How the Credit Scoring Industry Works (and Doesn’t!)
By: Geff Woodward
The credit scoring industry, little changed in the last 40 years, is not positioned to be the best arbiter of credit decisions for many of today’s consumers. The industry has been very concentrated for a long time. It is essentially comprised of only four companies – three credit bureaus (Equifax, Experian, and TransUnion) and one scoring model player (Fair Issac, better known as FICO). With huge barriers to entry, and no serious outside competition, these competitors have enjoyed oligopolistic profits for many years. They profit by selling your data and you can’t opt out. They SELL your financial data to financial institutions for profit and this information determines IF you get a loan and at what rate and terms.
There are many shocking, recent discoveries from studies about the credit-scoring agencies. You may be surprised to learn that you don’t own your own credit score or even the data used to calculate it. The credit-scoring companies keep their algorithms as proprietary and have a limited scope of data used for the calculations. They are completely reliant on credit reporting data from credit bureaus. The limited scope of the credit data makes it difficult to ascertain the true credit worthiness of many consumers. With little or no information about a consumer’s income, and fixed and variable expenses (except for debt payments), there is no real way for a credit score to accurately estimate if the consumer can handle additional debt. In other words, credit scores cannot actually gauge a consumer’s credit worthiness for a new loan. A $10,000 car loan for someone who earns $40,000 a year is way riskier than to someone that makes $400,000 a year.
You might be even more surprised to find that the data is often wrong, especially since the pandemic – and that it is being used in more places for more purposes than ever before (note – as reported in this CNN article from August of 2022). This means that the accuracy of credit scores is inextricably tied to the accuracy of this data. Unfortunately, studies have clearly shown how poor the accuracy of these credit reports are (79% contained errors, 25% contained serious errors that could result in denial of credit, etc. – as reported in this CNN article from August of 2022). Based on the number of complaints the situation has not improved. Complaints in 2020 were up over 60% from the previous record in 2019. Also, creditors are not required to report consumer data to the credit bureaus. For example, positive information from fringe lenders is typically not reported while negative information is almost always reported. Ultimately, if you cannot rely on the data in the calculations, you cannot rely on the result – the credit score.
Another surprise for many is that the credit-scoring companies can leave out entire sectors of the population. If a consumer does not have any credit (e.g., does not have/use credit cards, does not have loans, etc.), the consumer is considered “credit invisible”. Also, if a consumer has not used credit recently (or has just started using credit), the consumer is considered “credit unscorable”. Neither of these groups will have a credit score. In 2020, about 22% of the US adult population (almost 49 million) fell into one of these two categories. Even if these people pay all their bills on time and are generally considered financially healthy, they are usually denied access to mainstream credit vehicles. The reason for this is the very “narrow” view of financial data the credit scoring companies use. The more years you have been in debt, the better it is for your credit score (you read that right, yet it seems entirely wrong). If you have never had debt because you are foreign, young, or have simply had a healthy financial life, sorry, you don’t have a credit history. With the current credit scoring system, forget about getting a mortgage, a car loan, or even a simple credit card. And even though they know your name, social security number, and birth date, you better hope they’re all incredibly unique. Because more often than should be acceptable, Jane Doe #1 and Jane Doe #2’s information is inverted, or combined.
So, with all the misinformation and mistakes, what are consumers to do? All consumers are entitled to a free annual disclosure of their data upon request from each of the nationwide credit bureaus. Review your data and report any errors. But be warned, there is often a huge backlog for corrections to be made. Hope you’re not in a hurry in this fast-paced world. Use VeraScore!