Have you ever wondered what in the heck is a FICO score? Do you know what FICO is, but you don’t know how it’s calculated? I caught up with Jason Alderman of Visa, Inc. Jason runs the company’s global financial literacy initiative, which includes the award-winning “Practical Money Skills for Life” and “What’s My Score?” programs. These are his words . . .
1. What is a FICO score?
A credit score is a complex mathematical model that evaluates many types of information in your credit history. Lenders use credit scores to help them determine whether they want to open an account with you or lend you money – that is, whether you are a good credit risk.
Credit scores are three-digit numbers, typically ranging from about 300 to 850; the higher the number, the better your credit rating is.
The most commonly used credit scores are called FICO scores, named for Fair Isaac Corporation (FICO), which developed the proprietary software used by most credit bureaus to create your scores. (The three major credit bureaus from which most lenders purchase credit scores are Equifax, Experian and TransUnion.)
These credit bureaus track things like the numbers and types of credit accounts and loans you have, how long you’ve held these accounts and whether you’ve paid your bills on time. When you or a lender request, the bureaus will compile a credit report, which is essentially a snapshot of your credit history at that moment in time. Then, they use information found in your credit report to determine your credit score. (Note that because each credit bureau compiles and tracks slightly different information, your credit scores from each may vary.)
2. How are FICO scores calculated?
Five factors are used to determine your FICO score. They are:
- Payment history – Account payment information on specific types of accounts you may have, such as credit cards, retail accounts, installment loans (such as car loans), finance company accounts, mortgage, etc.
- Amounts owed – How much you owe on different accounts, including the proportion of balances owed to total credit limits. (The lower this ratio, the better.)
- Length of credit history – How long your various accounts have been open, as well as the time since the most recent activity in each.
- New credit – The number of recently opened accounts as compared to your overall number of open accounts, tracked by account type.
- Types of credit used – The number of various types of accounts you have (credit cards, loans, etc.)
Credit scores take into consideration positive and negative information in all five categories, but may weigh them differently depending on your individual circumstances. In general, the weighting proportions are roughly: Payment history (35%), amounts owed (30%), length of credit history, (15%), new credit (10%) and types of credit used (10%).
These percentages are helpful to know because the show that you can have the biggest impact on your credit score by improving your payment history and amounts owed – in other words, things like making payments on time and reducing the amounts you owe relative to your credit limits.
3. What else is factored into the FICO score besides credit cards?
Credit scores track your behavior in many different types of credit activity besides credit cards, including installment loans (such as car and student loans), home mortgages, consumer finance accounts (such as sub-prime loans and debt-repayment services). They also track unpaid collections, court judgments and tax liens, usually when the original debt was for more than $100.
FICO scores do not track factors such as race, color, religion, sexual orientation, national origin, marital status, age, salary, occupation, employment history, residence or interest rates being charged on existing accounts. However, when evaluating your fitness for credit, some lenders may supplement credit scores with their own criteria, including income, length of employment or other factors.
4. Why is it so important for young adults to pay attention to their credit?
When young adults first head off to college or move out on their own, they usually have a very limited credit history and may not fully understand the impact some of their early decisions may have on their ability to get credit later on.
Although you may receive offers to open new credit accounts or loans, it’s important to be very careful to limit your purchases and loans to a level where you can manage monthly payments. Once you start missing payments or paying less than the minimum amount due, your credit score will drop and several bad things can happen:
- Your accounts could be closed or new activity restricted
- Your interest rates on existing accounts could increase significantly
- When you apply for future accounts or loans, you may not qualify – or you will be charged much higher interest rates
- Some landlords and employers use credit scores when weighing potential candidates
5. What can hurt your credit score?
Several types of activity and behavior can damage your credit score, including:
- Paying bills late or missing payments.
- Not paying at least the minimum amount due.
- Keeping debt levels too high, either by maxing out or approaching credit limits, or by carrying a high debt-to-income ratio, which could indicate to a potential lender that you might have difficulty paying off new loans or account balances.
- Owning too many credit cards (which could indicate that if you maxed out on all your card limits, you might be unable to repay your debt).
- Not alerting creditors if you’ve moved or changed names.
- Not periodically checking your credit report to look for and correct inaccurate or missing information.
- Not using your full legal name in financial documents (it’s not uncommon for people with similar names to show up on each other’s credit report).
6. What can help your credit score?
There are several things you can do to maintain a good credit score or improve a low score, including:
- Keep your credit balances low relative to your available credit, both on individual accounts and overall. A good target is to never owe more than 25% of your available credit.
- Pay all bills on time. Late payments can have a big negative impact on credit scores. Many people choose to have automatic payments for recurring bills like utilities and loans deducted from their checking or credit card accounts to ensure they don’t miss deadlines; just make sure you have enough in your account to cover the amount due.
- Make more than the minimum payment due. This will significantly shorten the payment duration as well as the amount of interest you pay over the long run.
- Don’t open a lot of new accounts in a short period of time. Each time you apply for a new account, it shows as a credit inquiry on your credit report, which can signal to potential lenders that you may be in financial trouble.
- Pay off credit card debt rather than transferring it to a new account. Revolving your debt from card to card does not improve your debt-to-credit ratio. Also, by increasing the number of new accounts, you artificially diminish the length of your credit history because no one account is open very long. Plus, you’ll likely incur transfer fees that add to your overall debt.
- Review your credit reports regularly and correct errors and omissions. By federal law, you can order one free report annually from each of the three major credit bureaus at www.annualcreditreport.com.
To learn more about credit scores and how they work, I suggest visiting www.myficoscore.com and looking under the “Credit Education” tab. Another helpful resource is What’s My Score, Visa Inc.’s financial education web site. It is geared toward helping young adults understand the importance of establishing a responsible credit history, with extensive information on how credit reports work, how credit scores are calculated, tips for improving scores, and much more.