a “prime borrower” and will have no problem getting a good interest rate on your home loan, car loan, or credit card.

Sub-prime  If your credit score is below 680, you are “sub prime”, and will likely pay a much higher interest rate on your loan.

Poor  Below 560 is a poor score. At least that is how most lenders and credit issuers perceive it. You can still get a credit card but you will likely be hit with a security deposit or high acquisition fee. In addition, your interest rate will likely be 22 to 23%! You can forget about most home loans and the majority of new car loans at this score. Below 560 is no place to be. You will pay much, much more in higher interest and unnecessary fees. You may even pay more for your insurance rates. A very low score can even prevent you from getting a job with some companies.

How much does a low score cost you?

Credit Cards  Most if not all prime credit cards are entirely out of reach to consumers with bad credit. The few credit cards that are available to them (known as “sub-prime” cards) typically require exorbitant setup fees or recurring monthly fees, offer very low credit lines, often require cash deposits, and in most cases do not even report your positive credit activity to the credit bureaus.

Automobile Financing  If you are making payments on a car, you are probably paying between $5,000 and $9,000 more just for having bad credit. This added interest shows up every month in a higher payment. Take a look.

A $20,000 Car – Paid Over 5 Years:

Home Mortgages  Bad credit in auto financing can really hurt, but it’s nothing compared to the cost of bad credit when a home is involved. A typical home can cost between $50,000 and $130,000 or more in interest alone if you are buying the home with bad credit.

A $100,000 Home – Paid Over 30 Years:

As you can see, a low score can cost you hundreds of dollars per month! This is why it is so important to obtain and maintain as high a score as possible.

What is Used to Calculate a Credit Score?

Credit scores take into account various factors in a person’s financial history. Although the exact formulas for calculating credit scores are closely-guarded secrets, FICO® has disclosed the following components and the approximate weighted contribution of each.

35 Percent is Payment History: Late payments on bills, such as a mortgage, credit card or automobile loan, can cause a consumer’s FICO® credit score to drop. Paying bills as agreed over time will improve a consumer’s FICO® score.

30 Percent is Credit Utilization: The ratio of current revolving debt, such as credit card balances, to the total available credit limit. Consumers can improve their FICO® scores by paying off debt and lowering their utilization ratio. The closing of existing revolving accounts will typically adversely affect this ratio and therefore have a negative impact on their FICO® score.

15 Percent is Length of Credit History: As consumer’s credit history ages, assuming they pay their bills, it can have a positive impact on their FICO® score. In general, a longer credit history will increase your credit score.

10 Percent is Types of Credit Used: Consideration is taken on the mix of credit cards, retail accounts, installment loans, finance company accounts, and mortgage loans. Consumers can benefit by having a history of managing different types of credit.

10 Percent is New Credit: Multiple credit inquiries for a consumer seeking to open new credit, such as credit cards, retail store accounts, and personal loans, can hurt an individual’s score. Applying for lots of new credit in a short period of time is also viewed as risky and can cause a drop in an individual’s score. However, individuals shopping for a mortgage or auto loan over a short period will likely not experience a decrease in their scores as a result of these types of inquiries.

READ MORE ON HOW CREDIT SCORES ARE CALCULATED HERE

Improving Your Credit Score

Now that you know how your score is calculated, you can begin making changes to your current financial planning. The best things you can do are simple:

(1) Pay your bills on time. Sounds simple, but this is the biggest thing you can do to keep your score high.

(2) Delinquent payments and collections have a major negative impact on a score.

(3) Keep your balances low on unsecured revolving debt like credit cards. High outstanding balances can affect a score.

(4) The amount of your unused credit is an important factor in calculating your score. You should only apply for credit that you need.

(5) Make sure the information in your credit report is correct. If it’s not, dispute it with the credit agencies and/or with the creditor directly.

Removing negative items on your credit reports has the biggest impact on your FICO® score. Generally, negative items stay on your reports for seven years, but you can hire a professional credit report repair service such as SOKO Credit Repair to work on removing these negative items.