FICO stands for “Fair, Isaac & Company”, the company that has been the most trusted source in calculating credit scores for over 50 years.
History of Fair Isaac
In 1956 Bill Fair and Earl Isaac founded Fair Isaac and by 1958 they began contacting some of the largest companies to explain their new calculation that they believed would help with financial decisions. They called it the credit score. The company progressed slowly over the years but managed to land some very important commercial clients including Montgomery Ward in 1963 and the first bank credit card to use their scoring system, Connecticut Bank and Trust in 1970. However, it really wasn’t until 1981 when the company introduced their first credit bureau risk score which we now know as FICO. Ten years later in 1991 the FICO credit bureau risk scores were made available at all three major US credit reporting agencies -- Equifax, Trans Union, and Experian.
So what a FICO Credit Score used for?
The score itself is calculated using many different criteria found on your credit report. Below is a list of the categories calculated into your FICO score and the weighted percentages that each have on the overall score.
- 35% - Payment History
- 30% - Debt Owed
- 15% - Length of Credit History
- 10% - New Credit
- 10% - Type of Credit Used
These percentages can change slightly depending on how long a person has been using credit but for the most part this calculation applies to the general population.
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Payment History
The payment history includes several credit factors such as the payments made on certain types of accounts, adverse public records (liens, judgments, lawsuits, bankruptcy, and other collection items), the severity of delinquency or how long a payment has been past due, the amount past due, the time since any of these public records or delinquencies were past due (i.e. was it 5 months ago or 5 years ago that you had a late payment), the total number of past due items on file, and the number of accounts paid as agreed.
Total Debt Owed
Having credit with no balance isn’t always good because it doesn’t show a history of using credit, it only shows a history of having credit. Likewise, having huge balances can negatively affect your credit score as well especially if you have more debt than the total assets you own. Some of the items taken into account are the total amounts owed, the amounts owed on specific types of accounts (owing $30,000 on a car loan is treated differently than owing $30,000 in credit card debt), the number of different accounts with balances, and the amount of available credit being used.
Length of Credit History
The longer your accounts have been active the better. This is especially the case if the accounts have been used and there is a history of activity on the account. When judging your credit worthiness, the FICO calculation attempts to determine not only the amount of debt you have or that you have the ability to get credit, but more importantly that you have the ability to USE credit and pay off those loans responsibly. So the date your credit lines were open is taken into account as well as the date of the last activity on the account. If you have $50,000 in available credit with no balance people often expect the best possible scores. When you find out that they haven’t used any credit in 5 years you begin to realize the fact that NOT using any credit may be a red flag itself. Why haven’t they? There isn’t a recent history of their ability to repay a loan so maybe this person is more of a risk. The FICO score calculation attempts to calculate this risk and takes these factors into account.
New Credit
Your credit score is also affected by the number of new inquiries or newly opened accounts and even the proportion of new accounts to the total accounts on your credit report. In order to fairly determine what is “new” the FICO calculation also looks at the time since the last new inquiry or new account in addition to the type of account. This is why you should not apply for any new credit cards within 6 months prior to applying for a major loan like a home loan. It could lower your score which could hurt your chances of obtaining a better mortgage rate.
Type of Credit
The type of credit account you have has an impact on your total FICO score. A new installment account like a car loan is treated differently than opening up 3 new credit cards at department stores. Personal business loans may also be treated differently because some loans are seen as having the potential to create additional value. A student loan is an investment in your future and may result in a higher paying job. A business loan can be an investment that creates a return while a department store or retail credit card used to purchase a new purse typically creates little value and is just added debt. The FICO score categorizes the type of credit you have and adjusts your score appropriately.
Remember: Though the FICO score might be an important factor in determining whether you will get a new loan, it is typically NOT the only factor. Lenders may look at your total debt to asset ratio and your employment history. They may look at how long you’ve lived at your residence or any number of other factors to judge credit risk.