FICO credit scores are use by lenders to assess how likely you are to be able to repay a loan. If you intend applying for a mortgage, knowing how FICO credit scores work could be of advantage to you. Understanding them might enable you to improve your credit score before you make your application.
First, however, it is important to understand credit reports, and the part they play in the calculation of your credit score. The three main credit bureaus, Experian, Equifax and TransUnion, each compile their own credit reports using a variety of data relating to your creditworthiness. Included is these data are your credit and repayment history, and the way you use credit, such as whether you are always around your credit limit or if you tend to keep it low.
The Function of Credit Reports in FICO Scores
FICO is short for the Fair Isaac Corporation, and is the most widely used credit score in the USA. FICO takes data from all three of your credit reports and generates a credit score by applying a weighting to each datum item. Without the initial credit reports, then, there could be no credit score.
Fundamentally, FICO scores are a shortcut to lenders, enabling them to check one single numerical figure rather than trawl through the alpha-numeric data offered by three different credit bureaus. They offer a rapid means of making a lending decision, not just ‘yes’ or ‘no,’ but also how much the lender can risk lending and at what interest rate.
How FICO Scores are Calculated
The three credit reports are scanned using an algorithm in roughly the same way as search engine scan web pages. Each factor use in your credit report is given a weighting, and the algorithm calculates your credit score thus:
Payment History: 35%
You must show that you are paying your bills and repaying loans you already have or have had in the past. Late payments, defaults and court judgments all count to reduce your score, and the more recent your problems the more significant they will be.
Outstanding Debt: 30%
The more you owe now, the less your borrowing power. Included are your credit card debts, overdraft and any other form of finance you are currently repaying. The computation also takes into account the state of your store and credit cards: try to maintain your cards within 25% of their limits.
Length of Credit: 15%
The longer you have had your credit cards and loans the better your score. This is because the lenders have a better idea of how you have been repaying, so stick with the same cards as long as you can. Many people switch regularly for better deals and interest-free terms, but come mortgage application time this might cost them dearly – in high interest rates, or even a refusal depending on the rest of the data.
New Credit Accounts: 10%
New credit will be punished by a reduced score until you have established a repayment history. Also penalized will be hard credit inquiries, where you have ticked a box agreeing that your credit records can be checked when you apply for new credit (e.g. mail order catalogs involving credit, new cards, secured or unsecured loans). Personal searches do not count.
Type of Current Credit: 10%
The final 10% of your FICO score is based upon the form taken by the credit you have. For example, it is best to have several different types of credit than several different credit cards. Examples are car loans, forms of revolving credit (store cards, store accounts), and personal loans.
If you have not yet taken out credit of any type, you will not have a credit score. The minimum criterion to get a FICO score is that you must have at least one credit account that has been updated over the past 6 months. So if you have never had credit, or closed your last credit account over 6 months ago you will have no FICO score!
Effect of FICO Credit Scores on Mortgages
FICO scores range from 300 to 850. There is currently no accepted definition of the various terms used, such as prime and sub-prime mortgages. However, a common definition is that any score above 710 is prime, with sub-prime being below 640.
If your FICO credit score is between around 510 and 640, you may be considered sub-prime and be offered a limited mortgage at a higher interest rate than normal. However, since the sub-prime collapse, many lenders are wary of such low scores. Below around 510 nobody will offer you a mortgage.
A credit score of 760 and above will likely result in you being offered a good mortgage with lower interest rates. You will also be offered a greater variety of mortgage options, such as fixed or adjustable mortgages. For example, with score of below 700, your interest rate might be set at 6.3%, with over 760 at 5.8% and below 600 at from 8.6 – 9.5%. These figures are for comparison only and not actual rates being currently offered.
That is fundamentally how FICO scores work, and by working on the various factors discussed you should be able to improve your score. FICO credit scores are important factors in the interest rate and type of mortgage you are offered – or even if you are offered a mortgage at all.