Understanding How a FICO Credit Score is Determined
This video from the Continuing Feducation series provides a short overview of credit scores—how they are determined and why they are important.
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Understanding how a FICO Credit Score is Determined, Presented by: Econ Lowdown.
A FICO credit 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 story packed into a three-digit number, which indicates a person's credit risk. Your credit score is based on 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 (Fair Isaacs Corporation) and other credit scoring companies are always updating their formulas or models, and lenders choose which model to use.
Even though FICO updates its formulas, it uses the same general categories in all models for the development of its credit scores.
Here are the categories FICO generally includes with a rough estimate of the emphasis placed on each category.
Payment History accounts for roughly 35 percent of the credit score; Amounts Owed Relative to Limits accounts for roughly 30 percent, Length of Credit History accounts for about 15 percent, Frequency of New Credit accounts for roughly 10 percent and Types of Credit Used accounts for about 10 percent.
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 the most recent delinquency was 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 10 years for bankruptcy filings. In the latest FICO model, lenders will see borrower’s trended data for the past 24 months for every borrower. They will be able to see if a borrower pays balances in full over time. This change will likely benefit those who are working to pay off their debts. But, it could cause a drop in the scores of people who have acquired more debt over that time.
Amounts owed Relative to Limits is your debt-to-credit ratio or your debt utilization. Say you have five credit cards, each with a $20,000 limit. That means you've got a $100,000 credit limit. You may only be using 10 percent of that, and that's positive; however, if that means you've maxed out on one card, that's negative. FICO’s most recent model places more weight on rising levels of debt, higher debt utilization and late payments. It also places more emphasis on personal loans. Regardless of the model being used, it’s important to keep your utilization low.
Length of Credit History takes the average length of time you have had your credit card accounts into consideration. The longer history you have of 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 of this new debt. Therefore, they will be less likely to lend you money.
While examining Types of Credit used, lenders prefer to see that you are capable of handling different types of credit. So, someone who only has credit card debt will 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, buy car insurance at lower premiums, and obtain credit at lower interest rates. That's right: A good credit score will save you money.
Here's an example: Kim and Lee are applying for a $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 a different story.
Kim pays all her bills on time and in full, she usually uses about 10 percent of her total credit limit, and she's had the same credit cards since college.
Lee, on the other hand, frequently forgets to pay his bills on time, he uses over 50 percent of his credit limit and, when he maxes out a credit card, he 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 – Kim would, because her credit score is closer to 800 while Lee’s is closer to 600.
Suppose that Kim received a 5 percent simple interest rate on the $10,000 loan while Lee received an 8 percent simple interest rate. Over the course of a year, Kim would pay $500 in interest while Lee would pay $800 in interest. That's $300 more interest than Kim. He 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 fees. Avoid opening new credit card accounts or installment loans. Keep your debt-to-credit ratio low. Don't cancel your oldest credit cards as length of credit history is important, And, remember, monitor your credit reports.
By law each of the three credit bureaus, TransUnion, Equifax and Experian, must provide you with a free credit report every year. You can obtain these free 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.
While you can get your credit report for free from each of the big three credit-reporting companies every 12 months, you generally have to pay to get your numerical score. Free scores, however, are often available through financial institutions or nonprofit credit counseling services.
Now you understand a little more about how a FICO credit score is determined. Visit stlouisfed.org and the education resources for more information on credit and other topics.
Continuing Feducation brought to you by Econ Lowdown.
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