Improve Credit Scores

FICO SCORING METHODOLOGY

By looking at previous credit report data and default rates based on that data, FICO believes that by matching an individual's credit report to those of other consumers with similar entries, it can more accurately predict default rates. They match people in this way and then assign them to categories. Based on the category in which the consumer is placed, he or she is then given a scorecard. Each consumer's credit history is initially assigned one of ten scorecards based on his or her worst credit entry and is sequentially passed through multiple scorecards. People who have filed for bankruptcy in the last year, for example, are assigned the worst initial scorecard, as are those with recent late payments.

This is why it's not necessarily beneficial to have all adverse entries drop off your report. Because of the way scorecards work, you may have worked your way up to the highest level within a given scorecard, and when entire tradelines fall off (due to the statute of limitations for adverse reporting, for example) you end up in a different, "better" initial scorecard, which can actually lower your score overall. That is, the lesser initial scorecard has a ceiling that goes higher than the floor of the next highest scorecard. People with a sparse credit history in particular are more susceptible to this anomaly, since the weight of a longer credit history counteracts the dropping off of an old account—one that is holding up a score because of its age. Yes, length of credit history counts substantially, which is explained shortly.¹

FICO scores range from 300 to 850, and, assuming that your total debt-to-income ratio falls within the acceptable limits (i.e., your total monthly debt, including the new loan, doesn't exceed 45 percent of your gross income), a score of 620+ will get you approved with a mainstream mortgage lender. To get the best interest rates, however, you will need a score of 720+. If your score is 780+, mortgage lenders will fight over your business, perhaps offering even better terms, such as reduced points (each point is equal to 1 percent of the total loan) or closing costs. A score of 500-619 will get you a B or C loan (alternative loan, often referred to as "subprime") with inflated interest rates and other undesirable terms, such as higher closing costs. Even if your score falls within their acceptable range, subprime mortgage lenders will usually decline you for 12 months following a bankruptcy. Add another year if you've had a foreclosure. By comparison, it takes two years to get loan approval from mainstream lenders following a bankruptcy and three years following a foreclosure.

Most mortgage lenders will pull all three credit reports and scores and then use the middle score. Some will even take the average of the top two scores and throw out the worst. Reputable auto lenders will most often take the highest FICO score, though some banks and credit unions will only pull the reports from bureaus to which they subscribe. Find out in advance of any auto loan application by checking with the dealer's finance department (or the bank or credit union if you're obtaining the loan directly).

Why Care? Higher Scores Can Save You Money

The importance of improving your FICO score cannot be overstated, and the biggest jumps in savings occur in the 620-700 range for mainstream mortgage and auto loans.

Using FICO's Loan Savings Calculator (www.myfico.com), it's easy to see what kind of savings someone seeking a $200,000 mortgage can expect from a small change in his or her credit score. Figure 5 shows an example from June 6, 2005.

Someone with a score of 674 versus 700 can expect to pay $222 more per month ($1,378-$1,156), $2,664 more per year ($222 x 12 months), or $79,914 more over the life of the loan ($296,207- $216,293). But 26 FICO points doesn't really tell the story. Note that all you need if you have a score of 674 is one point higher in order to go to the next tier, the 675-699 tier, which represents a savings of $153 per month ($1,378-$1,225).

Copyright © 2005 Fair Isaac Corporation. Fair Isaac, the Fair Isaac logo, and the Fair Isaac product and service names are trademarks or registered trademarks of Fair Isaac Corporation.

1. FICO claims, "Bad credit hurts you more than age helps you." My experience does not bear this out. FICO's Nexgen model is supposed to eliminate this problem. And yet, if FICO claims that it's not a problem with the classic FICO scoring model, why does it then claim that Nexgen fixes the problem?