In Depth: The FICO Score

If you're in the market to buy a home, you've no doubt heard that you need a good FICO score to qualify for a low interest rate on a loan. But what exactly is the FICO score, where does it come from, and how high does your score have to be to get the best rates?

A FICO score is a generic term for a credit bureau score and specifically refers to the score derived from the FICO statistical model. A credit bureau score measures the relative degree of risk a potential borrower represents to the lender or investor. Each of the three credit bureaus (Equifax, TransUnion and Experian) has their own method, or statistical model, for calculating scores. The bureaus rely exclusively on their own data for calculating scores.

Fair, Isaac & Co. (FICO) began its pioneering work with credit scoring in the late 1950s. Since then, scoring has become widely accepted by lenders as a reliable means of credit evaluation. A credit score attempts to condense a borrower's credit history into a single number. Fair, Isaac & Co. and the credit bureaus do not reveal how these scores are computed. The Federal Trade Commission has ruled this to be acceptable.

FICO scores vary from approximately 375 to 900 points. Higher scores are better. To get the best interest rates, you will generally need to score 680 or higher. If your score is at least 680, you are considered to have 'A' credit. If your score is below 620, you will generally pay a higher rate on your mortgage, and your credit is considered "sub prime." Depending on your score and credit, you may be considered to be a 'B', 'C', or 'D' credit borrower. If your score is between 620 and 680, based upon factors such as income, assets, employment, etc., the lender may decide into which credit category you fall. See table to give you an idea of your credit ranking (A+ through E) based upon your credit score:

FICO scores are calculated by using scoring models and mathematical tables that assign points for different pieces of information, which best predict future credit performance. Developing these models involves studying how millions of people have used credit. Some of the predictive factors used in the models are found in the reason codes.

Reason codes are included in credit reports and help explain why a credit report scored as it did, the weight given to factors making up the score, and where a consumer should direct their efforts toward increasing their score. The reason codes and their respective weights are:

• Late Payments, Collections, Bankruptcies--35%
• Outstanding Debt--30%
• Length of Credit History--15%
• Types of Credit--10%

Inquiries (Applications for New Credit)--10%

It is difficult to increase your score in a short period of time. However, over the long term, here are some things you can do to increase your rating:

• Pay your bills on time. Late payments and collections can have a serious impact on your score. Note that late payments, collections and bankruptcies are the most heavily weighted of the reason codes.
• Reduce your credit-card balances. If you consistently have high balances on your credit cards, your credit score will be negatively affected. Note that this applies to the second most heavily weighted reason code.
• If you have limited credit, obtain additional credit. Not having sufficient credit can negatively affect your score.
• Do not apply for credit frequently. Having a large number of inquiries on your credit report can worsen your score.

Generally, several companies checking your credit over a short time period will not hurt your score. Mortgage lenders realize that when a borrower is shopping for a rate, his or her credit may be investigated by more than one lender.

If you see an error on your report, inform the correct credit bureau. As mentioned earlier, the three major bureaus in the U.S. are Equifax (www.equifax.com, 1-800-685-1111), TransUnion (www.transunion.com, 1-800-916-8800) and Experian (www.experian.com, 1-888-397-3742). All have procedures for promptly correcting errors. Your mortgage company may also be able to help you correct credit report errors.