How FICO Scores Work

 

This section is the meat, the main course, of this chapter. Time to get our hands dirty and zero in  on the types of scores that will make or break you when you go to qualify for a mortgage, car or credit card. These are the ones that matter, after all.

As you now know, a FICO-family score is what banks and mortgage lenders use to assess your credit and determine what level of risk you are to them as a borrower. These scores calculate your data in a specific way that no other scoring model does. It’s essential to know what goes into the determination of these scores so you can prioritize and make good decisions on which of your credit issues to address now.

Once you understand what factors contribute to your FICO scores, you will be able to see what needs your attention most and what precisely it will take to improve your credit situation quickly.

Scores range from 300-850, so there are 550 available points. FICO breaks down into five categories. Each category makes up of a certain percentage of your overall score. Looking at the pie chart you can see how much each category is valued in your score. We’ll discuss each of them in turn so you know exactly what they mean and how they factor in to impact your credit.

If you assign the 550 available points in a FICO score categorically, the most that can come from your payment history is about 192 points, there are 165 points possible from your amounts owed, 83 from your credit history length, and 55 each from both your new credit and credit mix categories.

Payment History

At 35% of your overall FICO score, payment history is the biggest category. What is your track record of making payments to past and current creditors? Basically, credit companies are looking at your previous actions and using them as an indicator of how you are likely to behave in the future. This will influence whether they are willing to take a chance on you by issuing a loan or granting you a credit card within a range of interest rates, or simply denying your request altogether. If your history shows any problem with you making payments on time, it will negatively affect your score. How much? It depends on a few factors: severity, recency, and frequency.

Although credit scores are calculated by computers, it’s useful to look at this from a human perspective because these three categories actually make a lot of sense. If, for example, a less-than-perfect family member asked you to lend them $100, you’d take their track record into account to determine whether or not you’re likely to see that $100 again. In order to do so, it’d be wise to measure their rough spots using the same three factors that credit companies do.

How severe are the negative items in their credit history? When they had trouble making their car payments back in 2017, were they just a little bit late (like 30 days), or did the loan go so past due that the car was repossessed? How recently did their credit trouble happen? If they’ve gotten back in the saddle and had no other issues since then, you might choose to lend the money; whereas, if for the last few months they’ve been making late payments on a new personal loan, you might not think that they’re in a position to be able to pay you back in the near future. Finally, how frequently are they delinquent? You might not feel comfortable lending them the money if they were consistently 60 or 90 days behind on their payments for a full year, as opposed to if it was just a fluke that happened once or twice.

Amounts Owed

The second-to-largest category that makes up your FICO score is your amounts owed, at 30%.

This has to do with how large your balances are in relation to how much credit you have available. A big part of this category is your credit card utilization. What percentage of your credit limits are currently being used? It’s good to have regular activity on your credit card accounts, but despite what you may have heard, it’s important to spend only a small proportion of your credit limits. It may seem counterintuitive not to use the full percentage of credit that you’re allowed, but keep in mind that when the computer calculates your credit score, it doesn’t know how much money you have in the bank or what your income is. It doesn’t have any of that information to base its evaluation on. Keeping high credit card balances affects your scores in a big way. It’s a fact! I’ve seen FICO scores take a 100-point nosedive just because the person maxed out their credit cards.

Later we’ll talk more specifically about the sweet spot where your credit card balances should be. For now, what you need to know is that when credit companies see you are utilizing a relatively small percentage of your available credit, what that means to them is that you are maintaining cash solvency and don’t need to charge up to your limits to make ends meet. In other words, it looks like you’re in a good position financially. The logic is you’re more likely to be able to make payments on a new mortgage or car loan if you’re not taxed by servicing a bunch of existing debt.

Length of Credit History

Making up 15% of your FICO score is the category that considers how established your credit is. What is the age of your oldest account, and the average age of your accounts? It’s advantageous to have a seasoned credit history than a younger one that was started more recently. Even if you tend to have accounts that are active for shorter periods of time (i.e. short-term car loans or mortgages), it’s better to show you have longer-standing experience with credit than if you had no experience. At the same time, if you go from having little or no credit history to suddenly opening a bunch of credit card accounts, it raises red flags for credit companies because you have not yet proven that you can manage those different accounts. Thus, your credit score will be negatively affected.

Ideally, you want to have accounts open as long as you possibly can. That’s why credit cards are such an important way to help improve your credit score; they are one type of credit line you can have open for a long period of time. Car payments and other similar loans will end whenever you finish paying them off, but in theory you could have a credit card open your entire life. Even if you’ve gotten in over your head with credit cards in the past and have some delinquencies, it’s not necessarily a good idea to close those accounts after you’ve gotten current and paid them down. Doing so could be more damaging to your score than keeping them part of your history (as long as you’re not incurring new delinquencies, of course). The goal is to have aged credit lines, so don’t close accounts that you could keep open, like credit cards, even if you’re no longer using them.

Types of Credit

This category, which makes up 10% of your FICO score, has to do with the types of credit you have in play. How diversified is your credit portfolio? Or, in other words, do you have a healthy mix of open credit accounts? Specifically, there are two types of credit you want to be well represented on your credit report: installment loans and revolving accounts.

An installment loan, as the name suggests, is a debt of a fixed amount financed and broken up into payments over a set period of time, like a bank loan or car payment. A revolving account is a perpetual line of credit, such as a credit card, that does not have a fixed amount you are required to pay every month before the account’s paid off. This kind of account will remain open indefinitely, as long as neither you nor the card issuer cancel it.

While you may think it might reflect better to have fewer obligations when you are trying to qualify for a mortgage, it’s more beneficial to have a variety of accounts than a single car payment or credit card. Credit companies see this as evidence that you can juggle different types of credit and pay those bills on time every month, which makes you appear less risky to them. Having too few of either type of account (or both) is what the credit industry calls a “thin file.”

Keeping a good mix of both types of credit accounts contributes positively to your credit score. According to FICO, the perfect mix of credit is three revolving accounts for every one installment loan.

New Credit

The final category, which also contributes 10% to your FICO score, considers potential new obligations you may be taking on. Basically what it boils down to is credit score inquiries. What’s known as “hard” inquiries show up on your credit report whenever you apply for a loan, credit card or mortgage.

Individual hard inquiries do affect your score, but not a lot. So little, in fact, that to focus on getting inaccurate inquiries or other inquiry-related issues removed from your report doesn’t make much sense. If you need to boost your FICO scores quickly, there are typically plenty of high-impact items to be handled first. (Note: “Soft” inquiries, like when you pull your own credit report, do not affect your credit score.)

Generally, hard inquiries are not a big deal — unless there’s an avalanche of them all at once. As previously mentioned, opening up a bunch of new credit accounts at the same time is not good practice and will lower your scores by reducing your average length of history category. Doing so will further lower your rating because of the combined effect of all the hard credit inquiries. Be careful not to apply for new credit accounts too often in a year, as hard inquiries impact your scores for 12 months. They fall off your report entirely after 24 months.

In perspective, having a few hard inquiries in your credit history is expected. If the inquiry is happening for a good reason, don’t worry about it. For example, if you’re adding a new line of credit to ultimately improve the health of your credit mix, taking a small temporary hit for the hard credit inquiry is worth it. Sometimes it’s necessary to take a small step backward to go several steps forward.

Do keep in mind that the shopping window for mortgages and auto loans that ranges depending on the types of FICO scores being used, so if you want to get the best rate by applying for credit with more than one lender, you have a couple of weeks before those hard inquiries start showing up on your credit report and influencing your scores.