Around the world, credit scores are the most commonly used tool by financial institutions for determining consumer credit risks. Credit card companies, mortgage banks, online lenders and auto dealers are some examples of companies that regularly check applicants’ credit scores in order to assess whether they are credit worthy[i], and under what conditions. Moreover, in many countries a person’s credit score can affect them beyond the lending space, for example when applying for an apartment lease or even a job.
Despite the importance credit scores have on our daily lives, and despite their overall utility, they may not always fully reflect a person’s financial situation and probability of repayment. In this two-part article, we will briefly review what constitutes a person’s credit score, and some primary issues associated with them, as well as some potential solutions.
What determines a person’s credit score?
Although bureau credit scores and their ranges vary across different countries and institutions, there are typically 5 main factors that affect a person’s credit score. Ranked by how much they affect the final score[ii]:
- Payment history- this refers to the degree to which prior financial obligations were paid on time. For example, previous loan payments, credit card payments, and student loans. Also, any recent debt settlements or bankruptcies.
- Outstanding debt- This refers to a person’s credit utilization ratio, or the amount of available credit they are actually using, where the less the better.
- Length of credit history- The amount of time a person has been using credit, and age of their oldest account, such that the longer positive history the better.
- New credit inquiries- This refers to the number of recent credit inquiries. For example, someone who has applied for multiple new credit cards in a short period might be ‘penalized’ in their credit score.
- Types of credit – Having a variety of accounts types. These might include credit cards, a mortgage, installment loans, etc. Having multiple types of accounts can indicate experience in managing credit, and therefore is considered to be more favorable.
While it’s crucial to understand the factors that impact one’s credit score, it is also important to be aware of what does not. Information like a person’s bank balances, employment status, income or occupation will not directly affect bureau scores. Additionally, credit bureaus do not (and cannot) make use of demographic data to change a person’s score, including information such as marital status, place of residence, age, and race.
What’s the problem with traditional credit scores?
While credit scores are used by most financial institutions globally to assess a person’s credit worthiness, they have a number of limitations. We will outline a few:
- No-hits- Since credit scores are based on historical data, someone new to credit will be unscoreable. As a result, billions of people around the world are excluded access to fair and affordable credit. Moreover, oftentimes these segments of the population are at the ‘bottom of the pyramid’, and need credit the most.
- Short term outlook- Financial institutions are aware that the scorecards they use, based on bureau scores, have only a limited lifetime. This means that many people’s scorecards need to be updated and re-evaluated over time or otherwise become obsolete (or non-representative)[iii]. Covid-19 is an excellent example of this. Ironically, many individuals may still have high bureau credit scores reflecting pre Covid performance, despite having recently been furloughed, while they currently are in fact a greater credit risk than their bureau scores might reflect.
- Score boosting- Another issue around credit scores, revolves around credit bureaus trying to be more transparent by disclosing how they calculate their scores. Although this has many upsides, it can also cause people to manipulate their scores in a non-representative way in order to make themselves seem like a better credit risk, and in turn trigger new types of default risks for the lender[iv].
- Erroneous data- According to the Brookings Institute, the main problem with credit scores is the astounding number of errors in the credit reports. In fact, at least one in five consumers have a potentially material error in their credit file that makes them look riskier than they actually are[v]. Such errors can make loans more expensive, or altogether rejected.
- International migration- In general, there are three multinational credit bureaus: Equifax, TransUnion and Experian. Since a person’s FICO Scores depend on the data listed on their credit reports, they might not see the same score from every credit-reporting agency[vi]. Because different lenders have different criteria for making a loan, the credit decision may depend on which credit bureau the lender turns to for credit scores[vii]. Moreover, it is important to remember that credit scores are not universal. This means that new immigrants may likely need to rebuild their credit score from scratch, and thus potentially restrict their immediate access to credit.
- Data breaches- Finally, another major issue revolves around data privacy. Credit bureaus have access to the population’s most sensitive personal financial information. In 2017, Equifax, one of the three largest consumer credit reporting agencies in the United States, reported that its systems had been breached and the sensitive personal data of 148 million Americans had been compromised[viii]. These data include names, addresses, phone numbers, and social security numbers, among other information. Although this was the biggest credit bureau data breach in history, there’s no guaranteeing it will be the last, which poses additional questions surrounding credit bureaus, and the access to sensitive data they have for producing credit scores.
In summary, although credit scores do in many ways allow institutions to compare individuals’ credit worthiness and make credit decisions accordingly, these are not without flaws. Moreover, we see that the people being hurt from the downsides of credit scores, are oftentimes those who need credit the most, including immigrants, youngsters and people living in rural areas.
The second part of this article will be reviewing the impact of traditional credit scores on thin filed and unbanked applicants. Then, potential solutions and fixes will be reviewed.