Tuesday, December 15, 2009

How Do Credit Reporting Companies Determine My FICO Credit Score?

They have a formula by which they calculate the score of each individual. It’s designed to give them an objective (mostly) method to predict how likely it is that you’ll repay a new loan.

Often, a credit score is referred to as a “FICO” score. Where did this term come from?

From two men named Fair and Isaac! In the mid-1950s, they founded a company called Fair Isaac Corporation. Over the ensuing years, the name got shortened to “FICO.”

Fair, Isaac is a for-profit company, traded on the New York Stock Exchange (NYSE: FI). Their exact formula for calculating credit scores is termed “proprietary;” that is, it’s secret.

Each of the major American credit reporting agencies (CRAs) has a relationship with Fair Isaac. The “Big Three” CRAs are: Experian, Equifax, and Transunion. You can find them easily on the Internet.

In a common-sense world, each CRA would have the same credit score for each person. So, why don’t they? Because they each have different formulas for determining your credit score! That means your score may vary from one CRA to the other!

Each CRA formula is based on experience with millions of consumers. With each credit rating company, the higher your score, the better your credit is rated.

Now, above, I said that the credit formulas are secret. And they are, but we can sketch the general elements of those formulas. So, for example, we know that FICO models analyze these items in your history:

* Past delinquencies
* Derogatory payment behavior
* Current debt level
* Length of credit history
* Types of credit
* Number of inquiries by lenders and others into credit history.

Although the models vary as I stated earlier, the general formula looks like this:

* 35 percent on a borrower's payment history.
* 30 percent on debt.
* 15 percent on how long the applicant has had credit.
* 10 percent on new credit
* Another 10 percent on types of credit.

What Is the Range of FICO Scores?

Keep in mind that the following ranges sometimes change or vary with a particular source.

In general, however, the higher the score, the better your credit rating is, as stated earlier.

At the top end of the range is the perfect score of 850. As you can guess, very few, very rich people achieve this kind of perfection (only 1% of the U.S. population)! They get the lowest and best interest rates and get their loans fast. And why not? From a lender’s point of view, they’re an extremely low risk!

Eleven percent (11%) of the American population has a score of 800. That means they’ll also get lower interest rates and have their loans closed within days (just not as fast as the “perfect people” above).

So, what’s the score of the average American? 720! The interest rate for these individuals will be higher than the two categories above, and it might take days or weeks to close the loan, depending on the market.

It’s when your FICO score gets below approximately the 620 mark that you’re going to have to work harder to get mortgage money from a lender.

Here’s why: With that score, they calculate that borrowers will default on that loan better than half the time! From their viewpoint, it doesn’t make very good business sense to lend money in such situations.

However if they do loan the money, it will carry a higher interest rate to cover the added risk. Of course, in this situations, lenders look very closely at a borrower’s financial history in order to determine whether or not there are any “red flags;” that is, missed payments, late payments, unpaid debts, bankruptcies, etc.

So, there you have it! Now you know how your credit score is calculated. I hope I’ve taken the mystery out of the whole process. If not, contact me today at 402.598.3965 or peg@maloney.com, and I’d be happy to answer your questions about credit and/or mortgages!


Michael Roman said...

http://www.RemoveMyCreditInquiries.org is a web site I found that is ran by a community organization of credit experts and lawyers that can remove credit report inquiries for $10. They also appear to remove late comments as well on other sites.

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