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FICO Score - A Tool for More Debt?

Debt is Evil.  But many people would argue a necessary evil because our economic system relies on debt.  Just look at one major aspect of debt/credit system - the credit score - as an example of how reliant (or is captive a better word?) we are on debt.  The credit score system, as represented by THE most dominate scoring system - FICO Score, encourages more debt.

What is the FICO Score?

FICO Score was created by Fair Issac Corporation (hence the name FICO).  It is effectively the ONLY credit score used by the credit industry/lenders.  The three major credit bureaus (Equifax, Experian and Trans Union) use some form of a FICO Score.  How convenient is that?  Fair Issac controls the market for credit scores.

FICO Score is calculated using a mathematical formula based on the information contained in credit reports from the three major credit bureaus.  This formula basically measures the future risk of default of a borrower.  The score ranges from 300 to 850 (btw - good luck getting 850 - nobody is perfect).  A higher score the better.

EMPHASIS ADDED:

FICO Score is based on information in contained in credit reports.

This is why it is important to understand and stay on top of what is in our credit report.  By federal law, we can get a FREE annual credit report from annualcreditreport.com.  Beware of scams that use a very similar website name (ie. freecreditreport.com). 

Fair Issac claims that no one piece of information or factor will determine our FICO Score.  FICO Score considers the following factors and approximate weights (according to Fair Issac):

1)  Payment history - Approximately 35% of score:
The important thing about this factor is the FICO score considers how late were payments, how much was owed, how recently they occurred and how many there were. 

2)  Amounts owed - Approximately 30% of score:
What matters here is the percentage of a person’s available debt/credit is being used.  Higher percentage may indicate whether a person is overextended.

3)  Length of credit history - Approximately 15% of score:
Longer history increases score but Fair Issac claims that people who haven’t been using debt very long may still get a high FICO Score.  Yeah right.

4)  New Credit or Number of Credit Inquiries - Approximately 10% of score
The factor examines how many new accounts that a person has.  Has a person opened several credit accounts in a short period of time?  How many credit inquiries have been made by potential lenders?

5)  Types of Credit in Use - Approximately 10% of score:
This factor examines the mix of the type of credit accounts - revolving credit vs. installment loans.  The key thing with this factor is not to open accounts if you don’t intend to use them.

What a Tool!

Fair Issac is a major player in the debt/credit industry as the proprietary owner of the FICO Score.  It’s major clients are the three credit bureaus and lenders.  Keep that in mind when considering the above factors.  Whose side do you think Fair Issac will be on - you and me or the credit industry?

A FICO Score can’t even be calculated until enough information and enough recent information is generated to base a score on - this means people have to incur debt - great for credit card industry. 

Does cutting up those credit cards and closing those unused accounts help increase FICO Score?  If you thought it would - guess again.  In fact, Fair Issac actually advices against cutting up those credit cards:

In fact, it might lower your FICO® score. First of all, any late payments associated with old accounts won’t disappear from your credit report if you close the account. Second, long established accounts show you have a longer history of managing credit, which is a good thing. And third, having available credit that you don’t use does not lower your FICO® score. You may have reasons other than your FICO® score to shut down old credit card accounts that you don’t use. But don’t do it just to get a better score.

What they don’t tell you is that based on factor #2 above if you close accounts that lowers your available credit (the denominator) which can have a negative impact on your FICO score.  For example, let’s start with $10,000 debt used on $100,000 total available credit - 10% of available credit is being used.  Now, let’s assume you are tired of carrying so many credit cards and/or pissed off that credit card companies will be charging fees for either paying off balances every month or not using the card so you want to close accounts.  Guess what happens that $10,000 debt used is compared to $50,000 total available credit (10,000/50,000) - your percentage of available credit used is now 20%.  This means your FICO score will take a hit because you closed accounts. 

What a nice tool to keep us in debt!

Good luck.

Source:  Fair Issac Corporation

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