There are online murmurs growing lately about the fairness of credit scores and consumer credit reporting. It’s a heated issue: This semi-hidden number can define a person’s life, but few people understand how exactly 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 score is the numerical expression of a person’s creditworthiness. Drawn from an analysis of debts incurred and payments made, the most widely used credit score, the FICO score, usually ranges from 300 (a bad risk) to 850 (extremely credit-worthy). A credit report is the raw data that is used to determine your credit score. It’s made up of your credit account history, credit inquiries, and public records.
Banks and other lenders use your credit score and other details in your credit report to decide whether to lend you money, how much money you can borrow, repayment rates, and other loan criteria.
Who determines your credit score?
There are a number of credit bureaus in the United States, but there are three major 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 might have different numbers at each because different lenders and creditors may use slightly different formulas to calculate your score. They’re also relying on reports from creditors and other institutions, who might not all report to every 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 VantageScore.
How is your credit score calculated?
Your FICO score is a combination of five factors:
Payment history: 35% of your score
How much you owe on loans and credit cards: 30% of your score
Length of credit history: 15% of your FICO score
Types of accounts you have: 10% of your FICO
Recent credit activity: 10% of your FICO
Within that broad framework, there are a lot of variables, so the fiddly details that determine your number are periodically updated and tweaked.
Where did our current system come from?
The history of credit itself is likely 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 subjective opinions of credit reporters, and only for commercial entities, early credit reports were rife with the kind of racism and antisemitism you might expect, and filled with vague, subjective opinions like “enjoys generally a poor reputation as a man, but is gen[erall]y sup[pose]d to have money.” How helpful.
Centralized consumer credit reporting dates back 1912, when retailers who kept individual records on the likely risk posed by consumers pooled their resources and shared their records with one another. Like commercial credit records, early consumer reports weren’t just financial; they relied on information about people’s social, political, and sexual lives, and contained a lot of subjective opinions from money-jerks. The system was neither fair nor a particularly useful way of determining creditworthiness.
As consumer lending grew over the ensuing decades, lenders worked toward a more widespread, understandable, objective system, but it didn’t really come together into something like our current credit report system until the early 1970s. In 1970, the Fair Credit Reporting Act became law. It prohibits the inclusion of race, sexuality, and disability in credit reports; requires a level of transparency for credit bureaus; requires debts be expunged from reports after a length of time; and a lot more. This set the stage for a purely numbers-based credit determination—objective but impersonal.
Enter the FICO score. Originally created in the 1950s, Fair, Isaac and Company’s algorithm was adopted by the three largest credit reporting agencies officially in 1989, and that’s basically where things have stood since, although the FICO calculations are updated occasionally—we’ve been using FICO 9 since 2014, when the algorithm was changed to include rent payments, make medical debt weigh less, and eliminate paid collection accounts from score calculations.
But aren’t credit scores and credit reports inherently unjust?
How fair the credit score system is in practice is extremely complicated, but critics of the system (consumer law organizations, politicians, debtors unions, etc.) contend that even if things like race, gender, and disabilities are omitted from credit reports, in practice the system still has discriminatory effects. They argue that it essentially locks in established systemic biases and even exacerbates them—a bad credit score makes credit more expensive, which leads 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 a ton more—there’s a lot of criticism.
The future of the credit score
Although your FICO score is considered by about 90% of top lenders, according to some industry insiders, the number itself is becoming less and less important. Credit institutions are competing to identify good debtors—it’s how they make their bank, after all—so they’re all working to figure out a better system. Ken Lin, the CEO of CreditKarma, estimates that your credit score is only 20% to 40% of a lender’s final decision. Instead, lenders are weighing other information in your report in proprietary ways to decide how much they will lend you.
“Rather than just saying,‘This person missed two payments,’ banks are looking at factors like how much the payment was for and who it was to,” Lin told TheStreet.
How to get a copy of your credit report
It’s easy to get a copy of your credit report, and you really should, to know where you stand and to make sure there are no mistakes on it. You are eligible for a free credit report annually from all of the three major credit reporting companies, and you can get it by visiting annualcreditreport.com or calling (877) 322-8228. You can get additional credit reports if you’re denied credit, you believe your report is inaccurate, and other reasons. Contrary to popular belief, requesting a copy of your own credit report won’t lower your credit score.
(edited 8/1/2022 to correct website link)