British Columbia Sun

Wednesday, November 29, 2023

What is a FICO score and how is it calculated?

A FICO score is a credit score used by lenders to determine the creditworthiness of a borrower. It was created by the Fair Isaac Corporation (now known as FICO) in 1989, and has since become the most widely used credit scoring model in the United States. A FICO score is a three-digit number that ranges from 300 to 850, with a higher score indicating a better credit history and a lower risk of default.

FICO scores are calculated using a complex algorithm that takes into account a number of different factors, including a borrower’s payment history, amounts owed, length of credit history, new credit, and types of credit used. These factors are weighted differently depending on the specific version of the FICO scoring model being used.

The most commonly used version of the FICO score is the FICO Score 8, which is based on data from the three major credit bureaus: Equifax, Experian, and TransUnion. The score is calculated using the following factors:

  1. Payment history (35%): This is the most important factor in determining a FICO score. Lenders want to see that borrowers have a history of making their payments on time, and that they have not missed any payments in the past.
  2. Amounts owed (30%): This factor takes into account the total amount of debt that a borrower owes, as well as the ratio of their outstanding balances to their available credit. Borrowers who are using a large percentage of their available credit may be seen as a higher risk by lenders.
  3. Length of credit history (15%): Lenders like to see that borrowers have a long credit history, as it demonstrates their ability to manage credit over time. The longer a borrower has had credit, the better their score is likely to be.
  4. New credit (10%): When borrowers apply for new credit, it can have a temporary negative impact on their FICO score. Lenders want to see that borrowers are not taking on too much new credit too quickly, as it can be a sign of financial distress.
  5. Types of credit used (10%): The final factor takes into account the types of credit that a borrower has used in the past, including credit cards, loans, and mortgages. Having a mix of different types of credit can be beneficial for borrowers, as it demonstrates their ability to handle different types of financial obligations.

FICO scores are used by a wide variety of lenders, including banks, credit unions, credit card companies, and mortgage lenders. They are also used by landlords, insurance companies, and employers to evaluate the creditworthiness of potential tenants, policyholders, and employees.

In addition to the FICO Score 8, there are also several other versions of the FICO score that are used for specific types of lending, such as auto loans and mortgages. These scores may place greater or lesser weight on certain factors, depending on the specific lending environment.

It is important for borrowers to understand their FICO score, as it can have a significant impact on their ability to obtain credit and the interest rates they are offered. Borrowers can obtain a free copy of their credit report from each of the three major credit bureaus once per year, and can also purchase their FICO score from each bureau for a fee.

In conclusion, a FICO score is a critical factor in the lending process, and understanding how it is calculated is essential for borrowers who want to obtain credit at favorable rates. By focusing on factors such as payment history, amounts owed, length of credit history, new credit, and types of credit used, borrowers can improve their FICO score and demonstrate their creditworthiness to lenders. Additionally, by taking a broader approach to their financial health, borrowers can achieve greater financial stability and security and enjoy the benefits of a strong credit profile for years to come.

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