It’s the final day of April and the final day of Financial Literacy Month. Our journey this year took us through a look at stablecoins, interchange income, and payday alternative loans. As we wrap up our mission of learning more about the credit union industry (until next year), I decided to learn more about a key part of the present day lending experience: credit scores. Let’s take a look at how exactly they work, but before we do, a little history first.

Early access to credit

In many ways, the history of credit unions is tied closely to the history of access to credit. As reported in my History of Credit Unions series, credit unions originally formed from a need for access to affordable loans. In Germany in the 1850s, Hermann Schulze-Delitzsch started his Vorschussvereine (or “peoples’ banks”), assembling groups of people associated by a common bond to pool their money and share access to credit when larger banks denied them access.

As Hermann put it: “…your own selves and character must create your credit, and your collective liability will require you to choose your associates carefully, and to insist that they maintain regular, sober and industrious habits, making them worthy of credit.”

These Vorschussvereine were primarily located in urban centers to serve artisans, shopkeepers, and traders. Friedrich Wilhelm Raiffeisen would spread this concept to rural farming communities in the 1860s, convincing the wealthy to pool capital to lend out to locals (and for a reasonable rate of return).

The key behind all of this access to credit though was reputation. Whether at banks or these early cooperatives, businessmen had to convince the financial institutions to lend to them purely on the basis of the word of others.

The first credit bureaus are formed

While lending on reputation worked in small scales, it became clear, especially for commercial credit, that a better system was needed to understand an applicant’s credit reliability. Winding back to the 1840s, but this time in America, a need was arising among creditors to better understand debtors. What was once a system of localized relationships was becoming national. Truly knowing a debtor’s reputation when they were hundreds of miles distant was complicated.

Merchant Lewis Tappan saw this and created the Mercantile Agency in 1841 in New York City. The idea was to form a centralized network of information, using local informants nationwide to provide reports on debtors’ payment habits, business reputation, and asset strength. These reports were sent to the Mercantile Agency who maintained extensive ledgers of those individuals.

While it was effective in centralizing credit history and reputation, it was not without drawbacks. For one, the reports received were subjective and often biased. Without the protections we enjoy today, potential debtors could be cast in a poor light due to their race, gender, or class, reinforcing the existing hierarchy and negatively impacting access to credit.

This early model would still prove to be influential and other agencies would pop up to provide similar services. All had the same failure though: they were highly subjective with no standardization.

From reports to scoring

This system of lending on reputation would continue for decades. For highly localized credit unions lending to individuals with a close-knit common bond, lending on reputation was effective. Credit unions knew their members at a deeper level as regular in-person interaction was the way they operated.

Larger scale commercial lending still relied on those biased credit reports, however. Before the big three credit bureaus (now Experian, Equifax, and TransUnion) could formalize a process for a standardized score, a small company had been laying the groundwork.

Engineer Bill Fair and mathematician Earl Isaac would create the first credit score in the 1950s, under the company Fair, Isaac, and Company—later to be known more simply as FICO. What they sought to do was replace subjective reporting on credit reliability with concrete data, and use a complex algorithm to turn that data into an easily digestible score. Instead of personal accounts of a debtor’s credit worthiness, their payment history, outstanding debt, and length of credit history could be churned into a number.

There was initial pushback as skepticism arose around the new technology and the inclusion of computers and data as opposed to “knowing” the individual. But with the passage of the Fair Credit Reporting Act in 1970—which made credit reporting transparent—and the Equal Credit Opportunity Act in 1974–which made it unlawful to discriminate on the basis of race, gender, etc.—the appeal of a standardized, “unbiased” system of evaluating potential borrowers became more appealing.

In 1989, the FICO score became the most widely used model for evaluating credit, with the big three credit bureaus sending their reports. Its adoption, accompanied with the above Acts, improved access to credit for many individuals as an easily attainable way for lenders to assess credit worthiness. The algorithm has remained largely the same to what it is today, but what makes it up?

The modern day FICO score

While other credit scores do exist, the FICO score has remained the one predominantly used by lenders to make decisions. According to FICO, over 90% of top lenders rely on it.

Though the particulars of the score are shrouded in mystery, per FICO, an individual’s score is 35% payments history, 30% amounts owed, 15% length of credit history, 10% credit mix, and 10% new credit. As a consumer, this last one can cause some indigestion, as even just pulling a credit score can negatively impact the score, though not by much. That said, a “soft” pull does not affect credit at all, and multiple “hard” pulls done within a couple weeks are considered a single instance of credit research.

What can also be confusing to consumers is that FICO scores can vary depending on the type of inquiry and the FICO version being used. For the former, FICO has stated that, for example, an auto lender and a credit card issuer focus on different aspects of your credit profile to determine worthiness. As such, FICO created different scores that cater to those industry-specific needs.

FICO is also up to a version 10 of its scores, and each industry specific score has multiple versions too! It’s a lot to keep track of, but they do a good job of explaining what bureaus use what scores.

Where scores fail and where credit unions are winning

The adoption of credit scores swung the pendulum far from lending on reputation. If all that matters to a lender is your score, especially as technology has improved and auto-decisioning tools have become more common, then individuals with poor credit or no credit can be excluded.

Anecdotally, my first credit union, who I had been a member of for many years, denied my first auto loan because of my lack of credit history, and despite a reliable track record of paying my credit union credit card bill on time. As a young professional fairly fresh out of college, how else was I to build credit? As a result, I ended up going to a big bank willing to take on that risk. And that’s part of where the score’s failure factors in.

When lenders, including credit unions, place a lot of emphasis on the score and not enough on the person, people can be left behind. Newly arrived immigrants might face a similar issue of lack of credit history, preventing them from securing a loan despite their whole profile looking good. What’s more, as scores are snapshots, they can be susceptible to shock due to sudden loss.

And so what we have seen is the gamification of credit scores. People are coached on how to improve their score, not necessarily their finances.

But the pendulum is slowly swinging back. Credit unions recognize their cooperative origins and that concern for community still exists. As a result, we have begun to see more credit unions moving towards a wholistic approach to approvals, looking at an applicant’s entire lending profile instead of relying solely on their score. Reputation-based lending is on the rise, with AI tools being used in combination with deepening member relationships to better understand the member’s full picture.

This is a trend I hope to see continue to grow as credit unions seek to use technology to speed up the dirty work so they can get back to the business of knowing and helping members in need.