Credit scores are the ultimate gatekeepers. You can't enter the world of adulthood without at least some credit. You need credit to buy a home, rent an apartment, take out a loan, or buy a car; pretty much any big purchase you'll ever make in life requires credit.
There has long been discourse over whether or not the current credit scoring models are fair, and a new study presented by Forbes highlights some underlying issues that may have consumers thinking twice before supporting this seemingly archaic system.
The Big Three
There are three main credit bureaus that calculate your credit score: Experian, Equifax, and TransUnion.
Experian's roots started in London, England, in the early 1800s. The company came about after a group known as the Manchester Guardian Society began sharing information on citizens who were failing to settle their debts.
This information sharing is considered the earliest account of modern-day credit reporting. Jumping forward to 1960, two aerospace engineers predicted that currency would be changing from cash to credit, and so they formed a credit information unit branch of TRW, Inc. This information branch would eventually become Experian in the 1990s.
Equifax was founded in Atlanta, Georgia, as Retail Credit Company in 1899. By 1920, the company had spread throughout the United States and into Canada. By the 1960s, the credit company was one of the nation's largest credit bureaus, holding files on millions of Americans and Canadians.
The company's willingness to sell customer information garnered criticism in the 1960s and 70s. The company was collecting “facts, statistics, inaccuracies, and rumors” about pretty much every facet of people's lives. The company also reportedly rewarded employees for finding and collecting derogatory information on consumers.
In 1970, the company computerized its records, making it even easier for sensitive customer information to be found, Congress held a hearing that led to the enactment of the Fair Credit Reporting Act.
The Fair Credit Reporting Act gave consumers rights regarding the information that credit companies could store in corporate databanks. The information sharing scandal and subsequent hearings are reportedly what led Retail Credit Company to change its name to Equifax in 1975 to attempt to improve its image.
TransUnion was formed in 1968 as a holding company for Union Tank Car Company. The next year, the company acquired the Credit Bureau of Cook County, which at the time possessed and maintained 3.6 million credit accounts.
In 1981, a Chicago-based holding company, The Marmon Group, bought TransUnion for around $688 million. In 2010, the company was acquired by Goldman Sachs Capital Partners and Advent International, and in 2014, TransUnion acquired Hank Asher's data company TLO.
In June 2015, TransUnion became a publicly traded company.
A study presented by Forbes discusses the modern credit score system and how there may need to be reform to help it meet modern standards.
The credit score system has been receiving some criticism over the past few years regarding the accuracy of the scores and the usage of data that is “reflective of historical bias” while “omitting certain types of data.”
Credit scores range from 300 to 850. There are many different credit scoring models, but the two most popular are FICO and VantageScore. VantageScore was created by Experian, Equifax, and TransUnion.
Data has shown that one in 5 black consumers and one in 9 Hispanic consumers have FICO scores sub 620, meanwhile only one in every 19 white people has a credit score below 620.
One of the other biggest complaints credit scores get is the lack of “public scoring model options” as well as the fact that credit scores are used for things that have nothing to do with credit, such as getting a job.
There are also approximately 26 million Americans who are known as “credit invisible,” meaning they do not have a credit history. If you are one of those people, you are pretty much locked out of the current credit scoring system.
A report from the Consumer Financial Protection Bureau (CFPB) shows that black and Hispanic people, as well as those living in low-income areas, are most likely to fall into the “credit invisible” category.
In the past, credit scores were created to help eliminate bias among lenders. Borrowers' creditworthiness used to be measured using factors such as income, referrals, and even sometimes home visits.
In 1974, the Equal Credit Opportunity Act eliminated the practice of using sex, religion, race, marital status, and national origin to determine someone's creditworthiness. Today, credit scoring models such as FICO use the length of credit history, payment history, new credit, and credit mix to determine someone's credit score.
According to Frederick Wherry, a professor of sociology and the director of the Dignity and Debt Network at Princeton University, this data could be influenced by generational wealth that many black and Hispanic borrowers do not have access to.
“We’re often told to stop talking about history, but history won’t stop talking about us,” Wherry says. “The data used in current credit scoring models are not neutral; it’s a mirror of inequalities from the past. By using this data we’re amplifying those inequalities today. It has striking effects on people’s life chances.”
A History of Discrimination
According to Forbes, many Americans inherited their wealth through homeownership, and because of redlining-a discriminatory practice that makes it difficult for people of a certain race or geographic location to attain financial services-black Americans are not able to purchase homes that would help to pass down assets through their generations.
In 1944, a piece of legislation called the Servicemen's Readjustment Act was passed. The bill was supposed to reward service members with benefits that would hopefully improve their social mobility.
Unfortunately, in many cases, when eligible black service members went to cash in on the bill, they were met with staunch resistance or were denied the benefits altogether. The denial of these benefits was the start of a snowball effect that could affect black Americans today.
A white service member may have been able to purchase an affordable home with the money from the bill and pass it on to their children, who would be able to benefit from the home equity along with any financial gains from the ancestors' ability to purchase a home using benefits from the bill.
However, because the black service members were not given the same benefits, they were not able to start the process of passing on generational wealth.
“On a macroscale, you have one group that benefited from government support. So white service members had the GI Bill and could live in high-opportunity neighborhoods like Levittown where mortgages were a fraction of rental costs, but Black service members were denied these opportunities,” says Chi Chi Wu, a staff attorney at the National Consumer Law Center. “So now you have this racial wealth gap because of that, white families built up equity in their home, inherited wealth, while fewer black families were able to do the same.”
Because of the issues in the past, black Americans now struggle to build their credit profile.
A New Scoring System
A study conducted by FinReg Labs found that when compared with traditional credit reporting, cash flow underwriting was more predictive. Their analysis also revealed that joining the two methods produces the most accurate results.
Aaron Klein is a senior fellow, economic studies at the Brookings Institution. He says that “what makes cash-flow underwriting an improvement on current models is that it’s about their current status, not their past. Credit scoring is great at showing financial distress, such as divorce, which is felt more in incomes of color.”
Experian came out with a program called Experian's Credit Boost, which takes into account cell phone and cable when looking at credit scores. This development could help balance credit scores going forward.
Critics believe that the three major credit reporting agencies have formed an oligopoly, and consumers have no say in which of the companies can access their data nor which company will be used to provide their credit report to anyone who might request it.
Frederick Wherry believes the solution is a public credit scoring agency.
“I’m not saying we need to eliminate private credit scoring companies, but I think it’s a win if you create a competitive environment with consumers by having that public option available,” Wherry says. “It’s like USPS and FedEx. I have the choice to go with a cheaper public mail carrier or get special services from a place like FedEx. We create a public entity for something like the post but not something as monumental as your credit score.