Among history's greatest secrets is the formula for credit scoring developed by the Fair Isaac Corporation. Although we do not known exactly how the FICO formula calculates scores, we know what information it uses to arrive at a score and a general idea of the weights of the most important factors.
The Formula
The FICO website reveals that 35 percent of a score comes from "payment history," which includes any missed payments and the time since the last occurrence of a negative item, such as a public judgment. The amount of debt owed constitutes 30 percent of a score, but within this category are other factors, such as the number of accounts with a balance and the proportion of credit outstanding to credit available. The length of the borrower's credit history counts for 15 percent. Any new credit and types of credit used round the formula at 10 percent a piece.
The Calculation
Each lender has software that pulls a borrower's credit report and runs the calculation. Outdated versions of the FICO formula software give different scores from the latest version -- FICO 08 as of 2011. Most lenders use credit reports from the three major credit bureaus in the U.S. to fill out the variables in the equation.
What Does it Mean?
All credit scoring systems attempt to quantify a person's risk of not paying a loan in purely mathematical terms rather than using informal judgments of a borrower's character, which give much less accurate results. In the FICO system, a score of 585 means the person has a 2.25 to 1 chance of defaulting on a loan, which makes him a very poor risk.
Considerations
Several credit scoring models exist and the national credit reporting agencies constantly try to develop one that lenders want to use. As of 2011, most creditors prefer the FICO model because of trust in the name brand and accuracy. A minority of lenders use an alternative to the FICO model and may even have a special in-house formula. Either way, a scoring model still tries to determine your creditworthiness.
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