The question remains: How did one little number come to have such an outsized effect on our lives?
Credit scoring has been in widespread use by lenders for several decades. By the end of the 1970s, most major lenders used some kind of creditscoring formulas to decide whether to accept or reject applications. Many were introduced to credit scoring by two pioneers in the field: engineer Bill Fair and mathematician Earl Isaac, who founded the firm Fair Isaac in 1956. Over the years, the pair convinced lenders that mathematical formulas could do a better job of predicting whether an applicant would default than even the most experienced loan officers.
A formula wasn’t as subject to human whims and biases. It wouldn’t turn down a potentially good credit risk because the applicant was the “wrong” race, religion, or gender, and it wouldn’t accept a bad risk because the applicant was a friend.
Credit scoring, aided by ever more powerful computers, was also fast. Lending decisions could be made in a matter of minutes, rather than days or weeks.
Early on, each company had its own credit-scoring formula, tailored to the amount of risk it wanted to take, its history with various types of borrowers, and the kind of people it attracted as customers. The factors that fed into the formula varied, but many took into account the applicant’s income, occupation, length of time with an employer, length of time at an address, and some of the information available on his or her credit report, such as the longest time that a payment was ever overdue.
These calculations took place behind the scenes, invisible to the consumer and understood by a relatively small number of experts and loan executives. The cost to develop and implement these custom formulas was—and still is—considerable. It was not unusual to spend $100,000 or more and take 12 months just to set one up. In addition, not every creditor had a big enough database to work with, especially if the company wanted to branch out into a new line of lending. A credit card lender that wanted to start offering car loans, for example, might find that its database couldn’t adequately predict risk in vehicle lending.
That led to credit scores that are based on the biggest lending databases of all—those that are held at the major credit bureaus, which include Equifax, Experian, and TransUnion. Fair Isaac developed the first credit bureau-based scoring system in the mid-1980s, and the idea quickly caught on. Instead of basing their calculations on any single lender’s experience, this type of scoring factored in the behavior of literally millions of borrowers.
The model looked for patterns of behavior that indicated a borrower might default, as well as patterns that indicated a borrower was likely to pay as agreed. The score evaluated the consumer’s history of paying bills, the number and type of credit accounts, how much available credit the customer was using, and other factors.
This credit-scoring model was useful for more than just accepting or rejecting applicants. Some lenders decided to accept higher-risk clients but to charge them more to compensate for the greater chance that they might default. Lenders also used scores to screen vast numbers of borrowers to find potential future customers. Instead of waiting for people to apply, credit card companies and other lenders could send out reams of preapproved offers to likely prospects.
How Credit Use Has Changed over the Years
Credit scoring is one of the reasons why consumer credit absolutely exploded in the 1990s. Lenders felt more confident about making loans to wider groups of people because they had a more precise tool for measuring risk. Credit scoring also allowed them to make decisions faster, enabling them to make more loans. The result was an unprecedented rise in the amount of available consumer credit. Here are just a few examples of how available credit expanded during that time:
• The total volume of consumer loans—credit cards, auto loans, and other nonmortgage debt—more than doubled between 1990 and 2000, to $1.7 trillion.
• The amount of credit card debt outstanding rose nearly threefold between 1990 and 2002, from $173 billion to $661 billion.
• Home equity lending soared from $261 billion in 1993 to more than $1 trillion ten years later.
Credit scoring got a huge boost in 1995. That’s when the country’s two biggest mortgage-finance agencies, Fannie Mae and Freddie Mac, recommended lenders use FICO credit scores. Because Fannie Mae and Freddie Mac purchase more than two-thirds of the mortgages made, their recommendations carry enormous weight in the home loan industry.
The recommendations are also what finally began to bring credit scoring to the public’s attention. If you’ve ever applied for a mortgage, you know it’s a much more involved process than getting a credit card. When you apply for a credit card, you typically fill out a relatively brief form, submit it, and get your answer back quickly—sometimes within minutes, if you’re applying online or at a
retail store. The process is highly automated, and there typically isn’t much personal contact. Contrast that with a mortgage. Not only do you have to provide a lot more information about your finances, but getting a home loan also requires that you have ongoing personal contact with a loan officer or mortgage broker. You might be asked to clarify something in your application, be told to supply more information, or be given updates about how your request for funds is being received.
Consumer’s Fight for Truth About Credit Scores
It was in the course of those conversations that an increasing number of consumers starting hearing about FICOs and credit scores. For the first time, people learned that the reason they did or didn’t get the loan they wanted was because of a three-digit number. It became obvious that lenders were putting a lot of stock in these mysterious scores. But when consumers tried asking for more details, they often hit a brick wall. Fair Isaac, the leader in the credit-scoring world, wanted to keep the information secret. The company said it worried that consumers wouldn’t understand the nuances of credit scoring, or they would try to “game the system” if they knew more. Fair Isaac feared that its formulas would lose their predictive ability if consumers started changing their behavior to boost their scores.
Now, some sympathetic mortgage officials didn’t buy into Fair Isaac’s company line. They thought consumers deserved to know their score, and these officials also often tried to explain how the numbers were created. Unfortunately, because Fair Isaac wouldn’t disclose the formula details, a lot of these explanations were dead wrong. Even more unfortunately, some loan officers perpetuate these myths about credit scoring, despite the fact that we have much more information about what goes into them. (You’ll read more on these myths in Chapter 5, “Credit-Scoring Myths.”) Resentment about the secret nature of credit scores came to a head in early 2000. That’s when one of the then-new breed of Internet lenders, E-Loan, defied Fair Isaac by letting consumers view their FICO credit scores. For about a month, people could actually take a peek at their scores online and learn some rudimentary information about what the numbers meant.
Some 25,000 consumers took advantage of the free service before E-Loan’s source for credit-scoring information was cut off. But the proverbial cat was out of the bag. A few months later, with consumer advocates demanding disclosure and lawmakers drafting legislation requiring it, Fair Isaac caved. It posted the 22 factors affecting a credit score on its Web site, grouped into the 5 categories you’ll read about in the next chapter. Shortly after that, the company partnered with credit bureau Equifax to provide consumers with their credit scores and reports for a $12.95 fee.
In late 2003, Congress finally got around to passing a law that gave people a right to see their scores. By the time this update to the Fair Credit Reporting Act was signed into law, however, access to credit scores was almost old hat.
Controversies over credit scoring continue to rage. Here are just of few of them.
Credit Scoring’s Vulnerability to Errors
No matter how good the mathematics of credit scoring, it’s based on information in your credit report—which may be, and frequently is, wrong. Sometimes the errors are small or irrelevant, such as when your credit file lists a past employer as a current employer. Other times the problems are significant, such as when your file contains accounts that don’t belong to you.
Many people discover this misinformation only after they’ve been turned down for credit. The credit bureaus handle billions of pieces of data every day, so to some extent, errors, outdated, and missing information are inevitable—but the credit-reporting system often makes it difficult to get rid of errors after you spot them. The problem is only getting worse. The rise in automated lending decisions means a human might never see your application or notice that something’s awry. The explosion in identity theft, with its ten million victims a year, means more bad, fraudulent information is included in innocent people’s credit files every day. Patricia of Seattle, Washington, tells of the ongoing horror of becoming a victim:
“I’ve always been careful about protecting my identity. Unfortunately,
when I was trying to purchase a home, the real estate broker, to whom I’d
given my application with birth date and Social Security number, had her
laptop stolen. My worst fears came true when, four months later, I suddenly
had creditors calling me like crazy asking why I wasn’t paying on
accounts that were just recently opened in my name. On top of this, I
learned the criminals had also stolen my mail with preapproved credit
cards. This has created a nightmare of time, work, and frustration trying
to clean up my credit history. It’s been over two years now, and I’m still
working with the major credit-reporting agencies as we speak.”
Credit Scoring’s Complexity
You’re being judged by the formula, so shouldn’t it be easy to understand and predictable? Not even credit-scoring experts can always forecast in advance how certain behaviors will affect a score. Because the formula takes into account so many variables, the best answer they can muster is, “It depends.” The variety of different scoring formulas and different approaches
among lenders can confuse matters even further. Lenders can get scores calculated from different versions of the FICO formula. They also can have in-house formulas that incorporate a FICO score along with other information that might punish or reward certain behaviors more heavily than the FICO formula does on its own. Some call the result a FICO score, even though that’s not technically correct. Not surprisingly, this causes confusion for consumers and mortgage professionals alike.
A. J. Cleland, an Indianapolis mortgage broker, discovered how different scores could be when trying to help a client who had been turned down for a loan by a bank. The bank reported the client’s FICO score was 602, whereas the FICO score Cleland pulled for the client—on the same day and from the same credit bureau—was 31 points lower:
“I called my credit provider and was informed that there are different
types of reports and different scores,” Cleland said. “I thought your score
was your score, period.”
Credit Scoring’s Use for Noncredit Decisions
I mentioned earlier that your landlord or employer might check your credit and your credit score when evaluating your application; however, the most controversial noncredit use of scoring is in insurance. Insurers have discovered that there’s an enormously strong link between the quality of your credit and the likelihood you’ll file a claim. They can’t really explain it, but every large study of the issue has confirmed that this link exists. The worse your credit, the more likely you will cost an insurer money. The better your credit, the less likely you are to have an accident or otherwise
suffer an insured loss. As a result, more than 90 percent of homeowners and auto insurers use credit scoring to decide who to cover and what premiums to charge them. That outrages many consumers and consumer advocates who don’t see a logical connection between credit and insurance. Julie, a city worker in Poulsbo,Washington, saw her insurances soar after a divorce and subsequent bankruptcy trashed her credit:
“I have had the same insurer for 30 years, never been late, never missed
a payment, never had an accident, and never filed a claim—yet now I pay
the price of higher rates. I absolutely do not understand how this is fair.”
This leads to another controversy, spelled out in the next section.
Credit Scoring’s Potential Unfairness
Developers of credit scoring point out their formulas are designed not to discriminate. Credit scores don’t factor in your income, race, religion, ethnic background, or anything else that’s not on your credit report. Like many divorced people, Julie discovered that her ex still had the power to trash her credit long after the marriage was over. His unpaid bills, run up on once-joint accounts, showed up on her credit report and ultimately led her to file bankruptcy.
But it’s not clear whether the result of those formulas actually is nondiscriminatory. Some consumer advocates worry that some disadvantaged groups might suffer disproportionately as a result of credit scoring. Among their theories: People who have low incomes or who live in some minority neighborhoods might have less access to mainstream lenders and thus have worse credit scores. The lenders these disadvantaged populations do use—finance companies, subprime lenders, and community groups— might not report to credit bureaus, making it harder to build a credit history.
If these lenders do report to the bureaus, their accounts might count for less in the credit-scoring formula than those of mainstream lenders. Seasonal work is also more prevalent in some neighborhoods, which can lead to a higher rate of late payments in the off-seasons. Even if credit scoring doesn’t discriminate against groups, it might discriminate against you.
No credit-scoring system is perfect. Lenders know that their formulas will reject a certain number of people who actually would have paid their bills. Another group will be accepted as good risks, but then default. If these groups get too large, the lender has trouble. When too many bad applicants are accepted, the lender’s profits plunge. When too many good applicants are rejected, the lender’s competitors can scoop them up and make more money.
But lenders accept a certain number of misclassified applicants as a cost of doing business. That’s little comfort to you, if you’re one of the responsible ones who loses out on the mortgage you need to buy a home, or if you end up paying more for it.
Given all the problems with credit scoring, it’s understandable that some people think the system is fatally flawed. Some of my readers tell me they’re so angry about scoring and the behavior of lenders in general that they’ve cut up their credit cards and are determined to live a credit-free life. The rest of us, though, live in a world where credit is all but a necessity. Few of us can pay cash for a home, and many need loans to buy cars. Credit can help launch a new business or pay for an education. And most Americans like the convenience of using credit cards. Although it’s true that improper use of credit can be disastrous, credit properly used can enhance your life. If we want to have credit, we need to know how credit scoring works. Knowledge is power, and the tools I give you in this book will help you take control of your credit and your financial life.
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