Credit: What is a FICO Score?

I didn't plan on bringing you another credit-related post so soon. In fact, I expected that I would probably be giving you a post on tax issues about now, but maybe I'll do another post on tax day for that one. Anyway, today we will talk about one of the greatest mysteries in the world of credit: The (dreaded) FICO Score!

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The reason that the FICO score is such a mystery, is that Fair, Isaac, and Company (the developers of the FICO score) won't release the formula that they use to compute it. Over time, we have figured some things out about what drives the score, and I will share with you some of what we have learned to this point.

I'm sure that by now, everyone has heard of the FICO score, as it has become a topic of major discussion, and is one of the major components in the process of applying for any loan, but especially with regard to mortgage loans. With all of the news about the housing crisis and the tightening of mortgage lending, the FICO score has become a point of contention.

The basic breakdown of your FICO score is as follows:

• Payment History - 35%
• Outstanding Balances - 30%
• Length of Credit History - 15%
• Amount of New Credit - 10%
• Types of Credit Used - 10%

Payment History

If you pay your bills on time, this helps a lot. If you have late payments, collections, back child support, and/or judgments appearing on your credit report, this hurts a lot. The amount past due, length of delinquencies, time since you last paid late, number of past due items, and number of accounts "paid as agreed" all play a role in determining the "Payment History" portion of your score. Obviously, if you pay all of your accounts on time, this is a huge help to your score!

Amounts Owed

Obviously, the amount of money that you owe is a factor here, but what is less obvious is that the amount you owe for certain types of debt can work against you. If you have amounts owing to Finance Companies (i.e. Wells Fargo Finance, Finance & Thrift, etc.), this will lower your score, even if the payments are always on time, because these are considered "lenders of last resort." If you could have been granted credit at better rates, the assumption is that you would have used another credit card or finance method. The unfortunate part of this is that these institutions often finance autos and furniture at stores you frequent, so you might have a balance with them, even if you have stellar credit otherwise.

American Express can also lower your credit score, because they don't show a credit limit. This means that the FICO system assumes that you are using 100% of your available credit on the card. Also, if you have an account where the limit has been lowered, this can hurt you as well. You don't want to be over your credit limit on any account, because you will take a severe hit to your score. The outstanding balance as a proportion of the credit limit is also a factor, with any balance in excess of 20% of the credit limit working against you, albeit on a sliding scale. For best results, stay under 20%. To avoid any dings, stay under 45%.

Length of Credit History

This is how long you have had a credit record, as well as how long your existing accounts have been open. If you have accounts with histories over two years, DO NOT CLOSE THEM! You can stop using them, but it is better in most cases to keep the accounts open with a zero balance.

New Credit

This runs in concert with Length of Credit History, but takes a special look at recently opened accounts and the number of recent credit inquiries. This factor also looks at your attempts to re-establish good payment patterns after a series of past payment problems.

Types of Credit Used

This looks at what proportion of your credit usage is comprised of mortgages, installment (auto or other purchase-money) loans, credit cards, finance company accounts, etc. If you have 100% credit cards, this can count against you, while a mortgage will generally help your score.

Summary

Keep in mind that your FICO score takes into account ALL of the above issues. Yes, some of these issues seem to overlap, but the overall weighting of each issue is as stated above. Your FICO score only takes into account information on your credit report, so your job, income, and education level do not play a part in your score, but they may affect a lender's desire to offer you credit. Also, the Credit Reporting Agency does not determine whether you get credit; only your lender makes that decision, but your credit score will be an important factor in that decision.

Clarification

You may hear some things in the news about FICO '08. This is a change to the scoring system that eliminates the advantage of riding on someone else's credit history by becoming an authorized user on their established cards. At this point, only Experian plans to use it, as both TransUnion and Equifax are in litigation opposing its implementation. If you plan to use this 'credit riding' technique, you can probably continue to do so for the foreseeable future. With most lenders looking at your mid-score, and TU and EQ still using the old formula, your EX score will matter less.

In a later posting, I will provide tips on how to Keep and Maintain a High FICO. Stay tuned!