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Are credit scores a necessary evil?

Those three little numbers can make or break your financial life.

Rows of piggy banks, seen from above. Getty Images

Imagine a world without credit scores. It might sound blissful, never wondering if three little numbers could tank your ability to buy a car or get a loan, but it would get complicated pretty quickly. Credit scores and reports exist because lenders need a sense of how likely they are to have their loans repaid, and you don’t really want lenders just going on instinct and gut feeling when deciding whom to lend to and on what terms. That could easily lead to discrimination.

But the current framework — in which triple-digit scores derived from reports out of three faceless credit bureaus hold an outsized importance in our economy — is also flawed, and it’s still discriminatory.

It advantages certain people (often those who are better off financially, and white) because of sometimes arbitrary factors, such as whether they’re a homeowner or a renter, or whether their parents thought to put their name on a credit card to start building a history. Critics say this system is difficult to navigate and poorly managed, and that the three bureaus that currently rule the American credit system are too powerful and too unaccountable.

Credit and consumer reporting complaints made up more than half of all of the complaints the Consumer Financial Protection Bureau (CFPB) received in 2020. There are also questions about how much reach credit scores have in our day-to-day lives. It’s one thing for a business to look up my credit score before giving me an auto loan; it’s another thing for an employer to take a look at my credit report before hiring me for a job.

“Credit is the lifeblood of the economy and critical for families,” said Aaron Klein, a senior fellow in economic studies at the Brookings Institution, but under the current setup, “we rely on an outdated and inaccurate system of credit scores.”

There are ideas for new ways of assessing reliability out there, such as taking web history into account or getting artificial intelligence involved or just looking at someone’s bank account. There have been increasing efforts to include rent payment history in credit reporting and scoring so that renters have a better shot at improving their numbers. On a broader and perhaps squishier level, it’s worth asking if the way we deal with credit needs to shift as well. Plenty of people have financial mishaps at some point over the course of their lives. How large a price should they be expected to pay for that? The financial playing field in the US isn’t exactly level.

“There are, for example, moments when we know that in the life course, there’s going to be some bumpiness that will then later smooth out. Your exposure to that bumpiness is going to have much more to do with the wealth of your parents, with the kinds of occupations your family has, than it will your reliability,” said Frederick Wherry, a professor of sociology at Princeton University and director of the Dignity and Debt Network. “It’ll also have a lot more to do with the neighborhood you grew up in and race.”

A brief primer on credit scores and credit reports

Generally, when most people talk about their credit scores, they mean their FICO score, which was introduced by Fair, Isaac, and Company, a tech company dating back to the 1950s, in 1989. Scores range from 300 to 850. According to the CFPB, a score at 660 or above qualifies as prime, while 620-659 puts you in the near-prime category and 720 and up gets you into super-prime. Below 619 is considered subprime, and below 580 is deep subprime. Different entities have their own versions of what’s good and what’s bad, but generally, above the 700-ish range is good.

About 90 percent of top lenders use FICO scores when deciding whether or not to give someone a loan or when deciphering interest rates for the loan or borrowing limits. A higher credit score is going to get you a better interest rate on your mortgage; if you’re looking to rent, it’s one of the factors landlords look at to decipher whether to accept your application. People don’t have a single FICO score — the model is often changing, and there are different types of scores, like an auto score or one for a credit card.

FICO scores are calculated using data from your credit reports, which are put together by three major credit bureaus: Equifax, Experian, and TransUnion. Credit reports include information such as your history of repayment, whether or not you’ve got negative marks for defaulting on a debt or paying late, the types of credit you have, how long you’ve had credit, and how often you’ve applied for credit. (You’re legally entitled to get one free credit report from each bureau each year at annualcreditreport.com).

When there’s a “hard” inquiry into your credit, which happens when you apply for a new line of credit or a loan, it dings your score a bit. It’s usually not a problem and the score bounces back quickly, but if you’re applying for multiple lines of credit at once, it can be a red flag to lenders. It’s also just stressful to see your credit score drop.

“It doesn’t have all of your history. What it has is your history of things that we count, and what we tend to count are far more favorable for wealthier people than for low-income people,” Klein said. If you pay your mortgage, it goes in; if you pay your rent, it often doesn’t. If you pay your cellphone bill directly, it doesn’t count, but if you pay it with a credit card and then pay off the credit card, it does.

Credit scores and reports prize credit over just spending the money you have, in a way forcing you into the system. If at some point you’re going to want to buy a house or a car or get a loan, you have to build credit — and if you don’t, you’ll run into trouble down the line. Millions of people are also “credit invisible,” meaning they don’t have credit that’s treated as scorable under the current system. People who are Black, Hispanic, or live in low-income neighborhoods are likelier to find themselves in this situation, as are people in rural and highly urban areas. Internet access appears to play a role in whether people are credit invisible, too. In these situations, it’s not that people are or aren’t reliable, it’s just that the current framework doesn’t include them.

When someone has a bad credit score or no credit score, life isn’t necessarily impossible to navigate, financially, but it’s harder. A low credit score may not stop you from buying a house, but it’s going to make buying that house more expensive. “You start seeing diverging pathways, and it’s not that you’re not still going up ... it’s just the slope of your upward climb is lower,” Wherry said. “Those who can least afford to pay more pay more to get the exact same thing that their wealthier counterparts pay less for.”

The way we deal with credit scoring and reporting is flawed

The current credit system is far from perfect, and critics have long pointed to its many flaws, ranging from it being dominated by sometimes irresponsible private interests to the ways it entrenches inequalities in the financial system.

For one thing, credit reports often contain mistakes — a lot of them. A 2013 FTC study found that one in five consumers had an error on at least one of their three reports. Of the more than 300,000 complaints specifically about credit and consumer reporting the CFPB received in 2020, approximately two out of three pertained to incorrect information on the reports.

When there are errors in credit reports, it can be very difficult to get them corrected. For some people, the errors can work in their favor. But for others, they do not — if someone with the same name gets sent to a debt collector and it shows up on your report, it can hinder you from getting that apartment or a good rate on your car loan.

“The credit bureaus are not incentivized for accuracy, they’re incentivized for volume and speed,” Klein said. “As long as the errors are symmetric, in the aggregate, their data will still be right. [But] there’s going to be a group of people who are getting harmed and a group of people who are benefiting.”

The credit bureaus have been the subjects of major scandals in the past. In 2017, a data breach at Equifax left the private information of tens of millions of people exposed. The same year, the CFPB ordered Equifax and TransUnion to pay upward of $20 million over charges that they had tricked consumers about the usefulness and cost of credit scores. Equifax, Experian, and TransUnion make their money off of selling the data they collect. Rep. Maxine Waters (D-CA), who chairs the House Financial Services Committee and has been critical of the credit industry, in 2019 declared the sector “broken.” She blamed the “commodification of consumers and their personal data.”

The system right now is supposed to be fair — the idea is that if a person is reduced to a number, their individual characteristics, such as their race, won’t be factored in. Indeed, there are laws barring lenders from discriminating against potential borrowers based on certain characteristics. Critics say that bias is baked in and that the advantages and disadvantages of where you live or how you look show up in your credit report and scores anyway.

“Although credit scores never formally take race into account, they draw on data about personal borrowing and payment history that is profoundly shaped by generations of discriminatory public policies and corporate practices that limited access to wealth for Black and Latinx families,” Amy Traub, then-associate director of policy and research at progressive think tank Demos, said in testimony before Congress earlier this year. She pointed to research showing that 50 percent of white households have a FICO score of over 700, compared to just 20 percent of Black households. Meanwhile, one-third of Black households have insufficient credit and lack a credit score, compared to just 18 percent of white households. “Whenever credit data is used in decision-making, it multiplies inequality,” she said.

Wherry said he worries that credit scores and reports have “taken an outsized role in terms of a person’s financial and social sense of security.” It does often feel like a bad credit score can make or break you, and that one bad mark can have real, lasting consequences in your life, even in places where you might not expect it. Potential employers can get a look at a version of your credit report even if it has nothing to do with the job that you’re applying for. In Wherry’s mind, that’s too much. “We have to be very wary of the use of running credit scores for employment,” he said.

Klein noted that some of the system is just silly. Generally, many negative items, such as late payments and foreclosures, fall off of credit reports after seven years under the Fair Credit Reporting Act. That number, he said, comes from the Bible. “The system isn’t nearly as advanced as it pretends to be,” he said.

There are lots of ideas on how to fix the credit system

Capitol Hill, think tanks, consumer groups, regulators, and businesses aren’t short on ideas for changes to be made to the credit system.

In the House of Representatives, bills such as the Comprehensive CREDIT Act have been put forth. That piece of legislation would overhaul much of the current framework, including giving consumers the right to appeal the results of disputed items on their reports, banning the use of credit scores for employment, and shortening the time negative credit information can stay on a credit report. President Joe Biden has also expressed interest in the industry, on the campaign trail discussing the need for a public entity to track credit, an idea embraced by some activists, lawmakers, and consumer advocates. Rohit Chopra, who was just confirmed as the new head of the CFPB, could also spearhead changes.

Klein said he believes a better system could be to look at cash flow — essentially, just seeing how much money goes in and out of someone’s bank account for some set period of time. FICO offers such a product, which it says can be used by lenders to “help broaden access for young or immigrant applicants building a credit profile as well as those reestablishing their financial standing following distress.”

Even some seemingly minor changes could improve the system, such as including rent payments in credit histories more often. A TransUnion report found that including rent payment reporting increased a consumer’s credit score by nearly 60 points. Most landlords don’t report rental payments to credit bureaus, so that information is generally left off, though experts say that’s changing.

There are all sorts of proposals out there regarding new ways for lenders to make determinations and potentially expand access to more borrowers. For example, Common Future, a network of organizations that support communities and small businesses, is undertaking a character-based lender pilot program to help entrepreneurs of color who are often overlooked by the traditional financial system. “If you are lower-income, if you have less wealth, your credit score will likely be worse,” said Eric Horvath, director of capital strategies at Common Future. “And if part of getting small business financing is around your credit score, you can see how those are intimately linked.”

“There’s already character-based capital in other forms. There’s no credit scoring in venture capital,” said Rodney Foxworth, CEO of Common Future. “People of color and women have not been afforded the same opportunities to access reputation and relationships to be able to shift that into investment and lending capital.”

In 2019, five federal regulators put out a statement on using alternative data in credit underwriting, including cash flow, noting that it has the potential to expand credit access. There’s also been discussion among experts of using browsing history or online activity to try to determine creditworthiness. The issue is thorny: Artificial intelligence is hardly free from bias, and there are no guarantees a computer won’t learn how to discriminate, too. Klein says he’d been told by a bank that its computers got really good at predicting infidelity based on a consumer’s activity. Divorce, which can follow infidelity, is a top driver of bankruptcy — conceivably, a lender might want to know if someone’s marriage is in trouble.

The bigger picture is that there are no easy answers about how to handle credit and debt, no exact formula to determine just how lenders and borrowers should do business and interact. There’s a fundamental tension between pricing things on the basis of risk and fairness, and reasonable minds can disagree about what the balance should be.

Still, financial troubles are a fact of life for most people at some point in their lives, and how reliable they are with their finances depends much more on the safety net around them — determined by their families and geographies and identities — than it does on their desire to be responsible and pay creditors back.

“There’s been so much bias embedded into credit scoring,” Foxworth said. The next step is thinking creatively about how to push against that.

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