How is the value of something established? How do we decide what something or someone is worth? How much is that small Monet? What’s the value of 3 acres in Arroyo Hondo, this diamond ring, a smile from across the room, or a Facebook friend? The banking industry requires a property being mortgaged to be appraised, to have its value established to support the terms of a loan. But it’s not only the property that’s being evaluated. The borrower is as well and the primary tool for such assessment is a credit report with a borrower’s FICO scores. These numerical values not only impact the rate a borrower is offered, they affect whether or not a borrower qualifies for a loan at all. Like the value of a dollar or an SAT score the FICO is meaningful only because we agree to its merit and validity. But what is a FICO score and how is it calculated?

FICO is a publically traded company that provides analytics and metrics primarily for financial services and companies that make high volume decisions about lending and investing money. Known as Fair, Isaac and Company it was founded in 1956 in San Rafael, CA is by engineer Bill Fair and mathematician Earl Isaac. It began selling its first credit reporting systems within a couple of years and went public in 1987. It was around that period that FICO scores became a ubiquitous measurement of the value of most anyone borrowing money or purchasing financial services including residential mortgages, consumer credit, insurance services and business licensing in the financial world. It was accepted as the ultimate evaluation of an individual’s behavior and attitude towards debt, or in other words their creditworthiness. It became ‘The Tool’ for evaluating the risks of lending money to an individual and there is little if any flexibility in its application. If your score is low, your mortgage rate, for example, is increased and your monthly payment can be hundreds of dollars more than had you been given a higher score. If the scores are too low you won’t qualify for a mortgage at all. Given the significance of FICO scores, which are available through all the major consumer reporting agencies including Experian, Equifax and Transunion, it seems we should be able to predict how scores are determined, what algorithms or formulas are utilized and what our scores should be. But FICO has been and remains quite secretive as to how scores are derived and remains the primary metric for assessing customer risk despite challenges to its accuracy and efficacy.

While FICO keeps the exact formulas secret they have disclosed the following components:
35% – Payment history – This focuses on how often bills are paid on time and how frequently they are late
30% – Credit utilization – This is a calculation of the ratio of current revolving debt ( typically credit cards and credit lines) to the total credit available, a utilization ratio . If you’ve maxed out your credit cards your scores will be lower than if your balances are well below your credit limits
15% – Length of credit history – the older the better
10% – classifications of credit used – ie installment (eg car loans or mortgages), revolving (credit cards), etc
10% – Recent searches for credit – This confuses many consumers who have learned that each time a credit report has been pulled (ie a credit application is being made) the FICO score is lowered. This is true but varies according to what type of application is being made. An individual shopping for a mortgage or car over a few weeks is not penalized as much as someone making application with numerous credit card agencies. The thinking here is that a consumer should be encouraged to search for best rates or car prices and won’t be securing multiple mortgages or purchasing numerous cars at once while one applying for credit cards could quickly run up a lot of unsecured debt (ie debt that isn’t collateralized by property).

Other factors that impact FICO scores include any money owed because of a court judgment or tax lien or having one or more than one newly opened credit account. Perhaps the most controversial aspect of the FICO scoring system is the scoring impact of debts that have been turned over to collection agencies and are reported as either open or paid collections. It is extremely common to see a collection on a credit report for a small cell phone bill, cable tv service or most often medical services. Often these are bills that are under $100 and have been disputed or were assumed to be paid by insurance but ultimately were turned over to collection agencies without the consumer even being aware. There is much controversy over the weighting of these collections and how accurate a predictor of creditworthiness they are. Over the last 10 years there have been efforts by other credit reporting and assessing agencies such as Vantage score to dispute and replace FICO as the sole evaluator of a consumer risk and worth focusing in part on the role of collection reports. Given the importance of these scores with regards to interest rate on long term debt as well as qualification for a loan we will explore more about alternative models in the next issue of Enchanted Homes.

Written by Ted Dimond