FICO is a term that is often used as the generic word for credit scores, much the way Xerox is used when referring to any photocopy machine. But, the FICO score is a specific scoring system developed by the Fair Isaac Corporation. Fair Isaac is the company that developed the credit score and is the industry leader. Their scores are used by all three of the major credit bureaus and by over 70% of all lenders and creditors in America.
This is where it starts to gets a little confusing. Although the three bureaus use the FICO scoring system, each has their own way of calculating the score. Thus, when you receive a credit report from all three bureaus (a tri-merge report) you will get three different scores. It is further complicated by the fact that each of the bureaus may have different information in their files on you, thereby calculating their score based on different information.
But, wait, it gets more confusing. Each bureau not only has a slightly different scoring model that they purchased from Fair Isaac, but they also have different models for each credit type. So, your score will depend not only on which bureau is calculating the information, but also on the type of credit for which you apply.
Some of the more common types of scoring models are consumer, mortgage, automobile, and insurance scores. This helps explain why you get a slightly different score when you order a report for yourself (you will get the consumer scoring model version) compared to the scores your mortgage lender gets (they get the mortgage scoring model version).
In all cases, the FICO score has one major purpose: to predict your chances of default. In addition to grading your chances of default for a particular loan, creditors use credit scores for the following:
1. Fraud detection for credit and/or insurance.
2. Calculating the amount of profit a credit issuer is likely to make on a particular account of offer.
3. Predicting the risk of a specific default, like a foreclosure or a bankruptcy.
4. Forecasting the cost of an insurance policy claim.
5. Estimating how much a borrower who is in default is likely to pay.
6. Anticipating which customers may close certain accounts or pay certain accounts to zero.
7. Predicting the response rate to certain direct mail offers.
The bottom line is that creditors and the credit bureaus are in business to make money. They use credit scores, and FICO models in particular, to help determine their business plans and shape their credit decisions.
You should also always remember that the credit bureaus are for-profit entities, which create profit by having a product to sell. In this case, the product is your credit information, and their customers are the creditors who order credit reports.
Here are a few facts about credit scoring in general that you should keep in mind:
– You need to have and use credit to have a credit score.
– The FICO formula requires you to have at least one account on your credit report that has been open for six months and one account that has been updated in the past six months. Without this, you will not receive a score under FICO’s traditional scoring system.
– In 2004, Fair Isaac created the “Expansion Score” for people with thin or non-traditional credit histories. This scoring system can account for things like rental payments or checking account histories, but it is not widely accepted. It is better to work to establish traditional credit.
– A credit score is not typically the only thing lenders consider. But, it is a big factor. For example, in mortgage lending, a lender will consider your income, job history, debts and savings along with your scores. But, having a great income or terrific savings will not overcome a lousy credit score with most mortgage lenders.
– Those who will overlook your score will charge considerably higher rates and fees than traditional lenders.
– Credit scoring systems were designed for lenders, not consumers.
– Credit scores, and how they are determined, are not meant to be easy to understand. The actual formulas and details of how they work are closely guarded secrets.
Remember our earlier comment – the credit bureaus are in business to make money, not provide a service. As such, they fiercely protect their interests.