The credit scoring system has its downsides — here’s what a new credit scoring and reporting system could look like

In the U.S., credit scores can affect every aspect of someone’s life. This three-digit number can determine the interest rate you get on a mortgage, the APR you receive on a credit card and the rates you pay for car and homeowner’s insurance.

There are three major credit bureaus — Experian, Equifax and Transunion — which collect information on an individual’s credit use. This information is then recorded in a credit report, and a three-digit credit score is calculated using one of two major scoring models, FICO and VantageScore.

Most scores range from 300 to 850 with higher scores indicating that a borrower is lower risk and more likely to make on-time payments. FICO uses factors like payment history, amounts owed, credit mix, length of credit history and new credit.

Lenders have always needed a way to determine a borrower’s creditworthiness, and credit scores were a faster, easier way to do so. 

Yet are these three-digit numbers really a foolproof way of figuring out someone’s creditworthiness? What happens to people who don’t have credit scores or those who have poor scores?

Barbara Kiviat, assistant professor of sociology at Stanford, explains that while credit scores are meant to predict whether or not someone will default on a loan, these scores don’t reflect why someone has defaulted.

For example, someone may fail to pay their credit card bill in full during an economic downturn or a job loss but this doesn’t necessarily mean they’ve been irresponsible with their credit. Credit scores are supposed to show how creditworthy someone is, but they can be a flawed measure of creditworthiness because they don’t account for the many factors that affect someone’s ability to repay their debt.

“If you look at credit scores from the perspective of other social actors, like policymakers or consumer advocates, why someone does or does not repay might start to have more bearing on how you make sense of credit scores,” says Kiviat. 

The credit scoring system can also reflect and even worsen existing racial and wealth inequality.

As Kiviat writes, “it is harder to maintain good credit when one faces precarious work, has no wealthy family members to turn to in emergencies, is sold predatory loans, and otherwise experiences the disadvantages minorities in the U.S. disproportionately do.”

For racial minorities, a lack of a credit score or a credit file that’s too thin to be scored can mean a lack of access to credit. This leads many to rely on cash or loans with high APRs, creating a vicious cycle where people end up with high-interest debt that’s hard to pay off and which may ultimately hurt their credit scores.

A 2010 CFPB report found that a more significant percentage of Black and Hispanic individuals (15%) are credit invisible, or unscorable, compared to White and Asian individuals (9%). Furthermore, a larger percentage of credit-invisible individuals reside in low-income neighborhoods (30%) than in high-income ones (4%).

“It’s important to note that credit scores didn’t create some of the social economic disparities,” Sally Taylor, vice president and general manager at FICO, told CNBC. “They simply reflect the social economic disparities that are out there…”

One proposed solution to make more people’s credit visible is to include alternative forms of data on credit reports. For example, mortgage payments are included on your credit report while rental payments are typically not. Therefore, the system benefits homeowners but not renters.

Experian Boost was launched in 2019 and uses data not typically collected on people’s credit reports such as on-time utility, streaming subscription and telecom payments. It’s a free service and it only considers positive payment history, so late payments on added accounts won’t negatively affect your score. It also recently added the ability to include rent payments in the calculation of your credit score.

However, the use of alternative data could come with drawbacks. Just as homeowners are prone to falling behind on mortgage payments during a recession, renters are too. If credit bureaus or policymakers aren’t careful, including alternative data could end up hurting the people that it’s supposed to help the most. 

Another proposed solution is using cash-flow data from people’s bank accounts for underwriting, yet more research is still needed.

“Credit underwriting with cash-flow data involves using financial data insights from a bank account or other types of transaction accounts to evaluate consumers and small businesses for credit,” says Melissa Koide, CEO of FinRegLab.

FinRegLab looked at data from six non-bank financial services providers, such as Petal and Kabbage, and found that cash flow data for underwriting worked as well as traditional credit scores, and primarily benefited borrowers who were credit invisible or who had poor credit scores.

And of course, while the credit reporting system is error-free for the majority of people, many still have mistakes on their reports that could affect their credit scores, according to Aaron Klein, senior fellow in Economic Studies at the Brookings Institution.

A recent survey done by Consumer Reports found that more than one-third of people who checked their credit report found an error, the majority of which were related to an individual’s personal information, such as an incorrect name or address. This leaves consumers with the responsibility of checking their credit reports and scores for errors.

Credit reports became available to consumers for free in 2003. People can access one free credit report from each of the main credit bureaus once a year through annualcreditreport.com, which is authorized by federal law.

Consumers can also check their credit scores for free throughout the year using resources provided through credit card issuers. For example, people can use Chase Credit Journey or CreditWise from Capital One to find out their VantageScore® 3.0 credit score, even if they don’t have any credit cards.

Getting your FICO score can be a bit trickier. People can access it through Experian or a lender that partners with FICO. If you want to get it through a card issuer, you’ll need to be a Discover member in order to use Discover Credit Scorecard which provides free FICO scores. 

And in Washington, there’s been some political appetite for reform but not enough for change. 

Congresswoman Ayanna Pressley (D-MA) has spearheaded The Comprehensive CREDIT Act of 2021 which would reform the dispute process for mistakes on credit reports and would require that credit reporting agencies provide a free score to consumers once a year.

Credit scores provide an easy way for lenders to determine whether a borrower is creditworthy. However, the credit scoring and reporting systems can function imperfectly, leaving many of the most marginalized without credit scores or with poor credit scores. This can harm people’s ability to gain access to credit.

While there’s no consensus on how credit reporting and scoring can be more inclusive, some have proposed using alternative data or cash-flow data to underwrite decisions. Furthermore, policymakers have been considering how to make it easier for people to access their credit scores and resolve mistakes on their credit reports.

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