Credit and FICO

What is credit?

In the plainest terms, credit is trust. If a bank or credit card company extends you credit, they trust you with their money. They are trusting that you will pay them back in a timely fashion.


How do you measure trust?

Banks and lending institutions measure trust in terms of a “credit score”. The standard used in the United States is the FICO score.


What is FICO?

In the 1950’s the Fair Isaac Corporation established a model to determine the likelihood (risk) that a borrower will pay back money that is loaned to them. This scoring system was named FICO.


How does FICO work?

FICO scores range between 300 and 850. The lower the score, the higher the risk. The average score in the U.S. in 2004 is 725.

The factors used to make the score are:

Payment History – 35%

Do you pay bills on time, have you defaulted on loans, bankruptcies, etc.

Amounts Owed – 30%

This is a comparison of how much you owe versus how much credit you have a available to you. For the best credit score you should owe less than 10% of your available credit. That is like owing $1,000 on a credit card with a $10,000 limit. You can still get a good number in this area if you owe 20% or less of your available credit. In today's financial climate credit card issuers are lowering limits. This is in turn lowering credit scores. Are you over extended? Mortgage debt is not as bad as credit card debt for this item.

Length of Credit History – 15%
How long has your credit been established. Short histories that are clean will get high scores.

New Credit – 10%
Applying for too many credit accounts in a short period of time will lower your score.

Types of Credit in Use – 10%
Do you have a healthy mix of credit types? When I buy a car, I usually finance through my credit union, with no fee, and then pay it off with cash. This helps the credit mix. Having no debt and not using a credit card can hurt your credit score on this item.

Who calculates my FICO score?

There are three main credit-reporting agencies in the United States.
Equifax
Experian
TransUnion
Some lenders use the score from one agency and others use an average of two or three. All three use the same model but they can be slightly different based on what is reported to them by lenders.


What does a FICO score not consider?

A FICO score does not consider your race, sex, age, income, residence, marital status, or child/family support payments.


Why should I care about my credit score?

Your FICO score is a major factor that banks use when determining the interest rates on car loans, home mortgages, credit cards, and personal loans. If you have a high score, you are considered a low risk. A bank will give you their lowest interest rate.


Changes Coming

Some people and services have learned how to game the system. They “repair” credit to give someone a false high score long enough to secure a loan. Fair Isaac is making some changes in 2009 to close this loophole. I will update when the facts are out.

Consider a $150,000 mortgage:

A FICO score above 725 could get a 5.7% interest rate on a 30-year loan. The monthly payment (excluding insurance and taxes) would be $871 per month.
A FICO score around 600 could only get a 9.0% interest rate on a 30-year loan. The monthly payment would be $1207 per month.
The total payments for the 5.7% loan would be $313,560. The total payments for the 9.0% loan would be $434,520.
The lower FICO score means that you pay $120,960 more for your house!


What if I don’t need credit?

Do you need insurance? Your FICO score also affects your auto and homeowner insurance rates. Lower scores mean higher rates!