What is a FICO score and why do I care?

by Nick on August 4, 2010

A reader contacted me earlier today and asked if I could talk a bit about credit.  What a great question!  In my opinion, credit is one of the most powerful topics in personal finance.  But with great power comes great responsibility!  (Isn’t that a famous quote?  Anyone know by whom?)  That’s where your FICO score comes into play.  So what is a FICO score?  How is it calculated?  And why do I even care?  Let’s talk about those three questions separately below.  We’ll follow up with more details in later posts.

What is a FICO score?
A FICO score is one of many credit scores that attempts to represent your creditworthiness to lenders.  It is the most widely used credit score in the United States.  A credit score is simply a number.  It attempts to tell lenders how much risk they should associate with lending money to you.  FICO scores range from 300 to 850 – the higher the better.  That’s it.  Simple, right?

According to the free credit report I received during the promotion earlier in the week, the following are general FICO score ranges and how they’re perceived by lenders:

  • 760-850 – Great;
  • 725-759 – Very Good;
  • 660-724 – Good;
  • 560-659 – Not Good;
  • 330-559 – Bad.

These are only general ranges from great to bad and should be used only as a general guideline.  In reality, every point counts.  Where you fall on this scale (and even within the general groups) affects your ability to borrow and the terms of any credit received.  More on this later.

In the United States you’re entitled to one free credit report per year from each credit reporting agency. We’ll talk about ways to maximize this benefit and where to go for the reports that are actually free – not free if you sign up for something that costs a bunch of money if you forget to cancel – in later posts.  Unless you receive a promotion from one of the reporting agencies like the one earlier in the week, the free report will not give you a credit score – just the information on the report.  But that’s OK.  We’ll talk about what is good and bad on a report and it’s generally a good idea to get rid of as much “bad” (and inaccuracies) as possible.  The score is important, but we’ll go through how to identify the bad stuff and get rid of it to maximize your score.

For my Canadian friends (you know who you are) here is a PDF of the Government of Canada’s free publication about understanding your credit score.  There are some differences between the Canadian and United States systems.  One great benefit for my Canadian readers is that you are entitled to more credit reports per year as long as the request is made in writing (here and here are links to request forms).

How is a FICO score calculated?
A FICO score considers five general factors.  Not all factors are created equal, however.  Some are weigted more than others.  Below is the list of the five factors and the relevant percentage for each (showing how important each of the categories is in determining your FICO score):

  1. Payment history (35%);
  2. Amounts owed (30%);
  3. Length of credit history (15%);
  4. New credit (10%); and
  5. Types of credit used (10%).

That’s it.  We’ll talk about each of these factors in later posts, but they’re generally self explanatory.  What’s the lesson?  It really can be summed up in one sentence: To have a high FICO score you should focus on having a long history of on-time payments with low principal balances, few or no recent credit applications, but with open and well-managed credit cards and low-balanced installment accounts.

While I believe that this sentence sums up one way to get to a high FICO score, it’s important to me to emphasize that I believe some of this may be dangerous.  How?  Well, if I were the type of person who never met a sale I didn’t like, I would rather not have any credit cards or installment loans and sacrifice a smaller percentage of my credit report (types of credit used and possibly length of credit history) to not risk getting over my head with a high balances and late payments.  Under this example, I would be risking two factors that add up to 25% to protect two other factors that add up to 65%.  We’ll talk a bit about this in my posts about my credit strategy.

Bottom line: a high FICO score is very important to creditworthiness and lending terms, but it’s not the definition of financial prowess.  This is personal finance, remember.  So know yourself.  Sometimes it’s better to sacrifice a little to protect (or gain) a lot.

Why do I care?
I care because a high FICO score directly affects my ability to obtain credit and the interest rate offered.  In an ideal world I would never borrow a penny so my FICO score wouldn’t matter (in that case it actually wouldn’t even exist).  But I’m a realist.  I will likely need to borrow money to buy real estate.  And how much will my FICO score affect how much house I can afford?  A lot.  It’s almost scary. 

Let’s take a mortgage for example.  Where I live (New Jersey) a two-bedroom apartment ranges from $400,000 to $600,000 generally (based only on looking at real estate listings – no actual data).  So let’s take the midpoint there – $500,000.  And let’s assume we’re putting 20% down payment and getting a 30-year fixed-rate mortgage (for $400,000). 

According to this calculator, as of August 3, 2010, the difference between a credit score of 760 (the low end of “Great”) and 620-639 (“Not Good”) is 1.594%!  What does that mean in dollars?  (This is what’s important to me.) 

Well – here you go:

  

Sorry for the low quality chart.  I have no idea how to insert a chart so I did it in Excel and turned it into a picture.  But I don’t care about it looking pretty – I care about the numbers!

The difference between a credit score of 760 and one of 639 is $390 per month and over $140,000 in extra interest paid over the life of the loan.  Let me emphasize that again – $390 per month and $140,000!!! 

Stop reading this post for a second and think about all of the things in your budget that add up to $390 per month.  And what could you do with $140,000?  Go ahead.  I’ll still be here when you’re done picking your chin off the floor.

OK.  You back?  Do you know the answer to why I care about my FICO score?  I thought so.  To put it another way, I could have almost $80,000 more house for the same monthly payment if my score was 760 compared to if my score was 639.  And that’s if I decide to use that money to buy more house. 

Let’s have a little more fun with this.  If I decide to invest that $390 per month and earn even 5%, when I make my last mortgage payment I would have $239,973 after taxes, assuming no favorable tax treatment, and 25% federal and 8% state tax rates according to this calculator

That means I would have put $100,000 down, paid $306,456 in interest (not payments) and end up with $239,973 after taxes in an investment account.  At the end of the day I would have a house with a purchase price of $500,000 and, thirty years later, I would only have spent $66,483 in interest on the $400,000 loan, net of investing my High-FICO savings of $390 per month!  (It’s actually much better than this because the interest paid on the mortgage is tax deductable if certain conditions are met.  After that tax deduction it’s possible that I would have paid no net interest.  That’s a good mortgage rate!).  Change that to a 7% return and the investment account balance would be $302,317!  Not bad!

It’s even more important than just one mortgage comparison.  We’ll get into more detail in later posts on other things your credit score affects.  In short, by managing your credit well you can live better.  You can do more.  You can save more.  You can worry less.  You can provide more for your kids.  For your spouse.  And for you!  Get it?

Run your own numbers.  Your credit score can cost or save you money!  Real money!

So let’s manage our credit wisely.  I’m sure you know step one by now… say it with me:

Until next time – put the credit card down and slowly step away from the mall!

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