FICO Scores - The Basics
No doubt you've been hearing about "FICO Scores" or "Credit Scores" for some time now, but may not have a real solid grasp on what it is, and what it means to you.

Credit Scoring is a means of applying a sophisticated mathematical model to your credit behavior, and the behavior of other borrowers like you. It's a way to more accurately gauge how great of a risk you represent to a lender.

Your FICO score is especially important for two reasons.

1.In many cases your FICO score can make the difference between getting a loan approved or not. Borrowers with higher scores are more easily approved, while borrowers with lower scores represent a greater credit risk and are therefore more likely to be declined.

2. In almost all cases your FICO score will determines just how good of an interest rate you will enjoy. This is commonly referred to as "risk-based pricing" and it makes sense that low-risk borrowers should be rewarded with better rates and terms.

Although there a dozens of scoring models being employed (and more on the way) the most well-known company in the scoring business is Fair, Isaac and Company, known as FICO.

A Mathematical Model of You
Scoring models like the one developed by FICO have always been shrouded in mystery, especially when it comes to specifics. Generally speaking, though, they utilize your credit history, income, outstanding debt and debt utilization over the years, access to credit, and other indicators of your financial behavior to determine how likely you are to pay your bills on time, or if at all.

A numerical score is then developed, typically ranging from 300 to 900, with the low end of the scale indicating a poor credit risk. This can tell a lender whether or not he'll lend to you. For example, a credit score of 620 is frequently cited as a "cutoff point" for loans which can be funded by Fannie Mae or Freddie Mac. Below that, and you're usually off into the private "sub-prime" market, where rates are higher.

What's In Your score?
According to FICO, the breakdown of your score is as follows:

a. 35% of the score is determined by payment histories on your credit accounts, with recent history weighted a bit more heavily than the distant past;

b. 30% is based upon the amount of debt you have outstanding with all creditors;

c. 15% is produced on the basis of how long you've been a credit user (a longer history is better if you've always made timely payments);

d. 10% is comprised of very recent history, and whether or not you've been actively seeking (and getting) loans or credit lines in the past few months;

e. 10% is calculated from the mix of credit you hold, including installment loans (like car loans), leases, mortgages, credit cards, etc.

Other models being employed are sure to utilize these in various weightings, plus other data that may be fed in to the model. These might include your address or zip code, how often you've moved and other public and private information about you.

What It Means
So, now you've got a score. Why should you care? Increasingly, lenders are trying to fund loans with prices (rates, fees and terms) that more precisely match your risk. In theory, someone with a 900 score should get much better rates than someone with a 650 score.

So far, though, it hasn't exactly worked that way, at least not that precisely. There are several grades of credit which have arisen, most notably below the 620 line (A-, B, C, D). But above the 620 line, everyone pretty much pays the same. Lenders can penalize you for poorly managing credit, but don't much reward you for effectively and wisely managing your debt, at least so far.

Why Score At All?
It's not as though consumers have been clamoring for some sort of number, so why are we even bothering to go though this process for each loan? In the past, mortgages have been pooled together for sale, with these pools containing a range of credit risks—all pretty good, but some better than others, and some worse than others. Some borrowers would be more likely to pay off their loans early, and others might fail to make timely payments at all. The securities erived from these pools each carried a vaguely known level of risk to the investor, which made holding and hedging these as a part of an investment portfolio a bit of a tricky business.

It's long been the desire of investors to be able to slice and dice portfolios of mortgage loans to add or remove risk (and rewards) to a larger investment portfolio. With known risk, a greater level of performance could be assured. Investors are willing to pay more for a greater level of precision, and began pressing the industry to adopt a means to achieve it. Hence, credit scores; now, a seller can put together a package of loans for sale that aren't from a wide muddy pool of credit risks, but rather from a very specific kind or kinds of borrowers, all with scores which are close together.

Why All the Secrecy?
It's been a competitive stance by FICO not to release scores. It's simple enough to understand that once that FICO proved that scoring works, that other competing models would be developed. They are, including entries from the credit bureaus, Fannie Mae and Freddie Mac, and others.

But there's a good reason why they have resisted telling consumers about their scores and what goes into them. The scoring model depends upon consumers going about their business as usual, paying or not paying bills on time, opening lines of credit and getting credit cards as they normally would. If you knew that closing out a Visa account you barely use might raise your score by some amount, you would close it. That change in behavior, repeated millions of times (and across the various kinds of credit weighting) would distort or destroy the model, rendering the score and scoring process worthless.

FICO has claimed that revealing the score to a consumer would merely confuse the borrower even further, and that the score by itself isn't useful without proper understanding of the process.

The Bottom Line
For better or worse, FICO scores are often the make-or-break number when it comes to getting a good mortgage rate. If you are in the considering buying a home, you should consult with a loan officer before you go house-hunting to determine your credit-worthiness and what you can do to improve it if needs be. Please feel free to contact me at 817-416-2635 or e-mail me at bruce@bohomes.com if you would like me to recommend a loan officer, or if you have any questions.