In 2003 the Consumer Federation of America conducted a survey of the American public about their credit scores. The results of the survey are disturbing at best. According to the survey, only 2% of the respondents knew their credits scores and only 3% could name the three major credit reporting agencies. What is a credit score, how is it determined, and why is it so important?
Your credit score is called your FICO score. FICO is rapidly becoming part of our everyday vocabulary; however, most of us don’t know what it stands for. The term FICO is a trademarked acronym that stands for Fair Isaac Corporation. How the Fair Isaac Corporation and its FICO score became such an important part of our lives requires a little understanding of the financial history of the United States after World War II.
Credit scoring in the United States had its origin in the growing need to extend credit to consumers after World War II. In making the switch from wartime to peace, the U.S. economy suffered a downturn in the late forties and early fifties. Banks and merchant retailers needed a way to stimulate the economy through offering credit to their customers while at the same time limiting their own risk.
Prior to World War II securing purchases on credit was usually a matter of knowing the owner of the local stores at which people shopped or the manager of the bank where they kept their accounts. After World War II the number of families grew and so did the need for more housing and retail purchases on credit. Banks and retailers began looking for ways to determine the credit risk of potential borrowers in order to meet this growing need.
As a result, community banks and merchant retailers formed their own in-house credit reporting bureaus to compile information about their clients. This was an imperfect science at best. These credit bureaus only compiled negative information about people that often included arrest records, marital history, sexual preferences, and life style choices. They also did not share information with other banks or retailers. Decisions about extending credit were made purely on a subjective basis based on the sometimes erroneous information available. A way was needed to more accurately assess a person’s credit risk.
Enter Bill Fair and Earl Isaac. Fair was an engineer and Isaac was a mathematician. In 1956 they formed the Fair Isaac Corporation with the idea of creating a mathematical formula for determining a person’s credit risk. Fair and Isaac built a credit scoring system in 1958 using mathematical algorithms. By 1970 they had created the first credit card scoring system. 1975 saw the development of the first scoring system that took into account the financial behavior of existing credit customers. This score predicted the credit risk of these customers. The result was the birth of the FICO score that is accepted worldwide today.
Along with the development of the credit scoring system came the creation of credit reporting agencies. Banks and merchants began to seek ways to share information with each other concerning their customer’s credit history and potential repayment risk. Credit bureaus began merging in order to give a broader financial picture of credit customers. Eventually three credit reporting agencies emerged as the dominant credit reporting agencies in the United States. These credit reporting agencies are Equifax, Experian, and TransUnion. There are still a few smaller regional credit reporting agencies in existence in the United States, but they are gradually being bought by one of the big three.
Each month your financial information is sent to one or more of the credit reporting agencies from banks, credit card companies, and retail merchants with which you do credit based business. All of your information is compiled and then a score is calculated using the computerized mathematical algorithms supplied by Fair Isaac Corporation. Each of the credit reporting agencies will calculate a score. Your score will range between 300 and 850. If you are scored by all three of the major agencies, it is possible to have three different scores. A score of 720 and above is considered good. If your score falls below 600, that’s not good. The median score in the U.S. is 725.
The algorithms from Fair Isaac take into account five different factors of your financial picture. Your payment history is 35% of your score. The amount of debt you currently owe accounts for 30% of your score. 15% of your credit score is the length of your credit history. Your new credit that has been extended to you weighs in at 10% of the total score. Last, the type of credit accounts you have is also 10% of your score.
As mentioned before, the FICO score is accepted worldwide. This score is used for everything from evaluating credit risk when borrowing money or applying for a credit card to background checks for prospective employment to applying for life insurance. Like it or not, the FICO score now permeates almost every area of our lives.