A few people have asked recently about how credit scores are determined, what is a good credit score, what score it required for the best rate on a mortgage, etc. The following is an article I wrote for the PWA Newsletter back in 2008, updated for the interest rate world we live in today.
Okay, so you’ve checked your credit report, made sure there are no errors and are satisfied with the result. Now what? Now you have to understand what your credit report is used for and how your credit score is determined. When you apply for a credit card or a loan, the prospective lender gathers your information and attempts to determine your credit risk. They do that by analyzing the personal data you send them, by examining your credit report, and by reviewing your credit score, AKA your FICO score. This process ultimately decides whether you get the loan or not and the terms for which you’ll qualify. As shown below, your credit score can have a dramatic impact on the interest rate you’re offered and will therefore impact your payments and total interest over the course of the loan.
Your FICO score is determined by a complex system that was created by the Fair Issac Company (hence the name FICO). To our knowledge, the actual formula has never been released, but the general algorithm has, and that’s really all you need to know to improve your score. It is based on:
- Payment History (35%) – do you pay your bills on-time, have you ever filed bankruptcy, are you currently or have you ever been in default.
- Amounts Owed (30%) – what portion of your available credit are you using, how big are the balances (esp. on revolving debt), how many accounts (and of what type) are active and/or have balances.
- Length of Credit History / New Credit (25%) – time since your oldest account was opened, age of all active accounts, number of recent applications for accounts and new accounts, time since last application and new account
- Types of Credit Used (10%) – prior and current use of different types of credit (mortgage, installment, revolving, etc.)
There are many standards of what constitutes a “good” FICO score. Some say higher than 720, others say higher than 750, and still others say higher than 780. Because each lender will use the information in their own way, all we really know is that the higher your score is, the better off you’ll be. The median score is around 720 and the 90th percentile score is just over 800 according to estimates published by myFico.com and bankrate.com. To estimate your FICO score, you can use the free calculator at: http://www.bankrate.com/brm/fico/calc.asp or register for a free site like www.creditkarma.com which tracks an estimate of your score over time. To see the real thing, when you obtain your free annual credit report from one of the reporting agencies, purchase your score from them for a nominal fee (<$10).