No financial planning topic is more susceptible to false rumors and misconceptions than the infamous credit score. The term “credit” means debt that has been extended by a creditor (lender) to a consumer, with the promise and expectation that the consumer will pay it back in a pre-determined timeframe, usually (but not always) with interest. Your credit score influences what credit is available to you and under what terms. It summarizes your credit risk for lenders who are considering offering you products or services on credit, or are considering granting you a loan. Simply put, the higher your credit score, the more likely you will be granted credit, the more credit you will be granted, and the better the terms are likely to be.
What is the FICO® score?
There is more than one type of credit score, but by far the most popular and widely used score is the FICO® score, issued by Fair Isaac Corporation (hence the acronym, FICO®). Your FICO® scores are determined solely by the information in your credit reports, which are issued by the three major credit reporting bureaus: Transunion, Experian, and Equifax. One FICO® score will be generated for each bureau based solely on your credit report produced by that bureau. If the scores differ among the bureaus, it is because the information on the credit reports differs in some way. Some minor differences are to be expected. If the differences are significant, however, you should contact the lower scoring credit bureau(s) and make sure they have correct information about your credit history.
Who uses FICO® scores?
FICO® scores are highly predictive measures of customer risk. Therefore, companies that offer loans and other types of credit to consumers are the primary users of FICO® scores. They not only use FICO® scores to evaluate a potential borrower’s credit worthiness, they also use the scores to decide who should be offered credit, how much, and on what terms. It is important to note, however, that your credit score is not the only determining factor in whether or not a lender will extend credit. Your income, length of employment, and other factors will also influence your access to credit. Insurance companies also use your FICO® score to determine your eligibility and your premiums for certain types of insurance. Likewise, employers and landlords check your score when you submit an employment or rental application.
Use of FICO® scores is not limited to the primary credit market. FICO® scores are also used by organizations in the mortgage secondary market (e.g., Fannie Mae, Freddie Mac), as well as the major rating agencies such as Standard & Poor’s that enable pooling of loans into bond securities.
Basic vs. industry-specific FICO® scores
Mortgage, auto, and credit card companies incorporate basic FICO® scores in their determination of a consumer’s credit worthiness, but they also use industry-specific versions of the FICO® score technology (also provided by Fair Isaac Corporation) in order to better assess credit risk specific to their product offerings. For example, if you want to buy a new car, you will be interested in knowing your FICO® auto score, which the car dealer can provide. If you are applying for a credit card, a credit card company will likely determine your FICO® bankcard score.
Fair Isaac revises its FICO® score technology on occasion in order to keep pace with trends in consumer spending, new types of product offerings, and advances in risk prediction technology. Companies adopt the new versions at different rates; some are relatively quick to upgrade while others take several years to make the change.
What is a good FICO® score?
The basic FICO® score ranges from 300 to 850, with some industry-specific scores ranging from 250 to 900. In either range, the higher the score, the more credit worthy you are in the eyes of a creditor (and therefore eligible for the best offers of credit). FICO® scores fluctuate as the information in your credit reports changes. Ultimately, the lender determines whether or not you are credit worthy, not your FICO® score or the credit bureaus. That said, a basic score of 740 and above will typically yield the best credit offers and terms. In fact, some lenders don’t continue to improve upon the terms of a loan for scores above 740. At the other end of the spectrum, FICO® scores below 600 are typically considered bad credit. Unless you are brand new to the credit history game, a score this low most likely results from a combination of history of late payments, being over-extended on credit, defaulting on a loan, and possibly filing for bankruptcy. It can also occur because of mistakes on, or fraudulent activity against, one or more of your credit reports.
Why your FICO® score should matter to you
The FICO® score is often vilified because it represents big data influencing companies’ decisions about our trustworthiness as consumers. If you loathe debt and insist on paying for everything in cash, you may not care what your FICO® score is. However, this is unlikely since most people carry at least one credit card and/or have a home mortgage. And even if you take pride in being debt free, your FICO® score should still be important to you if you fill out an apartment rental application, apply for auto insurance, or look for a job, as most landlords, insurance companies, and employers do a financial background check before approving applications.
Let’s take a simple example of two people applying for a $500,000 30-year fixed rate home mortgage on a new home (assume for this example a 25% down payment). One applicant has a FICO® score of 740; the other 625. Both qualify for the mortgage but at different interest rates. Ms. 740 qualifies for a rate of 3.50%, whereas Mr. 625 receives a rate of 4.50%. Over the duration of the mortgage, Mr. 625 will pay approximately $100,000 more in interest than Ms. 740. That’s equivalent to about two years of college expenses at a private institution! All because of a mere one percentage point difference. If Mr. 625 had simply paid his credit card balances on time or not missed some of his student loan payments, he would have saved a boatload of cash over the life of the loan.
Now, imagine if Mr. 625 never takes steps to improve his credit score. Higher interest rate credit cards and other loans, as well as higher auto insurance premiums, can amount to hundreds of thousands of dollars in extra payments over the course of his life.
How to obtain your credit reports and your credit score
You can obtain a free copy of your credit report from each of the three credit reporting bureaus simultaneously by going to www.annualcreditreport.com. You are entitled to one free credit report from each credit bureau per year. Some people order directly from each bureau and stagger the requests across bureaus every four months in order to catch fraudulent behavior against their credit file over the course of a year while avoiding having to pay for the reports. (Beware of web sites that claim to offer free reports but then insist that you enter your credit card information.) The credit bureau web sites are: www.transunion.com, www.experian.com, and www.equifax.com.
You can also request your FICO® score from each credit reporting agency, or all three scores from www.myFICO.com, the consumer division of Fair Isaac Corporation. However, this request is not free and is bundled with purchases of your credit reports. A package deal at myFICO®.com consisting of a credit report and a FICO® score from each of the three credit bureaus currently runs around $60. You used to be able to obtain your FICO® score from myFICO.com for around $15 or $20, but now it is getting more difficult to do so without having to purchase your credit reports and other services, as well.
Before you fork over money for your FICO® score, check out www.credit.com or www.creditsesame.com. If you are willing to set up a (strong) password-protected account, answer a few questions, and enter a few pieces of personally identifiable information (Social Security number, date of birth, etc.), you can obtain one or two of your FICO® scores for free, and you can check on them periodically. If entering your personal information over the Internet makes you nervous, you can check with your local bank or credit union, as some have been known to provide FICO® scores to account holders for free.
In the next newsletter, I will explain how your FICO® scores are calculated (I will spare you the fancy math) and provide tips for improving your scores.