The Real History of Credit Ratings
Recently, there has been a growing murmur online about the fairness of credit ratings and consumer credit reports. It’s a hot question: This semi-hidden number can define a person’s life, but few understand exactly how a credit score is determined. So where do credit scores come from? Who decides what they are? How unfair are they?
What is a credit score and how is it different from a credit report?
A credit rating is a numerical expression of a person’s creditworthiness. Derived from an analysis of debts and payments made, the most widely used credit rating, the FICO rating, typically ranges from 300 (bad risk) to 850 (extremely creditworthy). A credit report is raw data that is used to determine your credit score. It consists of your credit score history, credit inquiries, and public records.
Banks and other lenders use your credit score and other information on your credit report to decide whether to lend you money, how much money you can borrow, repayment rates, and other credit criteria.
Who determines your credit score?
There are several credit bureaus in the United States, but there are three main players in the consumer reporting game: Experian, TransUnion and Equifax. All three of these private companies use similar calculations to determine your FICO score, but you may have different numbers in each because different lenders may use slightly different formulas to calculate your score. They also rely on reports from lenders and other agencies, which may not report to every single credit reporting agency. While the most widely used credit score is the FICO score, the big three credit bureaus have also created their own number called the VantageScore.
How is your credit score calculated?
Your FICO score is a combination of five factors:
- Payment history: 35% of your bill
- How much you owe on loans and credit cards: 30% of your bill
- Credit history length: 15% of your FICO score.
- Your account types: 10% of your FICO
- Recent lending activity: 10% of your FICO
There are many variables within this broad structure, so the small details that define your number are periodically updated and adjusted.
Where did our current system come from?
The history of credit itself is probably as long as the history of financial transactions, but for the most part our current system was born in the 1800s with commercial credit reporting. Based largely on the subjective opinions of credit reporters and for commercial entities only, early credit reports were rife with the racism and anti-Semitism that one would expect, and filled with vague, subjective opinions such as “generally has a bad reputation as a man, but is usually [required] have money.” How helpful.
Centralized reporting of consumer credit dates back to 1912 , when retailers who kept separate records of the likely risk posed by consumers pooled their resources and shared their records with each other. Like commercial credit reports, early consumer reports were not only financial; they relied on information about the social, political and sexual life of people and contained many subjective opinions of dealers. The system was neither fair nor a particularly useful way to determine creditworthiness.
As consumer lending grew in the following decades, lenders worked to create a more widely accepted, understandable, and objective system, but it didn’t assemble into something like our current credit reporting system until the early 1970s. In 1970, the Fair Credit Reporting Act became law. It prohibits the inclusion of race, gender, and disability on credit reports; requires a certain level of transparency for credit bureaus; requires that debts be excluded from reports after a certain period of time; and much more. This paved the way for the definition of credit solely on the basis of numbers – objective, but impersonal.
Enter your FICO score. Originally created in the 1950s, the Fair, Isaac and Company algorithm was formally adopted by the three largest credit reporting agencies in 1989, and has largely been the case since then, although FICO calculations are updated from time to time – we use FICO 9 with since then. 2014, when the algorithm was changed to include rent payments, reduce the weight of medical debt, and exclude fee-paid accounts from points calculations.
But aren’t credit scores and credit reports inherently unfair?
How fair a credit rating system is in practice is extremely difficult, but critics of the system (consumer advocacy organizations, politicians, debtor unions, etc.) argue that even if things like race, gender, and disability are omitted from credit reports , in practice the system still has discriminatory effects . They argue that this essentially blocks and even exacerbates entrenched systemic biases: a bad credit score makes credit more expensive, leading to a worse credit score and an endless cycle of poverty. Other criticisms include employers using credit reports to make hiring decisions, lack of transparency, inaccurate reports, the dehumanizing effect of reducing a person to a number, and more – there’s a lot of criticism.
The Future of Credit Rating
While your FICO score counts for roughly 90% of top lenders, the number itself is becoming less and less important, according to some industry insiders. Lending institutions compete to find good debtors – after all, that’s how they do their bank – so they all work to create a better system. Ken Lin, CEO of CreditKarma, estimates that your credit score is only 20% to 40% of the lender’s final decision. Instead, lenders weigh other information on your report to decide how much they will lend you.
“Instead of just saying, ‘This person missed two payments,’ banks look at factors like the amount of the payment and to whom it was made,” Lin told TheStreet .
How to get a copy of a credit report
It’s easy to get a copy of your credit report and you really need to know where you are and make sure it’s free of errors. You are eligible to receive a free credit report annually from all three major credit reporting companies and you can obtain one by visiting AnnualCreditreport.com or by calling (877) 322-8228. You may receive additional credit reports if you have been denied a loan, if you think your report is inaccurate, or for other reasons. Contrary to popular belief, asking for a copy of your own credit report will not lower your credit score.
( edited on 08/01/2022 to correct site link )