Why Is Your FICO Score Important?

Most of us have probably heard the term FICO score. But do you really know the purpose and how it affects our personal finances?   

Many think of FICO as the gatekeeper of credit. The concept was founded in the 1950s by William Fair and Earl Isaac of Fair Isaac Corp, thus FICO. Originally, they worked together at Stanford Research Institute developing ways to use computers to improve military decisions. It is interesting to note that they borrowed time from Standard Oil of California during off-peak hours and started writing computer programs to calculate scores designed to predict human behavior.  

In 1958 they pitched the system to fifty major lenders across America. Only one company bought into the concept. It was another five years before another company, Montgomery Ward, became a user. But it wasn’t until 1970 the FICO score was used by its first credit card issuer, Connecticut Bank and Trust. As you well understand this was a “radical” concept at that time. Fast forward to today, and it is the most trusted scoring system that credit companies use to predict risk and understand your purchasing behavior.  

Today FICO, along with Equifax and TransUnion, are the three major credit agencies that collect and report the data that creditors look at when you are applying for credit, whether that is a loan for a home or automobile, or for a credit card or other requests for borrowing. The higher your score, the lower risk you are considered for creditors. The lower risk you are, the more likely you can obtain loans or credit at a less expensive interest rate, thus saving you money. Over time, it can save you a lot of money. 

Your credit reports are simply a track record of your payment history, similar to your school grade point average. It is an average of all your credit payments to grade you in your credit-worthiness. And what started out as a service used primarily by banks and lending institutions, today it is increasingly used by insurance firms, landlords and even employers to look at your history to see how responsible you are financially as an individual. 

The range of scores are typically 300 to 850 with the higher the number, the better. In general, anything over 740 is considered excellent and banks, credit cards, insurance companies, etc. will give you the best rates. If your score is 650 or below, typically you will pay higher rates on loans and credit cards, if you qualify for them at all. 

For example, in today’s market if you are applying for a home loan for a thirty-year mortgage, if you have a score 659 or below you might qualify for 5.5 percent interest rate, or maybe even higher. If your score is 680 or higher, the interest rate on that same loan might be as low as 4.75 percent. On a $250,000 home loan you would pay $115.35 less a month. That is translated to $1,384.20 a year or $41,526 in additional payments over the thirty-year term.   

These three companies typically use various criteria to blend into what becomes your overall score, including 35 percent coming from payment history, 30 percent from amount owed, 15 percent length of history, 10 percent new credit and 10 percent from types of credit used. Missed payments to creditors can lower your score quickly. The amount you owe to creditors is a little harder to calculate as they look at how much you are using of your approved credit available. When lenders see you have maxed out your credit, they know you are more likely to miss payments. Other factors lenders consider is the length of your credit history, average age of your accounts, how often you have opened new accounts, and the different types of accounts you have open, such as mortgages, student loans, auto loans, etc. Obviously when all of these are put together, it can become a complicated formula.   

What is not complicated to understand is how you can protect your credit score. Don’t get overextended in credit, and always pay all your bills on time. Don’t apply for multiple accounts at the same time, and don’t try to close multiple accounts at the same time. Review your FICO, TransUnion and Equifax scores at least once a year to make sure someone hasn’t used your credit or that all transactions are accurately posted. If you disagree with the score they have for you, and yes sometimes they are in error, you should immediately contact them to correct the information. You can review your credit history for free once a year from all three agencies at www.annualcreditreport.com.  

And while many would probably agree it is best to make purchases in cash, sometimes financing is the only option. It is possible to be a wise borrower, and your FICO score is crucial to achieving this goal. Be a good steward of your finances by protecting your financial history and credit score.