An examination of the history of credit scoring, the “Big Three” credit reporting bureaus, your legal rights, and the importance of a good credit score

 

The credit score. Easily the three most important digits in a person’s life. The impact this seemingly harmless number can have on someone’s entire future is either terrifying or beneficial—depending on what your score is.

While credit scoring, as we currently know it, is a relatively recent development in American society, it has become so important to a person’s financial wellbeing that it deserves a lengthy discussion. Indeed, volumes of works have been written about this phenomenon, so commonplace, complicated, and fairly new is this practice in the grand scheme of commerce throughout human history.

Of course, like so many other (sometimes unethical) business practices involving commerce and capitalism, credit scoring is a uniquely American invention—one dating back just over 180 years—that has grown to encompass the entire world and affect virtually every adult human being utilizing credit on the planet.

To know the history of credit scoring is to understand the mechanisms behind where your score comes from, what it means both to you and to creditors, and how you can control your financial identity in order to maintain independence for yourself and future generations.

 

A Brief History of Credit Scoring 

As America began its ascent into what was to become the world’s first industrial powerhouse in the mid-1800s, merchants had long been using the practice of extending credit to fellow business owners and citizens with good reputations for paying their bills. But, prior to 1841, much of this was simply done by word-of-mouth. Banks, merchants, insurance companies, and wholesalers simply poked around into a person’s past and reputation to the best of their ability, then made an educated guess about who was or wasn’t worthy of a line of credit.

Merchants would inquire about the creditworthiness of a potential customer by asking around the town about the person in question. They would ask other business owners, family, friends, clergy, and fellow townspeople questions to determine a person’s financial standing. What is his character like? How much money does he make? Where does his money come from? What are his religious and political beliefs? Does he have any bad habits or addictions? How seriously does he take his bills? These types of questions gave merchants a general sense of whether the person in question was a risk, and they would (or would not) extend credit accordingly.

It wasn’t a perfect system, but it seemed to work for the most part early on, until the economy grew with the country’s swelling population, making this method nearly impossible to replicate at a larger scale to cover the ever-growing expansion of the United States westward. Credit extensions were mostly divvied out this way from the founding of the United States until the mid-nineteenth century, when an enterprising businessman, philanthropist, and abolitionist named Lewis Tappan developed the earliest known credit-reporting agency—The Mercantile Agency—in 1841.

The purpose of the agency, on its face, was simple: create a one-stop-shop where merchants could check on the truthfulness and reputation of potential clients. Here, according to an essay by Josh Lauer, merchants could come “to ascertain whether persons applying for credit are worthy of the same and to what extent.”

The problem with Tappan’s particular approach was that it relied heavily upon rumor and speculation. However, his company did manage to amass a great deal of information on consumers, but streamlining the process of collecting and reporting the overwhelming amount of information became virtually impossible to maintain. Nevertheless, Tappan’s model for credit scoring established a format that would be followed for over a century, though it would be tweaked and perfected over the years to arrive at the general practices used to this day.

It wasn’t until the 1950s that credit scoring, as we now know it, was put into practice. Prior to this time, bankers either used systems like Tappan’s Mercantile Agency, or else employed hearsay and cynicism to determine whether you were a good risk. Unfortunately, due to racial and gender biases widely accepted at the time these techniques were practiced, women and minorities were largely denied credit, unless someone “reputable” were to vouch for them.

In the mid-‘50s, two renowned statisticians, Bill Fair (also an engineer) and Earl Issac (an award-winning mathematician), made waves in the banking and credit industries by coming up with an early algorithm that predicted the likelihood of a person to default on a line of credit and the risk they posed to any potential creditor. This algorithm was largely comprised of five factors that determined a person’s creditworthiness, known today as the FICO score. (FICO is the name of the company founded in 1956 by Fair and Isaacs, called the Fair Isaacs Company, which boasts over 45 offices worldwide, primarily in the U.S., Europe, and Asia.) Though the algorithm has been adjusted several times since its early inception, it still largely adheres to the original formula created to place a numeric value on a person’s financial identity. And so, the FICO score was born.

 

The FICO Scoring Formula

In general, your FICO score (and hence the three-digit number assigned to you by each credit bureau) is made up of five distinct categories that determine the level of risk you pose to a potential creditor. It is this total three-digit score that credit reporting agencies largely use to document your credit history and worthiness for would-be lenders. So, understanding this number and how it is broken down is essential to knowing how your overall credit score is constructed.

  1. Your Payment History – The single most important element of your FICO credit score (35% of your overall score) is your payment history. Making payments on time and paying back your debts as agreed with your creditors is what potential lenders are most concerned with when looking into whether to lend to you. Lenders want to get their money back, plain and simple. So they want to see that you are the type of person who pays your bills, in full, and on time.
  2. The Total of Amounts Owed – This is the second most important factor in your overall FICO credit score, making up 30% of the total number. The simple explanation is that creditors want to see that you are not using up more than roughly 30% of the total amount of credit available to you through all of your accounts. Using more than 30% of your available credit (particularly on credit cards) is a red flag that tells creditors you’re likely living beyond your means and relying on credit to make ends meet, rather than for one-off purchases or smaller, affordable recurring purchases. As counterintuitive as it may seem, creditors want you to have credit, but not to use too much of it. It’s a tricky dance, but one that, if you’re aware of the moves behind the scenes, you can easily use in your favor.
  3. The Length of Your Credit History – Another 15% of your FICO score comes from the length of time you have held your various credit accounts. The longer you’ve held an account (in good standing), the better it is for your credit score. The score for this aspect of your credit history includes all of your credit accounts, from oldest to newest, and the average age of these accounts combined. The longer you have had a credit history, the better your score in this category tends to be, provided the accounts have never been severely delinquent or closed for non-payment (known as a charge-off).
  4. Your Credit Account Variety (or Mix) – The more variety you have in your credit history, the higher your score tends to be. Creditors like to see that your accounts are not all credit card debt, for example, and that you are applying and utilizing debt in several aspects of your life. This shows creditors that you have a handle on the ways to use credit to your advantage to improve multiple areas of your life, not just using credit as a way to get cash or purchase unnecessary things. At 10% of your FICO score, this factor plays an important role in showing your ability to manage credit in various aspects of your life. Most “healthy” credit scores consist of some or all of the following credit types: credit cards, student loans, car loans, home loans, and other types of credit lines, such as store credit or wholesale credit.
  5. Requests for New Credit – Each time you apply for a line of credit with a lender of any sort, it appears on your credit report as a “hard inquiry.” This means the potential lender making the inquiry is seriously considering loaning money based on the results of their request for your credit score. Asking for too many lines of credit too close together shows a potential lack of responsibility, as well as setting the consumer up for possible financial distress from too many open and active lines of credit. This makes up the final 10% of your FICO score.

 

What Can Damage Your Credit Score?

In addition to the factors above that play directly into how your FICO score is created, the following negative factors are what hurts your credit score the most. These factors are directly related to your inability to pay on time, whether you can actually afford the credit or loan(s) extended to you, and how much of your credit you are using at any given time.

  1. Missed or Late Payments – Because 35% of your FICO score is directly tied to the timeliness of your payments, this is the biggest—and quickest—single way to damage your credit score. Being late on a payment will take a chunk out of your score, and, if your payments remain unpaid, every 30 days your credit takes another hit. It is essential to pay on time. All the time.
  2. Using Too Much of Your Available Credit – As stated earlier, when you use more than 30% of your available lines of credit, potential lenders view this negatively. While it might make sense to use the credit extended to you (after all, isn’t that the whole purpose to a line of credit?), unfortunately, creditors want to know that you aren’t “maxing out” your available credit because it appears as though you are making bad financial decisions, or even desperately using your credit to survive when it should be being used for large purchases or small costs you can quickly pay off. Either way, it is a good idea to monitor your credit utilization to try to keep this percentage below 30% of your available credit.
  3. Applying for Too Much Credit in a Short Time Period – How short of a time period is “a short time period?” That depends on the credit bureau collecting information on the “hard inquiries” into your credit history. But, “hard inquiries” performed by potential creditors remain on your credit file for two years with all three of the main credit reporting bureaus, and therefore that length of time is a good rule of thumb to consider. While shopping around for home or car loan approvals, generally lenders do “soft inquiries” at first to see your credit score overall. So, shopping for preferred terms on a loan does not have an adverse effect on this part of your FICO score. However, getting multiple car loans in a two-year period, for instance, would have a negative effect on your score.
  4. Defaulting on Your Credit Accounts – These forms of nonpayment usually mean that you have not made a payment in several months, and therefore have defaulted on the terms of your loan. The most common forms of default are home foreclosure, bankruptcy, repossession of a car or other large purchases, charge-offs (an unpaid account that is frozen and closed), and settlements with creditors on highly delinquent accounts wherein the creditor agrees on a lesser amount than originally owed with the understanding that they will report this to the credit reporting agencies. The effects of defaulting on credit agreements can cause long-lasting, years-long damage to a person’s credit rating—sometimes up to ten years.

 

The “Big Three” Credit Reporting Bureaus

Though there is no one credit scoring bureau that trumps the others, the “big three” credit bureaus most commonly used to assess your creditworthiness are Experian, TransUnion, and Equifax. All three credit reporting companies monitor virtually every aspect of your life, from changes of address, number and types of vehicles owned, education, number of jobs held and for what length of time, income, marital status, and, of course, your actual credit and payment history as reported in your FICO score. Combined, these make up your overall financial identity, for better or for worse.

All three companies fiercely guard their proprietary information and the way they score your personal history alongside your credit score, but the credit reports from all three tend to align fairly closely with one another. The most important thing to remember is that you are legally entitled to see the contents of your credit reports with all three bureaus, and you are legally entitled to dispute any discrepancies or inaccuracies to protect your credit and your financial identity. However, if you do not act to “fix” any part of your credit score that is not correct, these blemishes will stay on your report and will be presumed to be accurate unless proven otherwise.

 

The Fair Credit Reporting Act

According to the Federal Trade Commission (FTC), roughly one in five Americans, or nearly 40 million people, has errors on their credit reports. Given that, the odds are quite likely that you or someone you know is being negatively affected by mistaken or purposely misreported information on your credit report.

The U.S. Government, aware of how important a person’s credit is to their financial wellbeing, passed the Fair Credit Reporting Act (FCRA) in 1970, in an effort to give Americans a method to control and manage their credit scores and reports with the various credit reporting agencies. Sadly, most Americans are unaware of their rights when it comes to this law, and an alarming number of predatory and unethical lenders use negative credit reports as a weapon in attempts to collect the debts owed to them and as punishment for nonpayment.

Despite the good intentions of the FCRA, in the aftermath of the Great Recession, Congress determined that there needed to be adjustments and amendments made to FCRA to account for the changing nature of commerce and the many ways lenders abuse and manipulate credit reporting to damage the reputations of borrowers. And so, in 2016, Rep. Maxine Waters (D), Chairwoman of the U.S. House Committee on Financial Services, introduced a groundbreaking bill called the “Comprehensive Consumer Credit Reporting Reform Act.” This sweeping legislation, predictably, stalled during the tenure of the Trump Administration, but has found new life now that the Democrats control both legislative branches and the executive branch of government.

Whether the bill, along with the other proposed solutions to overhauling our broken consumer credit reporting systems, ever passes both houses and is signed into law remains to be seen. But the good news is that the issue of credit scoring and the life-changing effects one’s credit score can have on a person’s financial future and wellbeing is not lost on the current leadership attempting to address the issue head-on, after decades of abuse and consumer manipulation.

 

How to Manage and Nurture Your Credit

All of this is to say that the significance of a person’s credit score cannot be overstated. The three-digit number assigned to you affects everything from interest rates to how much credit is extended to you, and can even have an impact on the types of jobs you can get, now that many employers check potential hires’ credit histories before extending a job offer. Our financial identities are forever bound to our credit score, whether we like it or not.

The first step to gaining financial freedom and taking control of your credit score is to address any outstanding credit discrepancies, improper reporting, bad or illegal debts, and delinquent accounts. Luckily, our ally company, DebtCleanse, is a one-stop-shop where all of these credit-damaging issues can be dealt with by a team of consumer protection attorneys who specialize in credit abuse and fraud.

Thankfully, there are ways to not only track your credit score (DebtCleanse offers unlimited, on-demand credit reports for all members), but also to nurture it and make sure that your score works for you rather than against you. In addition to the services offered by DebtCleanse, consumers can also take these basic—but extremely important—steps to remediate their credit and raise their credit scores in meaningful and lasting ways.

  1. Pay Bills on Time – Whenever possible, pay all your bills on or before their assigned due dates. This might seem like a no-brainer, but this is the most commonplace reason for people’s credit reports taking a hit. Try to keep due dates in mind, preferably in a calendar or some other form of consistent and visual reminder, so you can plan for upcoming payments and stave off this easy-to-forget aspect of your credit score that can spiral out of control.
  2. Catch Up on Any Overdue Payments – The out-of-control credit downward spiral previously mentioned often begins here. If you do not address outstanding (overdue) payments as soon as possible, these delinquent accounts begin to take a bigger and bigger chunk out of your credit score. The best way to stem the financial bleeding is to catch up on payments, steady your payment history, and then maintain timely payments moving forward.
  3. Pay Down as Much Debt as You Can, as Quickly as You Can – Because your debt-to-credit ratio is a huge factor in your credit score, it is essential that anytime you can afford to make more than the minimum payments on a credit account, you do so. Lowering the overall amount owed “frees up” credit available to you, but, more importantly, tells creditors you are not using all of your credit, which implies you’re financially comfortable enough to not be living off your line(s) of credit.
  4. Dispute Inaccurate or Illegal Information on Your Credit Report – It is essential that you monitor your credit score at all times, but especially at the beginning of the credit remediation process. You should scour your entire report, looking for false or inaccurate statements, unfair or illegal reports, or fraudulent credit lines in your name. There are numerous ways these types of negative items can show up on a person’s report, but each consumer has legal protections that enable you to dispute and correct anything that does not belong on your report. Again, our ally company DebtCleanse offers legal services plans that address these very types of credit-damaging reports to the bureaus, and all services are included in the low monthly service fee.
  5. Limit Your Requests for New Lines of Credit – Sometimes asking for too much credit too fast is a major red flag to creditors. It smells of desperation and/or fraud, and it shows a lack of financial responsibility about the reality of how money and credit work. Each time you apply for a new line of credit (whether a credit card, a car loan, a home loan, or anything else involving an extension of credit) it appears in your credit history. So limit yourself only to lines of credit you actually need, when you need them. And be sure you can afford the payments. Remember, this is real money that must be paid back, so don’t overreach beyond your income and repayment capabilities.

 

Are you ready to take charge of your financial identity? Visit AHP75.com to learn about how our ally company, DebtCleanse, can help you remediate your credit and build a solid foundation for a financial future.

Aaron Morales is the Social Justice Writer for AHP 75, based out of Chicago, IL.

amorales@ahp75.com

 

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