Last fall, a few months after leaving his job as chairman of the Federal Reserve, Ben Bernanke tried to refinance his mortgage. In spite of his prior position, a recent seven-figure book deal and the ability to earn a quarter-million dollars for giving a single speech, the bank turned him down for the loan. The amount: less than what he’d earn with three speeches.
Bernanke’s experience highlights flaws in a system that many consumers neither understand nor trust – and not just those who’ve been rejected for a loan. Managed by a handful of private companies and based on secret scoring processes, credit reports can have a dramatic impact on the financial prospects and overall lives of individuals and organizations. But though credit rating plays a necessary role in the overall banking system, the industry’s approach to assessing creditworthiness can harm both consumers and lenders. For instance:
- Credit rating agencies’ criteria reward some financial behaviors – like having multiple credit lines open – that may benefit lenders more than customers, while penalizing people with responsible financial habits just because they’ve stayed out of debt.
- Credit ratings can be seriously damaged by small blemishes that aren’t representative of people’s actual credit record, with collections agencies often called for unpaid amounts of less than $100. And many people remain unaware of these black marks on their records until the damage is already done. Worse, a 2013 federal study indicated that the credit reports of up to 40 million Americans have mistaken information – errors that in many cases can significantly lower their credit scores and also be a nightmare to fix.
- Credit ratings are closely tied to housing and employment opportunities, and they penalize people with multiple or recent job or address changes, or with less predictable income – even when that income is considerable (this was likely the reason for Bernanke’s rejection). Despite recent and pending legislation to place restrictions on the use of credit reports in the hiring process, almost half of U.S. employers conduct credit checks on prospective employees before they hire, making bad credit a major obstacle for people who are already struggling.
Further complicating the issue, factors like these have a greater impact on lower-income populations, particularly minorities, young adults and new immigrants, excluding them from the financial, housing and employment opportunities they need to get ahead. And what’s worse, 54 million people in the United States (and 4.5 billion people globally), have been deemed “credit invisibles” – those who have no credit standing at all. For many of them, their years of reliable payment on rent, utilities and phone bills aren’t captured, with credit agencies only noticing them when their payments are late or delinquent. The result: a financial system that excludes millions – including many potentially attractive customers.
This situation seems to be changing, as the U.S. Consumer Financial Protection Bureau brings new scrutiny to the credit rating industry. Last year, Fair Isaac, which tabulates the widely used FICO credit scores, announced that it was recalibrating its scoring process, due in part to findings from the regulator that it was over-penalizing customers for medical debts. And rating agencies TransUnion and Experian have recently begun advocating for broader credit reporting that considers on-time utility and rent payments, rather than focusing solely on loans, credit cards and mortgages – a move that could help millions of consumers with thin credit get better access to loans.
But in the meantime, some businesses are taking matters into their own hands, reaching entirely untapped segments of the loan market through innovative new methods to determine creditworthiness. For instance:
- The Mission Asset Fund is helping thousands of people – particularly Latino immigrants – build a credit history through their participation in informal lending circles. Based on the tanda model, these groups collect regular payments from members, and then distribute the combined amount to each member in turn. Besides helping members accumulate savings, the system opens a path to formal finance: members’ payments are reported to credit bureaus, leading to a credit score for 90% of participants.
- Lenddo developed an algorithm that determines people’s creditworthiness based on their social media presence – their interests, their friends, etc. – and their performance with Lenddo loans. It initially had its own loan portfolio lending mainly to the emerging middle class in developing countries, with a bad loans ratio that was better than the microfinance industry’s average. But as its algorithm improved, Lenddo recently stopped lending to focus on helping banks, e-commerce sites and other clients evaluate their customers’ trustworthiness. Meanwhile, the practice of using social media and other online activity for credit scoring has spread to other companies.
- Also focused on U.S. Latinos, Progreso Financiero bases its credit scoring model on an analysis of the financial patterns of Hispanic households, which often include extended families. Since multiple individuals contribute to bill payments in many of these homes, the company takes each individual’s contributions to rent and living expenses into account when considering them for loans. And it reports to the major credit rating agencies, helping its borrowers broaden their access to credit.
- Earnest uses big data – 80,000 to 100,000 data points per applicant – to assess everything from applicants’ educational background and earnings potential to the timeliness of their rent payments. It’s one of a number of companies geared toward young people, whose sparse credit histories and significant student debt make them appear risky to ratings agencies that don’t take their considerable career prospects into account.
With non-traditional credit scoring methods extending to small businesses, and similar approaches being launched in countries around the world, the credit scoring industry may be facing some very turbulent years. But whether these changes displace the legacy ratings agencies or force them to become more equitable and transparent, borrowers are likely to come out ahead.