If you’re looking for a loan, a credit card, a new mortgage, a home equity credit line, or even a small-business loan, you need to know what a FICO score is and what it tells a potential lender. Although your credit score may differ slightly depending on the credit bureau that reports on your credit history, Experian, Equifax, and Transunion all base their credit scores on the FICO score—which is why they’re usually very similar.
Because most small-business lenders also consider your FICO score, knowing more about the score and how it’s calculated will help you not only improve your personal credit score but also find more options when it comes time to apply for a small-business loan.
Where does FICO come from?
The FICO score was first introduced in 1958 by an engineer named Bill Fair and his mathematician partner Earl Isaac—and it was named after their company, Fair, Isaac, and Company. The goal was to help creditors make data-driven decisions before they offered a loan to a borrower.
In 1991, the FICO score was released to the three major personal credit bureaus (Experian, Equifax, and TransUnion), and in 1995, mortgage companies Fannie Mae and Freddie Mac started using the FICO score for mortgage lending.
Why is the FICO score important?
Since its introduction to the major credit bureaus in the early ‘90s, banks and other creditors have used the FICO score to evaluate a borrower’s creditworthiness for everything from auto loans, home mortgages, credit cards, and small-business loans.
Yes, your personal credit score, or FICO score, might not be the best measure of whether or not your business will successfully repay a business loan, but in tandem with some other metrics, it does help a lender answer three very important questions:
- Can your business repay a loan? Lenders will look at your business’s revenue and cash flow to see if you can afford the debt.
- Will your business repay a loan? Your FICO score plays a role here. A lender will look at your personal credit history to try to determine if you’re the type of borrower who typically meets his or her financial obligations. If you’ve consistently done so in the past (in both your personal and professional life), a lender can have a reasonable expectation that you will continue to do so in the future.
- Will your business make each and every loan payment? Your FICO score plays into this question too. Lenders are trying to determine what you’ll do in the future based on what you’ve done in the past. They’ll look at both your business credit profile and your personal FICO score to make that determination. The thought is if you make all your loan payments regarding your personal credit obligations, you will likely do the same with your business obligations.
There are circumstances where a business owner with a weak personal credit profile might still be able to successfully make loan payments. But over the years, lenders have seen a correlation between how a borrower meets their personal obligations and how they meet their business obligations. So as a small-business owner, you should assume that your personal credit score, or FICO score, will always be part of the equation.
How is the FICO score calculated?
Prior to universal acceptance of the FICO score and the Fair Credit Reporting Act, merchants would give verbal, inexact reports of a borrower’s payment history whenever a credit bureau asked. Following the introduction of the FICO score, it became much easier for potential creditors to evaluate your personal credit.
The formula for calculating the FICO score includes the following five metrics:
- Payment history (35% of your score). Late payments, bankruptcy, settlements, charge-offs, repossessions, and liens will all reduce your score.
- Debt-to-credit ratio (30% of your score). A debt-to-credit ratio compares the amount of credit you have available to the amount of credit you use. Keeping your credit use to around 15% to 20% is best, and maxing out your available credit each month isn’t recommended.
- Length of credit history (15% of your score). Lenders will look at the average age of the accounts on your credit report, as well as the age of your oldest account. The longer, or older, the credit file, the better. In other words, closing old accounts may not be the best strategy for building a strong personal credit score.
- Credit accounts (10% of your score). When it comes to debt, it’s best to have a blend of different account types. For example, a mix of a mortgage, an auto loan, a credit card, and revolving installment debt reflects better on your report than a couple of credit cards.
- New credit inquiries (10% of your score). Every time you apply for a new credit card or new credit account, it can reduce your score a few points. Fortunately, when you’re shopping for a mortgage, an auto loan, or a student loan, the credit bureaus recognize there will likely be multiple inquiries for the same thing and won’t ding your credit for each one. They will typically only ding you for the first inquiry.
As a general rule, if you apply for only the credit you really need and make each and every payment on time, you will build a strong FICO score over time. There really is no shortcut. In this case, slow and steady actually does win the race. Consistent behavior over time is what the credit bureaus reward with a good FICO score.
What does your FICO score say about you?
In addition to your FICO score, the credit bureaus also consider information on your public record, such as your name, birthdate, address, and employment. Your score will also be influenced by any information (both good and bad) your creditors report about your credit history. Any bankruptcies will also be reported to the credit bureaus.
The 1996 Fair Credit Reporting Act allows you to add a 100-word statement to any reports that have information you may dispute or want to explain. This is an opportunity to share any extenuating circumstances like a divorce, long-term illness, or job loss that may explain your less-than-perfect FICO score.
With that in mind, your FICO score says quite a bit about your personal credit history, and no matter the number, it will likely impact your loan application one way or another. So take a look at where your score sits on the scale and see how it’ll affect your lending opportunities.
Below 579: Bad
There are some lenders that will still work with a borrower who has a “bad” score, but it is considered a high-risk score. With a score like this, borrowers should expect to pay a higher interest rate on both consumer and business financing. And it is unlikely a business owner will qualify for a traditional business loan from a bank or credit union. The SBA will also typically not guarantee such a loan.
As a consumer, and as a business owner, you will likely have limited loan options if your FICO score is in the “poor” range, but there are options available. This is also considered a higher-risk credit score and will likely include higher interest rates and less favorable terms.
A score with the 620 to 679 range is considered a moderate-risk score, and many Americans fall into this category. As a business owner, a small-business loan is very possible, but it will not come with the most favorable terms or the lowest interest rate. A traditional loan at the bank is unlikely, and the FICO threshold of 660 is usually at the bottom of what the SBA will consider.
Anything between 680 and 739 is considered a good score. A borrower with this type of score should have no issues obtaining financing for both personal use and business use. And borrowers with a score in this range should expect to see more approvals and better interest rates.
740–799: Very good
If your FICO score is within the “very good” range, you’re considered a low-risk borrower and should have no problem qualifying for a personal loan or a business loan. Business loans will be especially easy to qualify for if you have a healthy business and cash flow.
Above 800: Excellent
If your score is considered “excellent,” you will not only qualify for either a personal or business loan but also should expect to have multiple financing options along with the best interest rates and most favorable terms.
Don’t qualify for a business loan? Get a personal loan instead.
Because lenders consider your personal credit history when evaluating your business loan application, it’s incredibly important to take actions that will bolster your personal score. Many lenders today, including traditional lenders like banks and credit unions (as well as some online lenders), factor your personal score into how they rate your creditworthiness and whether or not they’ll approve your business loan application.
Although a strong personal credit score might not guarantee a loan approval, a good FICO score will give you more options when you look for financing.
Not sure if your credit is up to snuff for a loan? We’ve got you covered. Take a look at our favorite small-business loans for bad credit.