Importance of Your Credit Rating & FICO Score

(March 29th, 2007)

Upon borrowing money and taking out credit, you are promising to pay back to the lender the original principal you borrowed + some interest fees after a certain period of time. How likely is it that you will pay back this debt you owe? To determine this, the FICO score was developed. FICO is a software that calculates your credit score and your risk levels of default, created by Fair Isaacs Corporation.

Your Credit score is determined by your Credit Bureau. Some of the factors involved in calculating your credit score include:

  • History of your credit payments (whether you have been paying on-time or delinquent)
  • Your current total outstanding debt
  • Frequency of applications for new credit
  • Time length of credit history

Credit scores vary between 350 (very high risk) to 850 (very low risk). In the graph below, we show the average credit scores of Americans in 2003.

Apart from using the FICO credit scoring system, most Credit Bureaus in US and Canada use a rating scale of 0-9 to rate your personal credit. In the following table:

  • "I": Stands for Installment Credit example home mortgage or auto financing loan.
  • "R": Stands for revolving credit example Credit Cards.
Rating Description
R0 ; I0 You are a newbie to Credit and there is no sufficient information to assign you a credit score. Therefore, you might just qualify for a $500 limit credit card to start building your credit history.
R1 ; I1 Pay back debt in 1 month
R2 ; I2 Pay back debt in 2 months
R3 ; I3 Pay back debt in 3 months
R4 ; I4 Pay back debt in 4 months
R5 ; I5 Have not paid your debts in 4 months
R7 ; I7 Your debt payments are under consolidation
R8 ; I8 Your debts were cleared by repossesing the items you purchased, and selling them at FMV (fair market value).
R9 ; I9 You are classified under Bad Debt Expense and your debt is deemed uncollectible. You therefore may be denied any future credit.

Components of Your Credit Score?

The 5 components that make up your Credit Score include:

  1. Previous Credit payments & performance history
  2. Current debt load
  3. Your past average credit length or history
  4. Types of credit available to you
  5. Your applications for new credit

In the graph below, we summarize the importance of each of these items in percentage format, with the total being 100%

From the above graph, you can decipher that keeping a good history of regular on-time payments will help you increase your credit score. Furthermore, keeping a low debt-load and not maxing out your credit cards also increases your credit score. Additionally, not making frequent credit applications but keeping your current credit history alive and in good performance will help you raise your credit score.

Credit Score and its Impact on Monthly Debt Payments

If you have a bad credit score, this means you are at an increased risk of defaulting on your debt payments. Some lenders might reject your application, while other lenders will offer you debt financing, but at higher interest rates. This is opposed to someone with a good credit history who will be offered debt financing, at lower interest rates. Therefore, the person with a bad credit history will have to pay what's called a "Risk Premium." Here is a sample data table taken from www.myfico.com It shows your credit score level, the interest rate you will be charged and subsequently your total monthly payments.

Credit Score Interest Rate Monthly Payment
500 - 559 9.29% $1,238
560 - 619 8.53% $1,157
620 - 674 7.30% $1,028
675 - 699 6.15% $914
700 - 719 5.61% $862
720 - 850 5.49% $814