Whenever you apply for a mortgage, car loan or other form of credit, the lender checks your credit rating. The most important item the lender looks at is your credit score, or FICO score. This is a number that summarizes how much risk you represent as a creditor, based on your credit history. The acronym FICO stands for Fair, Isaac, & Co., the company that developed the credit score system. FICO is used by the three major credit agencies to calculate your credit score, although they each use a trade name for their FICO score. Equifax calls the FICO score Beacon, and TransUnion uses the name Empirical. Experian calls it the Fair Isaac Risk Model.
Identification
The FICO score is a three-digit number between 300 (very poor) and 850 (perfect). The exact method of calculating a FICO score is not public knowledge (Fair, Isaac, & Co. won't say) but the general makeup of the score is known. There are five parts to a FICO score (see next section) based on your use of credit. Additional factors are also taken into account. If you order your FICO score you may see that each credit reporting company gives you a slightly different score. That's because they use their own records about your credit use to calculate the score. Since each company has its own database, the information used doesn't always match up exactly.
Parts of FICO
The biggest part of the FICO score is based on how promptly you make bill payments. This counts for 35 percent of the total. Rare lapses of a few days doesn't lower a score much, but even one payment more than 30 days late can drop the FICO score 100 points. The total debt and monthly payments compared to income counts for another 30 percent. Lenders hesitate to extend more credit to someone already overburdened with debt. The type of debt also is a factor (10 percent). Secured debt where there is collateral is better than unsecured debt. Another 10 percent is based on stability. Constantly applying for credit or closing accounts is seen as a sign of poor money management. The final part of the FICO score is time (15 percent). The longer a person's record of credit use is, the more points he/she can gain (or lose).
Considerations
In addition to overall credit behavior, the FICO system takes specific problems into account. Having a tax lien, defaulting on a debt or losing a court judgment for not paying a debt can all stay on a credit record for years. In the case of a default on a student loan, the black mark remains for life. A foreclosure or bankruptcy also is a serious negative when a FICO score is calculated, although bankruptcy falls into a special category and is handled differently (see below).
Bankruptcy and FICO
When a person declares bankruptcy, he almost always has a low FICO score already. However, one aspect of a Chapter 7 or Chapter 13 bankruptcy is that, although the bankruptcy goes on the credit history, other information (such as late payments) is removed. The net result is that the FICO score usually doesn't drop much (in some cases it even goes up a little). More important for a person hoping to rebuild his credit, those with bankruptcies are placed in a separate category in the FICO system. Their credit score from that point on depends primarily on how they handle credit after the bankruptcy. With good money management, an individual can restore his credit to a reasonably good level within two or three years.
Good and Bad FICO Scores
FICO is the standard used by Fannie Mae, Freddie Mac and other major mortgage providers. These companies look for a score of at least 640, but may accept one as low as 620. The Federal Housing Administration and the Department of Veterans Affairs allow scores as low as 580. Most lenders regard 620 as a dividing line. Lower scores are "subprime" and viewed as poor. The "good FICO score" is around 680 or higher. Borrowers with subprime scores can get credit from some lenders, but have to pay higher interest rates to compensate for the added credit risk they represent.
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