Lenders have a wide array of data available to make credit decisions on borrowers. Three major credit bureaus compile information about consumers' borrowing habits and use that information to create detailed credit reports, while another organization, the Fair Isaac Corporation (NYSE: FICO), or FICO, developed a proprietary algorithm that scores borrowers numerically from 300 to 850 on their creditworthiness. Some lenders make credit decisions strictly based on a borrower's FICO score, while others examine the data contained in one or more of the borrower's credit bureau reports.
When seeking a loan, it is helpful for borrowers to know their FICO score as well as what is on their credit bureau reports, such as those from Experian PLC (EXPN.L) and Equifax Inc. (NYSE: EFX); Transunion (NYSE: TRU) is the third major bureau, but this article will focus on the other two. A borrower who appears stronger under a particular scoring or reporting model should seek out lenders that use that model.
The Fair Isaac Company developed the FICO score in 1989 by creating a closely guarded mathematical formula that considers a variety of information contained in consumers' credit bureau reports. The company does not reveal the exact scoring model it uses, but its website does indicate how scores are weighted.
Payment history – how frequently the borrower pays on time versus late – is the most important factor, comprising 35% of a borrower's score. Amounts owed, meaning the ratio of a borrower's outstanding debt to his or her credit limits, make up another 30%. Length of credit history is 15% of a borrower's score; seasoned accounts raise a FICO score. Credit mix accounts for 10%, with FICO rewarding borrowers that demonstrate that they can manage various types of debt, such as mortgages, auto loans and revolving debt. New credit also makes up 10%; FICO looks down on borrowers who have recently opened multiple credit accounts.
Achieving a high FICO score requires having a mix of credit accounts and maintaining an excellent payment history. Borrowers should also show restraint by keeping their credit card balances well below their limits. Maxing out credit cards, paying late and applying for new credit haphazardly are all things that lower FICO scores.
Perhaps the biggest benefit of FICO over other credit-reporting models, such as Experian and Equifax, is that FICO represents the gold standard in the lending community. More banks and lenders use FICO to make credit decisions than any other scoring or reporting model. Although borrowers can explain negative items in their credit report, the fact remains that having a low FICO score is a deal breaker with numerous lenders. Many lenders, particularly in the mortgage industry, maintain hard-and-fast FICO minimums for approval. One point below this threshold results in a denial. Therefore, a strong argument exists that borrowers should prioritize FICO above all bureaus when trying to build or improve credit.
FICO's biggest drawback is that it leaves no room for discretion. If borrowers apply for a loan that requires a minimum of 660 FICO for approval and their score pulls as a 659, then they are denied the loan, regardless of the reason for their score. It could be something that in no way implies lack of creditworthiness for the particular loan being sought, but unfortunately, the FICO scoring model does not lend itself to subjectivity. Borrowers with low FICO scores but the quality information in their credit reports should pursue lenders that take a more holistic approach to making credit decisions.
Experian is one of the three major credit bureaus that produce reports detailing consumers' borrowing habits. Creditors, such as mortgage companies, auto finance companies and credit card companies, report borrowers' outstanding debt and payment histories to Experian, as well as to its peers Equifax and TransUnion (NYSE: TRU). The bureaus organize this information into reports that break down which accounts are in good standing, which are in bad standing and accounts that are in collections and public records, such as bankruptcies and liens.
Additionally, Experian has its own numerical scoring model, known as Experian PLUS, which offers a score from 330 to 830. Experian PLUS scores correlate strongly with FICO scores, though they are not the same thing, and the algorithms used to calculate them differ.
Experian's advantage over FICO is that the information it provides is more thorough than a simple number. A pair of borrowers could both have 700 FICO scores but vastly different credit histories. By reviewing Experian credit reports, lenders can look at each borrower's actual credit history — every debt that person has owed for a decade or longer — and analyze how that person managed that debt. It is possible that FICO's algorithm can give an ideal borrower the same FICO score as someone who is a high credit risk.
The main disadvantage with Experian is that, unlike FICO, it is rarely used as a standalone tool to make credit decisions. Even lenders who review credit reports in detail rather than going off a borrower's numerical score generally look at all three bureaus, not just Experian. Consequently, borrowers should periodically review all three credit reports to keep an eye out for erroneous or derogatory information.
Like Experian, Equifax is a major credit-reporting bureau. It produces credit reports similar to those from Experian, and that follow a similar format. Equifax reports are detailed and easy to read. If a borrower who five years ago paid his or her credit card bill late applies for a loan, a lender reviewing his or her Equifax report can pinpoint the exact month of the late payment. The report also indicates debts owned by collection agencies and liens against the borrower's assets.
Equifax offers numerical credit scores that range from 280 to 850. The bureau uses similar criteria as FICO to calculate these scores, but as with Experian, the exact formula is not the same. However, a high Equifax credit score typically indicates a high FICO score.
The advantages of Equifax are similar to those of Experian. The bureau's reports are detailed and provide lenders with deeper information about a consumer's borrowing habits than just a number. Its disadvantages are also the same. Borrowers cannot safely gauge their chances of loan approval by looking at their Equifax report alone. However, if their Equifax report is much stronger than their Experian report or FICO score, then they have the ability to search for lenders that prioritize Equifax.