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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is the former chair of the FDIC and author of Money Tales, financial education books for children.
The US surgeon-general has decided that drinking is hazardous to our health. Alas, no official has warned of the dangers of credit scores. Touted as a signal of financial virtue, credit scores, in fact, manipulate consumers into perverse financial behaviours. It is time to call them out for what they are: a hazard to our financial health.
Regrettably, the scores are as ubiquitous as beer on a college campus, used not only by lenders, but also by landlords, insurance companies, even dating apps. Countless “financial education” programmes lead young people to obsess over how they can build a top score. But rather than focusing on good money skills, the scores reward you more if you borrow a lot (and always make loan payments on time). They serve the interests of the lenders, not consumers.
Credit scores are dominated by Fico, the eponymous product of the Fair Isaac Corporation. Fico’s algorithm analyses credit data provided by a triopoly of “credit bureaus” — Equifax, Experian and TransUnion — which in turn, collect data on individual borrowers from lenders. These three credit bureaus launched a competitive score called “VantageScore” in 2006 but, like Fico, this also rewards borrowing, less so financial prudence. The US scores of both range from 300 to 850.
Whichever score you are measured by, you will be rewarded if you take out multiple credit cards. You will be rewarded if you add to the mix other types of credit such as personal loans, car loans or mortgages. While the credit scorers want you to be a serial credit card borrower, they can penalise you if you exceed 30 per cent of your limit on those cards. If you are a young person with a low credit limit, this will encourage you to take out even more cards. You will get little, if any, score boost for settling bills on time or paying off your credit card bill every month. In fact, you can have a nice high score if you just make the minimum payments on your credit card. Never mind that by doing so, it could take you years to pay off your debt, while you incur interest.
For years, Fico and the three credit bureaus have given lip service to incorporating non-debt measures into their data collection and scoring models — things like paying rent, or phone and utility bills. Yet only about 5 per cent of credit files have such information. (The scorers companies blame utilities and landlords for not reporting this.) Experian offers a free service called “Experian Boost” which allows consumers to supplement their credit files with good bill payment histories. But those using this service see, on average, a mere 14-point boost in their scores. For comparison, if you are more than 30 days late on a loan payment, your Fico or VantageScore can be whacked down by 100 points.
Financial regulators are complicit. Bank regulators generally do not use credit scores in gauging a bank’s loan underwriting and capital strength. However, the Federal Housing Finance Administration relies on them in setting capital requirements for Fannie Mae and Freddie Mac, the two government-sponsored entities that dominate US mortgage finance. To their credit, these agencies — with FHFA’s blessing — have started using rental data as a factor in deciding whether mortgage borrowers meet their underwriting standards. But scores still have a major impact on decision-making as the capital rules make high-Fico loans more profitable.
Credit scores have commoditised borrowers. More personalised assessments of an individual’s financial responsibility have given way to robotic lending decisions based on that big Fico score stamped on our heads. Fortunately, financial technology is increasingly providing prospective borrowers with the means to easily and securely share their bank account records with lenders. In this way, lenders can see how they’ve handled their money over time. Have they regularly paid bills? Do they have sufficient cash flow to make their loan payments? This kind of information is much more relevant to individuals’ credit worthiness than whether they have five credit cards.
Regulators should encourage this kind of “cash flow underwriting” and eliminate regulations that rely on credit scores. For young people, the true path to financial virtue is sticking to a budget, saving regularly, avoiding debt and paying off any credit card balance every month. Encouraging them to have multiple credit cards and other loans sets them up for failure. It enables overborrowing while making it more difficult for them to track their credit usage.
Credit scorers want us to borrow a lot so we can borrow more, while punishing us severely if we are late on our debt payments. Prominent warnings are needed. Consumers should beware.
