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Tuesday, July 23, 2024

What is a FICO Score? How it Impacts Lending Terms and Credit Decisions

What Is A Fico Score
John Ulzheimer

Written by: John Ulzheimer

John Ulzheimer
John Ulzheimer

John Ulzheimer is an expert on credit reporting, credit scoring, and identity theft. The author of four books on the subject, Ulzheimer has been featured thousands of times in media outlets including the Wall Street Journal, NBC Nightly News, New York Times, CNBC, and countless others. With over 30 years of credit-related professional experience, including with both Equifax and FICO, Ulzheimer is the only recognized credit expert who actually comes from the credit industry. He has been an expert witness in over 600 credit-related lawsuits and has been qualified to testify in both federal and state courts on the topic of consumer credit. In his hometown of Atlanta, Ulzheimer is a frequent guest lecturer at the University of Georgia and Emory University's School of Law.

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Edited by: Jon McDonald

Jon McDonald
Jon McDonald

Jon leverages 15-plus years of journalism expertise to inform financial consumers about emerging trends and companies making an impact in the industry. He is most knowledgeable in the areas of budgeting, credit card rewards, and responsible credit use. Jon has a passion for writing and editing, and his articles have appeared in publications produced by The New York Times.

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Reviewed by: Andrew Allen

Andrew Allen
Andrew Allen

For nearly 20 years, Andrew has worked for financial institutions ranging from regional investment organizations to some of the largest banks in the world. At Wells Fargo, Andrew was a Consultant within the Insight and Innovation division. A graduate of the University of Georgia’s Terry College of Business, Andrew’s goal has been promoting personal financial wellness and solid money decisions.

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Opinions expressed here are ours alone, and are not provided, endorsed, or approved by any issuer. Our articles follow strict editorial guidelines and are updated regularly.

A FICO score is any score designed and developed by the company, Fair Isaac. When you think of the term FICO, think of Ford or Coke as comparisons. 

Many cars and trucks are sold under the Ford brand, and many sodas, waters, and other beverages are sold under the Coke brand. FICO is the same way. 

There are countless credit scores and other types of scores that are collectively referred to as FICO scores, but they are not all the same, just like all Fords are not the same.

How FICO Scores are Calculated

The FICO scores, as are all credit scores, are entirely and exclusively influenced by information appearing on credit reports. FICO’s scoring systems are what is referred to as being tri-bureau, meaning they are available from all three of the national credit reporting agencies: Equifax, Experian, and TransUnion. Information that does not appear on your credit reports is not directly influential to your credit scores.

All credit scores, FICOs included, have a stated design objective. This is formally referred to as a scoring system’s performance definition.

For FICO’s credit bureau risk scores, the ones with which FICO is most commonly associated, the objective is to predict the likelihood that a consumer will go 90 days past due or worse on any obligation in the subsequent 24 months after the score has been calculated.

FICO’s models are actually the aggregate of multiple complex algorithms called scorecards. Each FICO score includes at least a dozen scorecards, which are separate models built to assess the risk of unique homogenous consumer populations. Meaning, the models are not one-size-fits-all systems, which ensures the fairness and accuracy of the scores.

FICO scorecard example

As part of the design and development process, credit score developers consider thousands of potential credit report-specific metrics that, when combined, will yield the most predictive scoring system possible. Ultimately, the series of metrics that are chosen and make their way into the FICO score will all fall neatly into one of these five categories.

Payment History: The payment history metrics consider the presence or absence of negative information. This category of metrics accounts for 35% of the points in your FICO credit scores. That’s more than any other category. 

If you have no negative information on your credit reports, you will bank the points associated with this category and you’ll be well on your way to earning and maintaining solid FICO scores.

If you do have negative information on your credit reports, the FICO scoring models will consider three variables associated with the information: The information’s severity, how recently the negative event occurred, and the volume or prevalence of negative information. 

And while it’s not normally a good idea to make assumptions about credit scores, it’s safe to do so here. If you’ve assumed more severe negative information is worse than less severe information, you’d be correct. If you’ve also assumed recent and prevalent negative information is worse than older and less frequent negative information, you’d also be correct.

What is negative information? If you’re wondering what the FICO score considers to be negative, it’s actually very simple. Any evidence that you are mismanaging your credit obligations is considered negative, including late payments, collections, repossessions, foreclosures, bankruptcy, default, settlements, defaults, and similar events.

Amounts Owed: The amounts owed metrics consider the debt that appears on your credit reports. This category of metrics accounts for 30% of the points in your FICO credit scores, which makes it the second most important category, right behind whether you’re making your payments on time.

This “debt” category is also the source of a great number of FICO scoring myths.

There are three types of consumer debt that appear on credit reports — installment, revolving, and open. Let’s take a closer look at each type:

  • Installment debt is a fixed payment for a fixed period of time debt, such as a mortgage or auto loan.
  • Revolving debt is mostly credit cards, where you have a predetermined credit limit, can draw against it, pay it back, and draw against it again. You also don’t have to pay off the balance each month and can carry or revolve some portion of the balance from month to month, which is expensive because that’s when you have to pay interest. 
  • Open debt is less common and is the type of debt that must be paid in full each month. Charge card balances and utilities are examples of open debt. In this context, open is not the opposite of closed.

Generally speaking, less debt is better than more debt for your finances and for your credit scores. But you can certainly have elite credit scores, well into the 800s, with debt. In fact, installment debt is almost benign to your FICO scores and it’s actually fairly easy to earn superior FICO scores with even seven figures of installment debt. 

This is why I never advise consumers to pay off installment debts as part of score improvement strategies, because it won’t yield much, if anything at all.

The revolving debt, credit card debt specifically, can be the problematic debt. There are several metrics associated with credit cards, including the infamous revolving utilization metric, which compares your credit card balances to your credit card limits, expressed as a percentage. 

This ratio should be as low as possible, less than 10% optimally. FICO has published studies indicating the highest scoring consumers have an average revolving utilization ratio of 7%.

utilization ratio example
The above illustrates the utilization ratio for a person with three credit cards.

It’s often reported that the target utilization ratio is 30%, which is incorrect. It is also often reported that the utilization ratio is worth 30% of the points in your FICO score, which is also incorrect.

The ratio is only one of several metrics in the category that, in its entirety, is worth 30%, and your target ratio should be less than 10%, as stated above.

Length of Credit History: This is the “time in file” category, which is worth 15% of your FICO score points. There are only a few metrics in this category, and they measure the average age of your accounts and the ages of your oldest and newest accounts. 

This category is commonly what holds people back from hitting 850 (the highest possible credit score). You can’t accelerate time, and your credit reports have to be decades old to max out the points in this category. Someone who has only used credit for a few years won’t do as well in this category as someone who has used credit for decades.

Credit Mix: The credit mix category considers the breadth of your experience across different types of accounts, like credit cards, mortgages, and finance company accounts. This category is worth only 10% of the points in your FICO scores. As your credit experiences evolve and you start to have more than just credit cards, you will do better in this category.

New Credit: The new credit category, which is also worth 10% of your FICO score points, is often labeled the inquiry category, although this series of metrics considers much more than credit inquiries. This category also considers the number of newly opened accounts, some of your hard inquiries, and the amount of time since you most recently opened a new account.

fico score factors
Five factors can influence credit scores.

Keeping in mind this category is the least important for your FICO scores, fewer inquiries are generally better than more inquiries, so it’s a good idea to be judicious when allowing companies to pull your credit reports. 

FICO Score Ranges

FICO’s generic credit bureau scores have a range, or scale, of 300 on the low end to 850 on the high end. FICO’s industry-specific credit scores, which we’ll cover later, range from 250 to 900. 

For FICO’s credit bureau scores, a lower score is always going to indicate elevated credit risk. Conversely, a higher FICO score is going to indicate less credit risk. So, it’s important to always strive to earn and maintain the highest scores possible.

Only lenders can truly judge what is a good or bad FICO score, because they’re the ones that make credit decisions. But here are some general parameters that can be used to categorize where you fall along the good-to-bad FICO score continuum. 

First things first, according to FICO, the average FICO score as of October 2023 was 717. So, anything above 717 is above average, and anything below 717 is below average. That’s a helpful threshold to use as you determine whether your score is good, as a below-average score should not be considered a good score using any definition.

According to FICO, consumers who have FICO scores at or above 760 have good enough scores to earn the lowest interest rates on mortgage loans. Around 40% of you have FICO scores at or above 760. So, from a mortgage lending perspective, 760 is a very good to exceptional FICO score. 

Month & YearAverage FICO Score 8
April 2020708
October 2020713
April 2021716
October 2021716
April 2022716
October 2022716
April 2023718
October 2023717
Source: FICO

The news gets better for auto lending. According to FICO, consumers who have FICO scores at or above 720 have good enough scores to earn the lowest interest rates on auto loans.

With 720 barely above average, calling 720 “very good” is a stretch. That means auto lenders have a lower bar as to what a consumer needs, score-wise, to earn the best deals. Well over 50% of you have FICO scores at or above 720. Anything below the 720 to 760 range means you are unlikely to get the best deal on installment loans.

For credit cards, the bar is variable (lower and higher) depending on the card issuer. Some card issuers don’t have subprime products, such as American Express. Other issuers are tailor-made for lower-scoring customers, such as Credit One Bank.

Some of you may be familiar with the term subprime, which is generally meant to refer to a borrower who cannot qualify for competitive terms on any form of credit and has to settle for less attractive terms on all forms of credit. 

FICO ranges

While there is no official dividing line between a prime and subprime credit score, anecdotally, that line seems to be around 660 to 680. So, while some sources suggest 680 is a “good” score, the lending industry disagrees.

At best, it’s “good enough” and also 37 points below average.  

The History of the FICO Score

FICO, the company, has been around since the 1950s, but that doesn’t mean credit bureau scores have existed since then. 

Origins and Development

The first FICO credit bureau scoring model installed at a credit bureau was BEACON, which was the commercial name of the FICO credit bureau score available from Equifax then. 

That score became commercially available in 1989. By 1991 the other two major credit bureaus, TransUnion and TRW, also made FICO credit bureau scores commercially available. Experian did not exist in the United States until 1996.

Global Adoption and Popularity

In 1995, Fannie Mae and Freddie Mac recommended the use of FICO scoring for mortgage lending. I was hired by FICO to help with this market adoption. From my first-hand experience, “recommend” really meant “required,” and mortgage loans guaranteed by Fannie Mae and Freddie Mac are still underwritten using FICO’s credit scores as a matter of policy.

By this time in the history of consumer lending, the FICO score was ubiquitous across all forms of credit. This included credit cards, auto loans, and mortgages. Today, the FICO score is still one of the most impressive examples of first-to-market domination in the United States.

According to the company, some 90% of top U.S. lenders use the FICO score, which is incredibly impressive considering we’re in the era of disruptors.

For a FICO score to continue to be used in the United States, it must always meet a considerable set of legal requirements. Three of the requirements are the model must be:

1. Empirically derived

2. Demonstrably sound

3. Must include adverse action codes

If a scoring model does not meet these criteria, it cannot be used in the United States.

To be empirically derived means the scoring models have to be built using sound and generally accepted mathematical methods. Scoring models are built using regression techniques, meaning they assess the relationship between current and past experiences to determine future outcomes. As in, what you do now and did yesterday can predict what you’ll do tomorrow.

To be demonstrably sound means the scoring model is proven to work. There are a number of methods to determine whether or not a credit scoring system works. The most common method is via a process called validation. 

Validation of scoring model occurs when it can be proven that it rank orders credit reports/consumers by risk. In simple terms, if higher scoring consumers always pay their future obligations better than lower scoring consumers, the model rank orders and is demonstrably sound.

Finally, adverse action is a fancy way of saying someone was denied or approved but with less favorable terms. This is communicated via a form called an adverse action notice, although most people simply call them denial letters. 

Adverse action notice required graphic
Source: consumercomplianceoutlook.org

One of the requirements in the U.S. is that lenders must provide the principal reasons they denied a consumer’s application if that denial was based on a credit report or credit score. The FICO score provides up to four reasons why the consumer didn’t score higher, and these reasons can be used by a lender to satisfy their adverse action notice (denial letter) requirements, to the extent the score was, in fact, the principal reason for a denial.  

Recent Changes and Updates

The FICO scoring models are redesigned and redeveloped periodically, just like your mobile phones are updated periodically. The last three generations of the FICO score are FICO 8, FICO 9, and the FICO 10 Suite. In that order, those three model generations were introduced in 2008-2009, 2015, and mid-to-late 2020. 

And while these dates aren’t really recent using Webster’s definition of the word, in the world of credit scoring, the models are not updated often because of the incredible amount of work that goes into building them — and also the work it takes for lenders to convert to them. 

As the most extreme example, mortgage lenders have been using the same FICO scores for more than 25 years because of an FHFA mandate. It just takes a long time for lenders and governing bodies, like the FHFA, to move to newer model generations. 

This is, of course, no fault of FICO or any of the credit reporting agencies. They can only make the models available, but can’t force anyone to use the most current versions.

In fact, the use of FICO scores by mortgage lenders is the most recent and relevant update with respect to the topic of the evolution of FICO scores and their use.

table for types of FICO scores

Starting in late 2025, mortgage loans guaranteed by Fannie Mae and Freddie Mac, which is about 70% of mortgages, will have to be underwritten with both a FICO 10T and a VantageScore 4 credit score. This is the most meaningful update to the use of credit scores for mortgage lending since before the turn of the century.

The primary difference between the FICO scores currently used for mortgage lending and the two newer scores that will eventually be used for mortgage lending is the consideration of trended data. 

Trended data allows these newer scoring models to see and consider how you’ve managed debt over the prior 24 months, whereas older credit scores only consider the most recent month’s update to the credit bureaus.

Why Your FICO Score Matters

It cannot be overstated just how important your FICO scores are to your bottom line. In fact, I wrote a book many years ago wrapped around the premise that earning good credit scores should be considered a wealth-building strategy.

If you pay less for loans, that’s more money in your bank account every month. That’s no different from choosing the right mutual fund or stock or building a healthy nest egg for retirement.

Simply put, if you want to be approved for a loan or a credit card, then you need “good enough” FICO scores. If you want the most competitive rates and terms on loans and credit cards, then your FICO scores have to be even better than simply good enough, as I addressed above.

FICO scores are used across various, including:

  • Auto lending
  • Insurance underwriting
  • Tenant screening
  • Mortgage lending
  • Credit card decision-making

The process they all use is called risk-based pricing, meaning their decision and subsequent terms you are assigned are based on the level of risk you pose to the lender, insurance company, or landlord. 

The better your scores, the less risk you pose, which makes it easier for everyone to offer you competitive deals. The higher your risk, the higher your cost.

One myth that’s worth busting here is that credit scores are used for employment screening. That’s incorrect. Credit reports can be used in limited scenarios for employment screening but not credit scores.

FICO vs. VantageScore

Prior to 2006 there was FICO — and that was about it. There was no other generally available and commonly used tri-bureau credit bureau score. But, in 2006 a new scoring model was debuted by the credit reporting agencies — the VantageScore credit score. 

The VantageScore credit score is a collaboration of the three credit reporting agencies. It was introduced in 2006 and has become a legitimate competing credit score option. 

In 2023, 27 billion VantageScore credit scores were used, which is more than three times the population of the globe, to give you some perspective. As I mentioned earlier, by the end of 2025, and possibly sooner, all mortgage loans guaranteed by Fannie Mae or Freddie Mac will be underwritten with both a FICO and VantageScore credit score.

FICO versus VantageScore graphic

There are several differences between FICO and VantageScore credit scores. First, there are dozens of FICO scores commercially available and commonly used, representing several generations of scoring models. 

FICO offers scores built for credit card lending, auto lending, insurance underwriting, and for generic use across any industry. VantageScore does not have these semi-customized, industry-specific versions.

The second difference between FICO and VantageScore credit scores is the minimum standard for scoring. As in: What does your credit report have to include for a score to be calculated? This is called the minimum scoring criteria, and it’s different across the two scoring platforms.

For FICO, the criteria is simple:

  • Your credit report must have at least one undisputed account that is older than six months.
  • Your credit report must have at least one undisputed account that has been updated in the last six months.
  • You cannot have a deceased indicator on your credit report.

One account can satisfy the first two criteria. For example, if you have a Capital One credit card that was opened five years ago that was also updated last month, and you don’t have a deceased indicator on your credit report, you will be scorable under all of the FICO scoring models.

VantageScore’s minimum scoring criteria is more relaxed. VantageScore’s scoring models will score consumers who have less than six months of credit history, or updates to their credit reports up to 24 months old, or without any open accounts. This more flexible criteria allow for 30 to 35 million more consumers to qualify for a VantageScore credit score, according to the company.

Still, the FICO score is seen as the standard for credit scoring in the U.S. and other countries. FICO’s scores are available from both of the Canadian credit reporting agencies, Equifax Canada and TransUnion of Canada. Its scores and other products and services are also used in some 120 countries.

How to Improve Your FICO Scores

There is no one-size-fits-all strategy to improve your FICO scores. Dozens of metrics interact with each other as part of the scoring process, which means there are many paths to lower and higher scores. What will work for you may not work for someone else.

Sustainable Habits for Long-Term Success

Generally speaking, if you can avoid negative information from landing on your credit reports, you’ll bank 35% of the points available in your FICO score, given the Payment History category is worth 35% of your FICO score points. You’ll be well on your way to great scores.

Because the next most valuable category deals with debt, an assumption could be that no debt is the best amount of debt. That’s not really accurate, given credit scoring models need to see how you’ve managed debt to predict how you will continue to manage debt. Proper management of debt is much better than avoiding debt.

To bank most of the points in the Amounts Owed category:

  • Maintain credit card debt that is low relative to your credit limits
  • Limit balances to only a few cards
  • Don’t over-focus on installment debt 

Installment debt is almost immaterial in your FICO score, given that it’s generally secured and defaults at a lower rate than the unsecured credit card debt, which means it’s not as problematic. Sure, it’s nice to not have any installment debt, but you can have six or seven figures of it and still have elite FICO scores.

No Quick Fix for Improving Your FICO Scores

Of course, you can’t simply snap your fingers and make negative information disappear — it doesn’t work that way. So there really isn’t a short-term strategy as it pertains to negative information and score improvement, unless the information is incorrect, and you can get it removed. Otherwise, you’ll have to wait for it to age, where it will become less influential to your FICO scores.

The real short-term strategy for improving your FICO scores is dealing with credit card debt. If you can pay your debt down and maybe even eliminate the balances on one or more of your cards, you’ll likely see your scores improve within 30 days, which is the amount of time for your credit report to go through a full cycle of updates from your lenders.

Dealing With Credit Report Errors

While most credit reports are accurate or only contain cosmetic or immaterial blemishes, it is important that they are as accurate as possible, given how influential they are to your FICO scores. Here, the law is on your side.

You have the right to challenge anything on your credit reports at Equifax, Experian, and TransUnion that you feel is incorrect — and at no cost.

The Fair Credit Reporting Act requires the credit bureaus to perform investigations in cases of disputed accuracy. When you contact the credit bureaus, they will either change your credit reports as requested or contact the furnisher of the disputed information, normally a debt collector or a financial services company, as part of their investigation, which normally doesn’t take more than two weeks. You’ll be informed of the results.

AnnualCreditReport.com screenshot
Consumers can access their credit reports for free on AnnualCreditReport.com.

You can always check your credit reports for errors at no cost and as often as every week at www.annualcreditreport.com. 

This is the single source of credit report information as mandated by the Fair Credit Reporting Act. You will not be asked for a method of payment.

The FICO Score is a Trusted Gauge of Financial Responsibility 

Generally speaking, it has been my long experience that most consumers associate FICO scores with FICO’s credit bureau risk scores. Those are the scores pulled by banks, credit card issuers, mortgage brokers, and credit unions when you apply for some form of credit and are used to determine whether or not you’ll be approved, and with what terms. 

FICO’s credit bureau scores have been available since 1989, have been redeveloped several times since, and are a trusted gauge of creditworthiness by countless lenders and other users of their scoring models. As of mid-2024, the most current generation of the FICO score is the suite of FICO 10 credit scores available from all three of the major credit reporting agencies in the U.S.