The first time I heard an explanation of a FICO score was while I was up late one night watching finance guru Suze Orman’s television show several years ago. Orman explained how it is calculated and why it’s important to have a good score as a consumer. When it comes to financial health and purchasing power, I should have learned about the importance of my FICO score long before that late night.
I never understood why high schools, colleges and community organizations don’t do more to educate people about credit, credit scores and how to be smarter consumers. As a result, people have a blind spot when it comes to credit. That blind spot is one reason why I enjoy writing about financial education.
According to a recent LendingTree.com survey, 59.1% of Americans don’t have a clue what their credit score is. So if you fall into that category, you’re in good company. A FICO score is what lenders use to assess an applicant’s credit risk and whether they should be approved for a loan or credit.
Where does the word “FICO” originate? It stands for Fair Isaac Corporation, which is the company that developed FICO scoring through data analysis. Since the early 1970s, most of the consumer reporting agencies (Equifax, Experian and TransUnion) have been aggregating credit information that comes in from creditors everywhere. Your FICO score, which can range from a low of 300 to a perfect score of 850, is calculated from many different pieces of data from your credit report.
There are five key areas of data used to compile a FICO score. Here are the areas and percentages that make up your score:
About 35% of your score is calculated from your past payment history with credit accounts. This encompasses your payment track record and whether you’ve paid your bills on time from month to month.
Next, 30% of your FICO score comes from the total amount of money you owe to creditors. Carrying a large amount of debt over a long period of time isn’t helpful in determining your credit worthiness. The closer you are to a zero credit balance, the better it will impact your credit score.
Fifteen percent of your FICO score depends on how long you established credit history. Establishing your creditworthiness happens over time, so if you’re new to having credit or are trying to rebuild your credit, you shouldn’t expect immediate results.
About 10% of your FICO score relies on a mix of your credit account types. This may include credit cards, retail accounts, installment loans, finance company accounts and mortgages. To earn a top-tier FICO score, you’ll need to demonstrate that you can successfully manage a mix of credit products, such as a car or student loan, a mortgage and at least one card.
The last 10% of your FICO score comes from the number of new credit accounts that you’ve opened in a short period of time. When you submit an application for a new credit card, cell phone service or utility service, your credit report most likely will be checked. This is what is called a “hard inquiry” and too many hard inquiries in a short period of time will temporarily ding your credit score. If you’re about to apply for a big loan, such as a car or home loan, you should avoid any unnecessary hard inquiries to keep your FICO score as high as possible. The higher your score, the better your interest rate (and lower payment) you will get.
Again, having a high FICO score is valuable because the higher your score, the better your rates for loans and credit accounts will be. Let’s compare two different FICO scores. Let’s say one home buyer had a 670 FICO score and got a $200,000 30-year mortgage in today’s rate environment. In contrast, let’s say another home buyer got the same house with a 720 score. The person with the higher score (a 50-point difference) can result in an interest rate that’s 2 percentage points lower, which amounts to a monthly mortgage payment that is approximately $240 lower.
As you can see, FICO scores are a big deal whether we’re talking about traditional credit lenders or nontraditional lenders. Your FICO score also comes into play when getting hired for a job, getting approved by a landlord, for starting utility and cable service and when calculating insurance premiums.
Hopefully now you know more about what goes into calculating your FICO score and how you can improve your score over time. One word of advice: Don’t kill yourself trying to achieve a perfect score! According to Credcardforum.com, only about 18% of the population have a FICO score above an 800 and less than 1% of people have a perfect 850.
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