How Credit Works: Understanding Your FICO Score
Though you might not spend much time thinking about it on a daily basis, your FICO score becomes incredibly important the minute you decide you want to borrow money to buy something big. Whether you want to have a credit card for emergencies or are ready to apply for a mortgage for your dream home, the first thing lenders will look at is your FICO score. It also plays a part in many employment decisions as companies now review potential employee credit scores as a way to determine reliability. You always want to have a high credit score so you’re in a strong position financially.
You need to be ready.
Spending some time now to understand your FICO score will help keep your numbers looking good. This is a much better plan than waiting until the last minute to learn—only to find out that your score isn’t good enough to get you the credit you need.
Here’s what you need to know.
FICO Facts and Figures
For starters, FICO stands for the Fair Isaac Corporation, the company that developed this scoring system. They created an algorithm to help credit reporting bureaus like Equifax, Experian and TransUnion to standardize how they interpreted risk. This was largely in response to the Fair Credit Reporting Act of 1970, which required credit bureaus to make their files public and stop using data about race, gender and disability to make judgments about whether people should get loans or not. Today, 90% of lenders use FICO scores to make lending decisions.
How Your FICO Score Is Determined
Everything used to calculate your FICO score comes from your credit report. This is the information reported to the credit bureaus by credit card companies and other lenders about your accounts with them. For example, if you have a car loan, that lender will report information about your account, including how much you’ve repaid and whether or not you have made any late payments.
FICO divides all this data into five weighted categories to calculate your credit score. Here’s the breakdown:
- Payment History (35%): Late or missing payments can tank your score, while a history of on-time payments will improve it. This is the most important category, so maintain your streak!
- Amounts Owed/Credit Utilization (30%): This number is based on how much you owe compared to your total available credit. Maxing out all your credit cards is bad; paying them off every month is good.
- Length of Credit History (15%): How long you’ve had credit is important. This category takes into account when you opened your first credit account and the average age of all your credit accounts.
- Credit Mix (10%): Having a mix of installment loans and revolving credit (i.e. credit cards) will generally boost your score, as is the overall number of accounts you have.
- New Credit (10%): Opening a new loan or credit card requires a credit inquiry, which is recorded in your credit report. Too many in a short period of time can signal increased risk for the lender and can lower your score.
Based on all this information from lenders, the FICO algorithm crunches the data to give you a total score. New lenders use the score to decide if you’re a good risk—and what kind of interest rate you’ll get.
What are Some Common Misconceptions?
- Carrying a balance improves your credit score
Keeping a balance on your credit score does not help you build credit or increase your FICO score. On the contrary it actually lowers your credit score because it increases your credit utilization. We’ve heard the myth that you have to pay interest or keep a balance on your credit card to increase your credit score. Personally, I’ve never paid $1 of interest and my credit score is 836.
- Income affects your score
Your income is not factored into your FICO score. However, your income does come into play for credit worthiness which is different than your credit score. You can obviously take on more debt if you make more money (you shouldn’t do this but you could).
- You share your FICO score with your spouse
Both you and your spouse have a separate FICO score. You do not share the score with your spouse. However, you may share accounts that show up on both your FICO scores if you sign a loan together. This usually happens when you finance a home together.
What’s a Good FICO Score?
FICO scores are kind of like SAT scores: They fall on a scale of 300 to 850. That scale is broken down into five segments that describe the risk you represent to lenders:
- 800-850: Exceptional
- 740-799: Very Good
- 670-739: Good (the national average is in this range)
- 580-669: Fair
- 300-579: Poor
Exceptional and Very Good scores often mean lower interest rates and fast approval. Average borrowers with Good scores are typically approved for credit. A Fair score usually means much higher interest rates, and a Poor score means you could be denied credit altogether.
The Bottom Line
Knowing your credit score—and what it means—is the first step to building a good credit rating and being able to borrow money for the things you need. The next step? Learning to raise your FICO score. We’ll tackle that in our next post in this series. You can also take The Core Four of Personal Finance to learn about FICO scores, debt and more.