Understanding the FICO Formula

For a number that helps determine so many things in our lives, we consumers know surprisingly little about how our credit scores are calculated. More closely guarded than the secret recipe for Coca Cola, the FICO formula was first developed in 1956 by two math gurus, Bill Fair and Earl Isaac, to help lenders determine the creditworthiness of potential customers.

Back then, they created a different formula for each business that wanted to use their system. In the 1980’s, the Fair Isaac Company (FICO) released the first general purpose formula – pretty much the same one we still use today.

FICO does not actually calculate our credit scores. They sell the software that calculates them to the “big three” credit reporting agencies (Experian, TransUnion, and Equifax). The credit reporting agencies then tweak the FICO formula according to their own rules, which is why your credit score may be a little different depending on which credit bureau you ask.

We may not know the exact details of how our scores are calculated, but FICO does let us know what kind of information matters. Your income does not come in to play at all. Getting a raise or reporting more income on your taxes will not improve your credit score. What matters in the FICO formula is your total debt, and how well you pay it. Here’s the scoop:

Payment History: 35%

How well you pay your debts is the most important factor for your FICO score. If you pay your credit accounts and loans on time each month, you’ll do very well in this area. Having one late payment will not tank your score, though. The FICO formula considers how late the payment was, how many late payments you have on each account, and how long an account remained delinquent. This is also where bankruptcies, liens, garnishments, foreclosures, and collection reports can affect your score.

Amounts Owed: 30%

The FICO formula looks at the total amount you owe by adding up all your debts. It also looks how many accounts have balances and the breakdown of the total owed (what percentage you owe on credit cards or mortgages compared to installment loans – like a car loan). Another important factor is your Credit Utilization Ratio, or in other words, how maxed out your lines of credit are. If you have borrowed nearly up to the max on your credit cards and still owe 4 years on a 5-year car loan, you will score lower in this area than someone who has more available credit.

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Length of Credit History: 15%

It takes about 6 months of payment history to establish a credit score. In general, the longer your history, the better. But, you can start out young with a good credit score from the beginning if you make smart credit choices from the get-go.

Types of Credit: 10%

This portion of your score looks at how your debt is spread over the types of credit available. The important thing here is to show good payment history in both credit card type debt and installment debt (like car loans or student loans).

New Credit: 10%

This last category considers how many accounts you’ve open in the recent past, especially if you have a relatively short credit history. The idea is that if you’ve opened several accounts recently, you may quickly overextend yourself and be unable to make your payments. If you are careful, and don’t apply for too many lines of credit at once, you can score well in this area.

So, even though we don’t know the mathematical formulas used by the FICO software, we do know what data is important. Your payment history and the amounts you owe make up 65% of your score. Having a good payment history with each creditor and keeping your credit card balances well below the limit are two simple ways to have a big impact on your credit score.

The information in this article was obtained from www.myfico.com.

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This information is intended for informational and educational purposes only and not as legal advice. If you have concerns about your credit report, harassment, identity theft, illegal collections activity, garnishments, or property liens, you should consult an attorney who specializes in consumer rights and defense.

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