My Take On FICO Scoring
by Jason SteeleI was reading MrCreditCard’s post from earlier today about the composition of FICO scores. I cannot dispute the facts he lays out, rather, I would like to take a broader look at some misconceptions about FICO scores as well as consider their overall fairness of the score itself.
Misconceptions
FICO scores, commonly referred to as “credit scores” have been the subject of much confusion and misunderstanding. This state of affairs is the way it is by design, as the Fair Issac Corporation (from whose name the acronym derives), has a policy of not disclosing the exact formula they use to determine your score. This is done both in the name of protecting their proprietary formula, as well as trying to keep people from “gaming” the system. Therefore, any reports on what makes up your FICO score, like MrCreditCard’s, are just highly refined approximations based on the experiences of many, many consumers.
Today, MrCreditCard tackled the problems of available credit and credit history in his post titled “Will My Credit Score Go Down Because I Close My Credit Card?”. The other side of the same issue is the misconception that you can increase your credit score by canceling your credit cards. It should be clear from MrCreditCard’s post that, by itself, canceling all of your cards will likely reduce your credit score. The exception would be a compulsive spender for whom having many credit cards results in so much spending that they cannot make their payments. While this may not be as rare a scenario as I would like to believe, I think most people do not fall into that category.
On this subject, I trust the advice my mortgage broker, a person who sees many people’s credit reports and scores every day. He informed me that the best way to have a high credit score was to have several credit cards, at least three or four, but perhaps more. Furthermore, he recommend asking them raise your credit limits as high as they will permit. Then, keep them for as long as possible. This will raise your credit history, while lowering your credit utilization.
Is This Fair?
For many, this reality is counter intuitive. People often ask: Why am I not rewarded for having fewer credit cards? Why should it hurt me if I don’t want more credit? Wouldn’t I be a better risk if I didn’t have such a high line of credit? These are all great questions. The only way I can answer these is to try to look at things from the credit card company’s perspective.
If I was going to loan money to a person, what would I look for? Certainly, someone who always pays their bills on time would be important. That is your payment history, and naturally, it is the largest component of your credit score. On the other hand, if someone just got their first credit card yesterday, and made their first payment on time, I might not be all that impressed. That is where length of history comes in. The idea is not just that you have paid all of your bills on time, but that you have been doing so for a while. The interesting thing is that they seem to consider credit history an average of the duration of your current accounts, rather than your cumulative experiences. My opinion is this: Who cares? What does it matter if I have a different credit card company every year, so long as I have cumulative history of paying my bills on time.
Amounts owed is the second biggest factor in your score, after payment history. This seems to make some sense, as the amount you owe may reflect your ability to pay in the future. The problems again is that this is a ratio of amount owed relative to amount available, known as credit utilization. Personally, I don’t see why it should be a factor if I have a huge line of credit with other companies, so long as I do not owe a lot of money. Wouldn’t your debt to income ration be a much more accurate indicator of future payments? If anything, it would seem to make sense if I had a lot of available credit, it would hurt my score. One could reason that all that credit would mean that I could get much further into debt. Oddly, that is not the case FICO scores. The more credit you have, the higher your credit score, logical or not
Finally, my biggest gripe is with having the types of credit used as a factor in your score. There are still people like myself who do not have a car loan, a school loan, or any other loan, other than a mortgage and credit cards. Am I penalized for not getting a car loan? Would I have a lower score if I rented instead of bought my house? It just stikes me as weird that we are given better scores if we borrow more money from a variety of sources than if we live frugally and within our means. It is that incentive, built into the credit scoring system, that really should be re-examined based on the crisis our country is experiencing from too much borrowing.