A Secret History of Credit Scores: Who Determined What Matters and Why

NEW YORK (MainStreet) — Everyone is obsessed with his own credit score, the three-digit number that supposedly summarizes your credit-worthiness and overall financial responsibility. But where did the credit score come from? Who decided that the infamous "five factors" that make up your credit score were important? What did banks and other lenders do before they had a credit score to go by, and why did they abandon that model? All this and more will be answered as we explore the secret history of credit scores.

Credit scores arose in the 1950s

For most of the modern economy, there was no such thing as a credit score. Lending decisions were made by loan officers who worked at banks. "If you wanted to buy a house or a car, you would go to the bank and you would talk to a fairly vigilant, cynical banker," says Randy Padawer, a consumer advocate with LexingtonLaw. This made determining who did and did not get credit largely a matter of individual judgment.

There were two major problems with this model of lending: First, it relied upon an individual loan officer's subjective judgment. This meant it was not a terribly accurate way of determining who actually would and would not repay loans. It also tended to be discriminatory. "There were questions of fairness and racial and gender bias on credit applications," Padawer says.

Enter Bill Fair and Earl Isaac. These two statisticians made a number of correlations between which behaviors made a person a good credit risk and which made them a bad credit risk. And for the most part, their predictions were accurate. But it wasn’t really until the 1970s that credit scores became as important in lending as they are now. The modern iteration of the FICO score, based on credit files from the three credit bureaus — Equifax, Experian and TransUnion — was introduced in 1989.

The move to credit score supremacy

Before credit scores, people still had credit reports. But these reports weren't distilled down into three-digit numbers. "Credit scores took a lot of randomness out of lending," says Ken Lin, CEO of CreditKarma. "Scores were developed in the '50s, but became much more prevalent in the '70s, '80s and '90s."

There are two main reasons for the move to a greater prominence of credit scores in determining whether to give someone a loan: first, a demand by consumers for more objective, less discriminatory forms of lending decisions; second, a far greater role for credit in the American economy. "Before the '70s, even if you wanted a credit card, you'd just go to your local bank," Padawer says. But after South Dakota and Delaware changed their banking laws, the credit card industry exploded. The old methods of approving or denying credit just weren’t going to keep pace with the changes in the industry.

Padawer notes that "while much was gained, much was also lost." While a three-digit credit score made some lenders be more fair, not all lenders were trying to be unfair. But the hyper-objectivity of the credit score removed the personal touch, where a lender could hear your side of the story and make a decision based on that, rather than just a three-digit number.

The world after credit scores

Lin believes we are moving into a world where the credit score will be far less prominent than it has been in the past. "Now you can really drill down," he says. "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." He estimates that a person's credit score is only 20% to 40% of the final decision, with the rest being hidden deeper inside the overall credit report and its extenuating circumstances.

In fact, more and more lenders are coming up with their own proprietary scores and lending standards. Regulators ensure that the factors used are nondiscriminatory, but basically every lender has its own in-house methods of determining creditworthiness. It's part of an overall drive to be more competitive. Lenders who can more accurately gauge who is capable of paying back a loan will thrive, while those lenders who are not so good at determining who can pay back a loan will lose money to defaulters.

So don’t put so much stock in your credit score as your overall credit report. And remember that there are some factors that are completely out of your control, even if you have impeccable credit. Lin, for example, was denied a credit card application in 2008, simply because he owned an adjustable-rate mortgage property in California. "It was a very nuanced decision, but that's what banks are trying to discover," he says.

— Written by Nicholas Pell for MainStreet

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