Though it seems commonplace now, the current system of credit in America is still relatively new, less than 100 years old, and still has flaws. The credit scoring system is more objective than previous systems of lending, however, there are many details about credit scores and how they affect lending, interest rates, and credit that consumers have not realized. After learning about the fine print, one wonders if consumers would be so quick to sign up for that department store credit card or lease that new car.
Today, a person’s FICO score often determines their ability to receive a line of credit or loan, like a thermometer for their finances. Before the institution of the FICO score, our credit scoring system was much more localized. In the early 1900s, a person’s credit score was derived from a single question regarding past and current loans: Can I count on the borrower to repay?
Previously, lenders judged intending customers on factors like word-of-mouth, payment history, and home visits. In “The Origin of the Credit Score,” Konsko writes that “character-based decision making was part of the process. The possibility that one could simply walk into a bank and have a good credit history but still get turned down because the banker did not like one’s demeanor.” In a perfect world where one’s pre-conceived notions were not a factor in business decisions, this system may work well. However, this highly subjective way of choosing whether or not to lend to someone has many issues.
First, it would be impossible to prove that bias did not play a role in the decision. A lender may, in fact, have a strong bias against a race, gender, or religion, but how would the borrower prove that unfair bias was the reason they were denied? On the other hand, a lender may not have a bias in any way and the borrower may have a long history of defaulting on loans and lines of credit. If this inconsistent borrower wanted to, they could accuse the lender of bias.
It is clear this system rested heavily on qualitative analysis. Because of the difficulties in fairly lending to borrowers, these qualitative factors evolved into quantitative numbers, like our credit scores now, that were meant to filter out personal judgment and bias, allowing for a fair system of credit automation.
In 1956, Bill Fair and Earl Isaac developed the automated credit scoring system we know today as FICO; it failed. Fair and Isaac continued to improve on the system and, with the help of computers and technological advancements, they were able to evolve their system into what is known as the FICO score. Since it is a quantitative score, it can be broken down easily into the percentages based on various factors in our credit history:
• 35% of the total credit score is based on a borrower’s payment history. This makes the repayment of debt the crucial factor in calculating one’s credit score.
• 30% of the credit score is based on a borrower’s credit utilization ratio, calculated by the borrower’s credit balance in relation to their available credit limit; or rather how much the borrower owes the lender.
• 15% of the credit score is based on the length of time each of the borrower’s accounts has been open.
• 10% of the credit score is comprised of new credit, which a borrower should avoid as it can signal financial distress and need of access to credit lines.
• The remaining 10% of the credit score is dedicated to the credit mix or how the borrower can handle repaying any amount they owe. A good mix of revolving credit represents less risk for the lenders.
Along with the FICO score, are three other major credit bureaus with scores that may affect a person’s borrowing ability: Experian, Equifax, and TransUnion. With these four main bureaus, a credit score can range and often fluctuates, based on reporting from lenders, businesses, etc.
VantageScore, NextGen, BEACON, and EMPIRICA are other lesser-known providers of credit scores. It’s advisable that a consumer be aware of their credit standing to know early if their identity has been stolen or if their score has dropped.
While every credit reporting system likely shows a slightly different score, the goal is to always have a higher score. The better a person’s credit score, the lower their interest rates are and the more they can borrow. Knowing your credit score before thinking about a major purchase can be a great asset while deciding on using a loan or not. For instance, if a person was interested in applying for a home equity loan and they found their credit score was a 739, they would be able to walk into a meeting with a mortgage lender, confident and ready to make that decision. Alternatively, if a person had to buy a new car after theirs was stolen, but they had a credit score of 522, they would be able to speak with a loan officer about options they have and how to repair their score.
Along with clearing a consumer to receive loans or lines of credit, our credit score can affect many other aspects of our financial lives. One of the most critical things to be affected by our credit score is one many don’t know about: insurance pricing.
Think back to the original system of credit based on public opinion. It seems like an invasion of our privacy to lend money that way. However, for the last two decades, insurance companies have been using people’s credit scores in order to determine their eligibility status for auto and homeowner’s insurance. This practice is more commonly known as “credit-based insurance scoring.”
While most insurance policyholders experience credit-based insurance scoring, many are not aware of the practice, nor of how much it can swing an insurance payment. One of the biggest causes of this lack of understanding is a lack of communication by the insurance companies. They use a credit score that may be low, but for no insurance-related reason, and then use that to increase prices. By not publicizing their practice of it, insurance companies can avoid answering any difficult questions and evade inquiry into how much the price of a policy was changed.
Because credit-based insurance scoring adjusts insurance premiums based on how low a person’s score is rather than on specific types of accounts and negative marks showing up, it inherently punishes the consumer for rational behavior. A credit score may be lower because the borrower chose to only have one credit card and only use it for emergencies. This makes good financial sense, to avoid debt and learn to live within their means. However, this might mean the borrower has worse credit than their neighbor with three car payments and a wallet full of credit cards. Instead of rewarding an insurance seeker, companies are punishing some with higher premiums and eligibility. This is counter-intuitive policy is confirmed by Consumer Reports in an article titled “The Secret Score Behind Your Auto Insurance.” Explaining how a consumer might have a surprisingly high premium, the article states “Even a driver with a great credit score whom lenders would normally bless with a low-interest mortgage could wind up with a less favorable insurance score and thus a high premium … Indeed, insurance scores can penalize consumers who use credit reasonably.”
Additionally, because of socio-economic statistics, certain ethnicities may be more at risk of unfair insurance practices because of the under-the-table practice of credit-based insurance scoring. This argument is acknowledged in a report by the FTC, titled “Credit-Based Insurance Scores: Impact on Consumers of Automobile Insurance,” which states “others contend that the use of these scores results in low-income consumers and members of minority groups paying higher premiums than other consumers.” Because certain ethnicities are statistically more likely to have lower credit scores based on socio-economic background and culture, these same groups are more likely to be victims of higher insurance premiums or being denied insurance. In “Is Your Credit Score Affecting Your Insurance Premiums?” Harrow explains that “In 2007, the Federal Trade Commission (FTC) found that, in the case of automobile insurance, the use of scores likely leads to African-Americans and Hispanics paying relatively more for automobile insurance than non-Hispanics, whites, or Asians.” (Harrow, “Is Your Credit Score Affecting Your Insurance Premiums?”). Though not directly racist, the policy of credit-based insurance scoring contributes to a culture of racism by reinforcing it.
While our current system of credit scoring is less than perfect, it is far more advanced than a system based on personal judgment and bias. However, we must continue to improve our credit and insurance industries and hold them accountable for the positive and negative impacts they make.
“Credit Scoring.” Insurance Information Institute. Web. 2017.
Harrow, Robert. “Is Credit Score Affecting Your Insurance Premiums?” Forbes, 25 Apr. 2016. Web. 28 Feb. 2017.
Konsko, Lindsay. “The Origin of the Credit Score.” NerdWallet, 12 Aug. 2014. Web. 28 Feb. 2017.
“Credit-Based Insurance Scores: Impact on Consumers of Automobile Insurance.” Federal Trade Commission. July 2007. Web. 08 Aug. 2017.
“The Secret Score Behind Your Auto Insurance.” Consumer Reports. Aug. 2006. Web. 08 Aug. 2017.