FFF University: The FICO Score
Much is made of the great FICO Score (aka your credit score). For years, scientists have worked in rooms without windows, attempting to create the perfect credit score. So what is this mythical creature and why is it important to us regular folks?
Years ago, in a land far far away, lending officers (the people in the bank that reside in the glass offices) actually worked for a living. I know it is hard to believe, but its true. When an individual came into the bank, looking to borrow money, the lending officer would spend time researching the person – their job, their reputation, their financial status, etc. The lending officer would use this information, along with rational thought (which has since become extinct), and determine whether the person was fit to borrow money and the likelihood of them repaying the loan. This information would be compiled and used to determine how much the bank would lend the individual, if at all.
Well…then came computers. And with computers came ‘data’. You see, computers don’t think rationally. They only store & process data. Bankers needed a method to standardize & mass produce this lending process and be able to store the corresponding ‘data’. [Enter: FICO score.] Named for the firm that developed the process, the FICO score is generated by a mathematical formula (something a computer can do) to provide the general credit worthiness of an individual. The formula based off of information found in your credit report – simply an individuals log of all things financial. A weighted scale of five financial factors combine to derive the FICO score. The breakdown of these factors is found above. Scores range from 300 – 900. Most folks fall in the 600-750 range.
There are three agencies that provide this mathematical decision making: Equifax, Experian and Trans Union. Now days, when banks make lending decisions, they use these ‘credit bureaus’ to automate the decision making process. This means roughly 75% of the time, everything makes reasonable sense. However, since there is no rational human behind the process, 25% of the time a dart-throwing monkey could provide the same service.
Example: A company owner who makes well-in-excess of $100,000 dollars a year applies for business credit cards for her company. As the owner of the company, her credit report is used to establish the credit limit on the company credit card account. Visa, via an Equifax report, denies her request for a $50,000 corporate credit limit (less than 50% of her annual income and far less than the average net profit of the company). Meanwhile, I (a person who makes no where near that much money) regularly receives pre-approved credit card offers for well-in-excess of 50% of my income. What gives? The FICO monkey strikes again.
Note the breakdown above. The FICO score is comprised of a person’s debt history. If you don’t borrow money, your FICO score is penalized. Subsequently, the FICO score says you must consistently borrow money, if you want to borrow money. That’s a little-bit stupid.
Most people only feel the FICO effects when they are applying for home loans or financing automobiles. Although most lenders lean on the FICO crutch, some folks still lend the old fashion way. If you are anti-debt, find a mortgage company that does ‘manual underwriting’ (old fashion lending). As far as cars, if you pay the note off in a timely manner, you will hardly notice the deference in FICO scores.
How do you check your FICO digits? By law, everyone is entitled to check their credit report (for free) once a year – per credit bureau. This will provide you a copy of the finance log on file at the corresponding bureau. Everyone is also entitled to one free annual credit score report. To check your score and/or reports, I recommend AnnualCreditReport.com. Despite the catchy tunes of FreeCreditReport.com, the aforementioned source, AnnualCreditReport.com, is the official government-sponsored source for the free reports. Personally, I check one bureau every 4 months. This allows me to monitor my reports all year long, without incurring any costs. Nifty huh?