THE BLOG

Do You Know This 4-letter 'F Word?'

09/28/2012 01:01 pm ET

Years ago, America was a different place than it is today: People didn't move around a lot. Our system of interstates didn't exist and neither did Disney World, and cars weren't as common... so those summer vacations that we might take for granted today were not even dreamt of by our grandparents or great-grandparents. People were born and raised in a small town, and they lived much of their lives there.

When they needed a loan, they would go to the local bank and talk to the owner -- probably someone they knew from school (and whose parents had known their parents!). Over a coffee and a handshake, the terms of a loan or a mortgage would be struck. You borrowed money and you paid it back because your good name and reputation were on the line and you had a relationship with the people you borrowed from.

But times have changed. People move around a lot more now. Banks are bigger, with numerous branches all over the place. And people need a lot more credit now than they did those many years ago.

So lenders needed a new way to measure creditworthiness in this changing culture.
That's when an engineer named Bill fair and a mathematician named Earl Isaac come into the story. They started the Fair Isaac Corporation, and in 1956 they developed a model for measuring a person's credit risk. Their algorithm created a credit score and the Fair Isaac Corporation score - the "F.I.Co." or "FICO" score -- is what most lenders rely on today to help them determine whether or not they lend someone money.

When you go into your bank or lending institution to borrow money, the lender pulls your FICO score from each company and then the "discard" the top and bottom score and base their lending decision on the middle FICO score. Although the FICO score itself doesn't "tell" a lender whether or not to lend, most lenders provide guidelines to their staff so that they only lend when a FICO score falls within certain parameters.

The 4-letter "F word" you need to know about is FICO -- it's the score that determines if a lender will lend you money and how much they'll lend you and at what interest rate. Some people feel that using an algorithm instead of a relationship to borrow money doesn't sound very nice but I think it's a good way to ensure that everyone who qualifies for credit can get it fairly. FICO erases the problem of only borrowing if you know the right people.

The world has changed: We no longer borrow money on a handshake from people we know. Instead, our ability to borrow money was decided in 1956 by an engineer and a mathematician. But the good news is: You can improve your credit score by learning about what factors make up into the FICO score and go to MyFICO.com to get your FICO score so you have a starting point to start fixing your credit!

Email me a credit question: JeanneKelly@Kgroupconsulting.com