FICO Scoring 101

Then things changed. Several lending agencies, along with a company located in Northern California, Fair Isaac Corporation ("FICO"), took a closer look and studied the relationship between credit scores and mortgage delinquencies. Using sophisticated computer models and metrics, Fair Isaac (www.fairisaac.com) discovered a predictable and definite relationship between a credit worthiness and credit score. Almost half of those borrowers with FICO scores below 550 became ninety days delinquent (i.e., "past due" greater than 90 days) at least once during their mortgage. On the other hand, only two out of every 10,000 borrowers with FICO scores above eight hundred became delinquent.

So lenders began to take a closer look at FICO scores and this is what they found out. The chart below shows the likelihood of a ninety-day delinquency for specific FICO scores. The results may surprise you.

When looking at the scores and the corresponding odds researched by FairIsaac Corporation, one can see a powerful relationship between credit worthiness and credit score. If you were lending a couple hundred thousand dollars to a friend, who would you want to lend it to - your friend with a high FICO score or your friend with a low FICO score? The answer is pretty obvious.

FICO Scores, What Affects Them, How Lenders Look At Them

Just suppose a mortgage loan officer has just ordered a credit report. She hears the sound of the laser printer and she knows the pages of the credit report are going to start spitting out in just a second. There is a moment of tension in the air, much like watching a basketball shot after it leaves the shooter's hands. It's not like a Michael Jordan last-second buzzer beating shot, where you know it's going to go in the basket. It's more like a Shaquille O'Neal free throw - you never know what is going to happen. The loan officer watches the pages stack up in the collection tray, but she waits to pick them up until all of the pages are finished printing. She waits like a spectator at the Staples Center watching the free throw either go in the basket or until the ball "clangs" off the rim. She takes a deep breath and looks at the credit report. If the FICO score (on page one of the report) exceeds a score of 700, it's like a perfect "swish" basket. This score will evoke a smile, then a grin, and then a shout and a "victory" style arm pump in the air. Conversely, a score below 600 will result in a frown, a furrowed brow, and perhaps an expletive. A score this low would be deemed an "air ball" - a horrible free throw shot. Lenders can make loans to applicants who swish it or those who shoot an air ball. The difference will be in the cost and the interest rate. The higher the score, the lower the rate. This inverse relationship holds true with almost all loans offered by a mortgage company.

FICO stands for Fair Isaac & Company, and credit scores are reported by each of the three major credit bureaus: Experian (formerly TRW), Equifax , and TransUnion. The score does not come up exactly the same on each bureau because each bureau places a slightly different emphasis on different items. Scores range from 360 to 850 and are called different names by each of the bureaus -- Experian calls it a FICO score, Equifax calls it a Beacon score, TransUnion calls it an Empirica score. For the sake of this article, we will call a credit score a "FICO" score, much like we refer to a bathroom tissue as a "Kleenex."

Here are some of the things that may negatively impact your FICO credit scores:

1. Delinquencies - The number, the severity, the recent pattern of late payments;
2. Recent Accounts -- Too many accounts opened within the last twelve months;
3. Credit History -- Limited credit history or no credit history;
4. Credit Limits -- Balances on revolving credit are between 51% and 100% of the maximum credit limits;
5. Public Records -- Public records, such as tax liens, judgments, or bankruptcies;
6. Inquiries -- Too many recent credit inquiries;
7. Credit Cards -- Too many new revolving accounts, some of which are damaging to your score;
8. Closed Accounts - In some cases, this may actually lower your score.

The FICO credit score is actually calculated using a "scorecard" whereby you receive points for certain things. Creditors and lenders who view your credit report do not get to see the scorecard, so they do not know exactly how your score was calculated. They just see the final scores and they see some of the "most likely" factors that influenced the score.

Basic guidelines on how to view the FICO scores vary slightly from lender to lender. Usually, a score above 680 will require a very basic review of the entire loan package. Scores between 640 and 680 require more thorough underwriting. Once a score gets below 640, an underwriter will look at a loan application with a more cautious approach. Many lenders will not even consider a loan with a FICO score below 600.

FICO Scores and Interest Rates

Credit scores can affect more than whether your loan gets approved or not. They can also affect how much you pay for your loan, too. Some lenders establish a "base price" and will reduce the points on a loan if the credit score is above a certain level. For example, one major national lender reduces the cost of a loan by a quarter point if the FICO score is greater than 725. If it is between 700 and 724, they will reduce the cost by one-eighth of a point. A point is equal to one percent of the loan amount. As you can see, the higher the score, the lower the rate. This can result in a sizable savings for a loan applicant.

There are other lenders who do it in reverse. They establish their base price, but instead of reducing the cost for good FICO scores, they "add on" costs for lower FICO scores. The results from either method would work out to be approximately the same interest rate. The second way "looks" better when you are quoting interest rates on a rate sheet or in an advertisement. It is important to obtain a clear "apples to apples" comparison when looking at two mortgage options. Make sure you get the right quote based on all of the facts.

Final Thoughts to Improve your Score

Nowadays, credit scores are important if you want to get the best interest rate available. Protect your FICO score. Work on improving your score. Do not open new revolving accounts needlessly. Don't close out all of your accounts because somebody told you to close them. Do not fill out credit applications needlessly, especially the "apply for this department store credit card and save 20% tonight" offers. Watch out for the "No payments until the year 2044" offers because the type of lender associated with this offer may lower your score. Do not keep your credit card balanced near the limit, or even greater than 50% of the limit. Make sure you do use your credit occasionally. Always make sure every creditor has their payment in their office no later than 10 days past due. Pay your bills on time each month. Try your hardest to payoff balances to zero each month. Stay away from the malls. Budget wisely and adopt a conservative and disciplined payment pattern with all purchases. And finally, to borrow our final basketball analogy, paying cash for items is like shooting a "slam dunk" - it's a sure way to keep your credit score high and it almost guarantees that you'll make the basket!