Credit Scores rule US access to Finance
Updated: Jul 23, 2019
A concise summary of everything you need to know about Credit Scores: importance, myths, tips and Request for Startups
Credit Scores rule access to affordable finance in the US. A credit score is a measure of how credit worthy you appear to be. It tells banks “what is the likelihood that this individual will pay me back if I lend him/her money?”
While there are flaws in the credit score which we will explore, the fact is 90% of lenders use the FICO score. Why? Because the FICO score is one of the most predictive measures of delinquency.
This article will explore why building good credit is valuable, debunks myths about credit scores, and summarizes available products and strategies to improve your credit score.
You need a good credit score
You need to understand how credit scores work (yes, it is confusing)
You can do things today to help your credit score
The best path forward depends on your financial situation
We need to disrupt the credit score system
Full disclosure: I am not a financial advisor— only an advocate. These notes should not serve as financial advice, only food for thought.
You need a good credit score
A typical person will likely pay over $275,000 in interest on credit purchases over the course of his or her life. Factor in the credit score, and the difference between good and bad credit can be several hundred thousands dollars of credit fees and interest over the lifetime of a consumer.
Beyond restricting access to affordable credit, poor credit scores impact many facets of a consumer’s life:
Renting an apartment — many landlords ask for applicants to submit their credit scores and discriminate based on this information
Getting a job — 60% of employers check your credit score and will turn you down if you have red flags on your credit history such as bankruptcy
Higher deposit on utilities or rent — the lower your credit score, the higher the amount required to put down on a security deposit
Higher insurance premiums — insurance companies check credit and will increase your premiums if they deem you risky
Access to cell phone contracts — lower credit scores may prevent you from getting service by major cell phone companies and have to resort to prepaid or more expensive alternatives
Buying a car — your credit score is often factored into approval for a car loan
You need to understand how credit scores work
Here are some myths about credit scores:
“The more money you make, the higher your credit score” → False: credit scores does not factor in income. Wealthy individuals who cannot make on time payments will have low credit scores. There is a correlation between credit scores and income, in part because the more disposable income you have, the more buffer for unexpected expenses, and therefore the less likely you will be unable to make a payment when something comes up. Anybody can have good credit scores.
“The more balance you carry, the higher your credit score” → False: if you end up carrying more than 30% of your balance, experts predict this could actually hurt your credit score. Consider the credit score as a point accumulation system. Paying your balance in full might not give you as much credit points than holding a 1–9% balance. That said, rolling a balance that accrues interest could quickly cost more than the savings associated with a slightly higher credit score. Don’t pay interest simply to get a higher score.
“The earlier you pay off your loans, the higher your credit score” → False:length of credit history is a key factor in your credit score. By paying a loan off early, you may not gain as many credit score points as if you made payments according to your contract since your loan will essentially be ‘shorter’. Only cancel credit cards and pay loans back early if the benefits of closing these lines (e.g. less interest and fees) outweigh the decrease in your credit score.
“Taking out a loan will increase my credit score” → Not necessarily. If the lender does not report to the National Consumer Reporting Agencies mentioned above, it is unlikely that this activity will be factored into your credit score. Also, the lender will likely do a hard credit pull to make a decision, which may lower your credit score. Independent of your score, lenders also look at how much debt you have compared to your income, and will more likely decline you if your debt to income is too high. It’s generally not a good idea to take out loans just to boost your credit score. Borrow only the money you need and can safely plan to pay back.
“Checking your credit score affects your credit score” → False. Checking your credit score does not affect your credit score as it is considered a ‘Soft Pull’. Monitoring your credit score can only be of benefit to you as it increases chances you spot fraud or inaccuracies with your credit report. When you apply for credit, lenders have to do a ‘Hard Pull’ on your credit score which does affect your credit score. Always read disclosures when applying for credit products to determine if there will be a hard pull on your credit — in general only accept hard pulls if you are getting a loan that will be credit reported.
“I should only track my FICO score” → False. There are many credit scores out there, such as Vantage Scores. You don’t have only one FICO score — you have more like 49. Each Consumer Reporting Agency provides different scores for different iterations of their models and different industries (e.g. Auto, Mortgage, Credit Card, etc.). Some inquiries might only affect one of your scores if the lender only pulls from one of the Consumer Reporting Agencies. This could be too much information to track — just know that they all track similar information, and the things you do to improve your credit will work on all of them to some extent
.“There are only 3 Consumer Reporting Agencies” → False. The term Consumer Reporting Agency applies to any business that collects and sells information to other companies about you. There are only 3 companies considered “Nationwide consumer reporting companies” by the CFPB: Experian, TransUnion and Equifax. Yet there are hundreds of other consumer reporting agencies, ranging from Employment screening to Tenant, Check and bank, Personal property insurance, Medical, Low-income and Subprime, etc. Know that any data you generate can be used against you during a credit decision.
So how do credit scores work?
Financial Institutions send their data about you to Consumer Reporting Agencies. In exchange, they receive from the Consumer Reporting Agencies even more data about you (data that includes what other Financial Institutions have reported) and other consumers which they use to know who to send offers to and who to approve for loans.
Consumer Reporting Agencies (TransUnion, Equifax, Experian) collect this data and make money selling data back to financial institutions.
Credit Score Companies then build credit scores on top of this data to make it easier for businesses to determine individual risk. For example, FICO is an analytics company that computes the FICO score based on credit reporting data. Vantage score is actually a joint venture between the three credit bureaus to compete against FICO. Businesses can purchase these scores as an add-on to existing data
While FICO is not going to share exactly how the FICO score is calculated (else they will lose their competitive advantage), FICO does share some directional guidance to help consumers. Here is what we know:
Your FICO score is composed of 5 factors:
Payment History: Make at least the minimum payment on time. Don’t miss your payments.
Amounts Owed: How much you owe and how much of your available credit are you using. Stay within the single digit utilization.
Length of Credit History: How long have you been using credit. You want to have accounts that are several years old.
New Credit: Hard inquiries factor in your score and could negatively affect during the first 6 months. Don’t open a new account right before applying for a large loan.
Types of Credit: The more experience you have with different types of credit (credit mix includes mortgage, car loans, etc.), the lower your risk and the higher your score.
As you can see, certain actions can have unexpected affects to your credit score. Here are two confusing examples:
Paying off your car loan or student loan can decrease your credit score since your “Types of Credit” score is now lower. Depending on your financial situation, paying off your high interest loans is a good idea even if it means losing some credit score points.
Applying for a new credit card can hurt you because of the hard pull (‘New Credit”) and the shorter credit history (decrease your “Length of Credit History” average), but increase your “Credit Mix” and “Payment History” over time. So it could be that your credit score will decrease at first and increase over time higher than it originally was.
You can do things today to improve your credit score
Here are some immediate things you should do to improve your credit:
Check your credit score at least every year. Obtain a free, full annual copy of your credit reports from AnnualCreditReport.com for each credit bureau. This data is used to generate your FICO score. 50% of people don’t check their credit report yearly, and only check it right before applying for a large loan — that is too late to change your score.
Monitor your credit score for accuracy. Services like CreditKarma enable you to check what is being reported about you every day. If there are any inaccuracies, file a dispute with the credit bureau or with the lender. Disputing will not hurt your score. Credit Scores will exclude most information that is showing up as being in dispute. If there is fraud, also get a police report and consider freezing your credit report. Timeliness is key.
Avoid late payments. Making a late payment on your credit reporting debt is one of the surest way to decrease your credit score. If you make the minimum payment, you will be reported as current and your score should go up over time. How recent something is on your credit report matters significantly for your score. For example, being 30 day late last month can be more damaging to your score than a bankruptcy many years ago.
Select credit reporting products. Not all lenders report to Consumer Reporting Agencies, and not all products are eligible to be credit reported. Single Payment Loans, for example, are not eligible to be reported to the National Consumer Reporting Agencies as the loan duration is typically less than 1 month.
Check hard pulls before applying. Hard inquiries can happen all over the place: renting a car with a debit card, switching banks, applying for a Credit Line Increase, point of purchase financing for that couch. Make sure you get something in return for the affect of a hard pull on your credit score. In general, hard pulls are fine if you are getting a product that will improve your credit score.
Keep your utilization low. A good rule is to not carry more than 30% of your credit limit from month to month. This means that if you have a $1000 credit limit, you should only keep a balance of up to $300 on that card. Single digit utilization on credit cards is best (1–9%). If you want to save money on interest, pay the card back in full every month.
Ask for a credit line increase. This will decrease your utilization. Only do so if you are confident that you won’t overspend to the point where you cannot make timely payments. Also check that the lender will not do a hard pull on your credit report when making a decision about your credit line.
Plan ahead. Budget so you can have a buffer for the unexpected as much as you can to avoid being late on payments. Traveling? Get a card with miles. Check offers, and see what scores are required to get these cards, and work your way backwards.
Add your child as an authorized user. Major issuers do report authorized user activity to the credit bureaus. Authorized users have access to the primary account credit line. This is a good way to help build your child’s credit score. You will still be responsible to pay the full balance.
Give it time. Your score will go up over time if you have open lines of credit since the longer your payment history, the better. Factors that might have hurt your credit score will go away over time (e.g. late payments, charge offs or bankruptcy stay for 7 years).
It is important to keep in mind that your Credit Score is not the only thing that is used when you apply for credit. Many lenders look at the balance between income and debt, and will decline you if you have too much debt or if you spend more than you earn, even if you may have a great credit score. The CFPB recommends that consumers keep their debt-to-income below 43% for consumers interested in being approved for a mortgage.
Bottom line: One of the best strategies is to make on time payments, not take out debt you don’t need, and keep your utilization low.
The best path forward depends on your financial situation
There is no silver bullet to building credit — it depends on your goals and financial situation.
Excellent FICO > 780
You are set and have high chances of being approved for the best credit products at the lowest rates.
Good: FICO > 700
You are likely to get approved for most major bank credit cards. At minimum, choose a credit card that is being reported to all three Credit Bureaus. If you are able to get approved for a card with rewards, select the card that rewards your spending habits with offers that you want (e.g. travel, shopping, etc.). The higher your score, the more likely you will be eligible for valuable offers.
Average: FICO 600–700
You might only have access to credit cards designed for average credit. Select a card that has low (or no) annual fee, and reasonable interest rates. Avoid cards with multiple or high fees (such as annual fees, monthly fees, setup fees, activation fees, late fees, etc.). Read the fine print. Follow the ‘hacks’ listed above to get improve your credit score.
Poor: FICO < 600
You might not be approved for an unsecured line of credit for now. In order to build credit, consider applying for one the following products:
Secured Credit Card. Similar to a credit card, but the bank will ask you for a security deposit to hold on to. The amount of the security deposit is often the same amount as the credit line, so you are not really increasing your purchasing power, but you are building your credit score. Make sure the secured card is being reported to all three bureaus and has low fees.
Secured Installment Loan (aka “Credit-Builder Loan”). This is the same as a loan, except you don’t actually get the loan until you make the final payment amount. Each month, payment history is reported to the credit bureaus, which helps build your credit score. At the end of the term, once you have paid your loan off, you will receive the full balance of the loan plus earned interest on that balance over the term of the loan. A Secured Installment Loan is great for consumers that do not have enough cash on hand to put down a security deposit on a Secured Credit Car (typically $300–500). It is also a great forcing mechanism to help people save.
Charge Card: These are similar to credit cards, however, you must pay off the total balance each month. You cannot carry a balance. Charge Cards do not have the concept of a credit limit or credit utilization and therefore will not improve the “Credit Used” portion of your score. The Charge Card does help your credit score because it reports your payment history. If your objective is to improve your credit score and you are responsible with a credit line, you should consider a revolving card such as the Secured Credit Card.
Service Credit. You also make monthly payments to your utility bill, gym membership, cell phone service, or rent. Some of these services are reported to the Consumer Reporting Agencies, but most do not. Many report when your account is sent to collections if you don’t make on time payments for some time, which can hurt your credit score. Some companies help consumers credit report their rent for a fee, which does factor into some credit scores such as FICO 9, FICO XD and Vantage. But most lending decisions still rely on earlier FICO versions, and those don’t factor rent into scores.
There are other lending products that can improve your credit score of course. These include Auto Loan, Mortgages, Installment Loans, etc. In general, these loans should be taken out if there is a need for liquidity — to buy a car, a house, or any expense worthy of the high interest rate of a loan. If there is no need for liquidity, consider a more affordable credit building product such as the Secured Card or the Secured Installment Loan.
We need to disrupt the credit score
The current credit score system has many flaws
Perverse incentives. The Credit Score encourages consumers to take on debt to prove their credit worthiness, which is not financially responsible. In addition, offering a higher credit score for those that keep some balance on their credit card compared to those that pay off their balance in full incentivizes consumers to pay more interest.
Bias towards negative reporting. Many companies only credit report when consumers do something wrong, not when they do something right. For example, national phone companies will only report your activity to Consumer Reporting Agencies if they place your account in collections. On top of that, they sometimes do a hard pull on your credit score. It is a lose lose situation in terms of credit. Other examples include medical debt or unpaid parking tickets.
Blindness towards the underbanked. Not only do the underbanked not have access to affordable financial products, many products they use are not credit reporting. For example, Payday Loans are not reporting to the National Consumer Reporting Agencies because they deem these credit lines to be of too short term. A consumer’s on-time payments on Payday Loans therefore does not help their FICO score even though it is an some indication of credit worthiness.
Prevalent inaccuracies. 1 in 5 Americans have a mistake on their credit reporting according to this study by the Federal Trade Commission. 13% would have a different score if they successfully disputed the mistake. There are very few controls in place to ensure accuracy in the credit reporting system other than disputes — Consumer Reporting Agencies do not check accuracy, and lenders often have mistakes in their reporting. Additionally, Consumer Reporting Agencies often make mistakes such as mixing names, or matching the wrong identities due to address changes.
Inefficient dispute process. There are many horror stories describing how long it takes to get something incorrect off of one’s record. The CFPB has done great work in enforcing the Fair Credit Reporting Act which protects consumers from inaccurate information. One method is to penalize lenders that are not reviewing disputes in a timely manner. Still, the number of complaints are continuing to increase (up to 4,000 monthly complaints as of Jan 2017).
Some improvements have been made, but not enough
53 million people in U.S. do not have FICO scores. These “Credit Invisible” consumers will have a very hard time getting any credit.
FICO came out with a new credit score called FICO XD to address this. This new score will help some 15 million previously unscorable consumers get a credit score using alternative data. The FICO XD score pulls from LexisNexis and The National Consumer Telecom and Utilities Exchange information about consumers such as data on phone, utility, and cable records or data on home ownership and home value, bank records, occupations, etc. While some consumers may have thin credit reporting files, there is plenty of publicly available data on them.
FICO has also partnered with Payment Reporting Builds Credit (PRBC) which is a fairly new consumer reporting agency that maintains a history of your bill payments including utilities, rent, cable, and other payments. The difference with PRBC is that consumers are allowed to report their own payments and can view their payment history at any time for free.
There are limitations with the FICO XD score. For one, the FICO XD score does not replace the FICO score for those that do have a FICO score, so the bulk of the issues highlighted above still stand. Furthermore, the public is not educated about this new score and would likely behave differently if they knew that not paying their phone bills could increase their mortgage rate.
Consumer education is critical and without it, many consumers will be harmed by this new score. Finally, the risk of inaccurate information increases dramatically as new data providers are used as they are just as likely to contain errors. These new sources of information are even harder for consumers to monitor and dispute. Regulatory oversight should apply here to the same rigor as the CFPB.
Change should come top down: Policy
It seems counterintuitive to ask those with less disposable and stable incomes to pay higher rates for the same amount of credit, thereby increasing their probability of default. But this vicious cycle is how the market economy works: those more risky will pay more for the same product in order to compensate for the higher default rate of ‘people like them’.
What is needed in the market economy is leadership from policy makers and regulators about the access, use, and review of personal data. For example, I do not believe businesses should be allowed to ask for a consumer’s credit score when determining if that consumer is fit for the job. While credit products might not be a ‘right’, fair access to employment, I believe, is. Similarly, housing is a right. While I understand why renters ask for credit scores, those with low credit scores should still be given an opportunity to rent under a different umbrella such as public housing.
And bottom up: Businesses
In a capitalist system, we cannot force lenders to use (or not use) data that is at their disposal when making credit decisions. Lenders will use data that is most predictive. In order to reduce the over-reliance on the FICO score, a new more predictive credit score should be built that is just as predictive, but fairer for the underbanked consumers. In order to beat the FICO score, you will either need better data or better analytics.
Better data. As mentioned previously, National Consumer Reporting Agencies often ignore data on subprime financial products such as Payday Loan data. If these are indeed predictive, build a score for the underbanked that includes this data and demonstrate that it is more predictive than the FICO score. Businesses will start using the new score instead. Companies like Nova Credit provide credit scores to immigrants who typically have no credit history in the US by leveraging data from their home countries.
Better analytics. Many lenders have simply thrown away the FICO score and computed their own scores based on the data provided by the Consumer Reporting Agencies. This could be a double-edged sword for the consumer. For example, if the lender uses alternative data such as education, work history, personal savings and investments , they might be giving an upper hand to those more well off, something the FICO score does not do explicitly.
Some companies are trying to change the entire playing field of Credit Scores. Bloom Credit, for example, is trying to build a new protocol on the Blockchain that will decentralize credit reporting data in an effort to empower consumers, democratize data, and reduce fraud. Such optimistic technologies still have a long way to go, and should remember that at the end of the day, in our capitalist society, the most predictive score will win (not the most consumer friendly).
Request for Startups
Here are some startup ideas that could help consumers:
Automated Personal Financial Advisor: Access to quality financial advice is still hard. Build an app that integrates with your credit score, crunches data and tells you what to optimize for based on your objectives (e.g. build credit, get credit line, get cash, etc.). Clearly show what is hurting your credit score and what you can do about it. Predict your credit score over time as you make online payments. Point to quality products to meet these objectives.
Automated Payment Optimization: Consumers often have many different debt products and bills, and have a hard time knowing what to pay off first. App that integrates with your bank account and debt (credit cards, mortgages and student debt) and tells you how to properly pay them based on your disposable income so as to increase your credit score (e.g. keep low utilization) or mitigate any harm to your credit score (e.g. avoid charge offs)
Credit Reporting Bills. Managing bills is hard — and most bills (Utilities, Gym Memberships, Phone Bill) are not credit reporting. Find a way to package bill payments as a secured line of credit that you credit report to bureaus. Consumers will pay the monthly due amount which is reported to agencies but also used to pay their bills. App that integrates with all your bills and credit reports them.
Consumer Friendly Credit Reporting Data. There are a ton of Consumer Reporting Agencies and reviewing your personal data with each of them is hard. App that aggregates all consumer reports into a single, pleasant customer view updated yearly. Highlights activity that is worth reviewing and who to reach out to.
Smart Recommendation Engine. It is often not clear whether an increase in credit score is better than a decrease in interest payments (and as we have seen these often are directionally opposed forces). App that crunches data and optimizes for your total cost of credit today and tomorrow. For instance, say you want to take out a mortgage — maybe taking out an unsecured loan for 12 months before the mortgage could save you more $ over the 30 next years than the interest on that installment loan.
New Credit Score. Many competing scores to the FICO score are being developed by cutting edge lenders. Once the secret sauce is identified, lenders have very little incentive to share with the rest of the market else they will risk losing their competitive advantage. But if their score is significantly more predictive, there is a business opportunity for a new analytics company.
There is a lot more to do to help the underbanked get access to affordable and responsible financial services