The History of the Credit Scoring System
Posted on 16 August, 2022 by Miranda Bottas in Finance
The History of Scredit Scoring: Where It Began, How It Developed, and Where We Stand Today
The credit scoring system is the universal and primary basis for achieving both financial and lifestyle goals in America.
When young Americans excitedly step onto a local car lot to purchase their first vehicle or begin scouring the web for the perfect first home, they quickly learn that the most critical party to satisfy isn't the seller. It's a lender... and securing a loan from that lender only happens with the FICO credit score stamp of approval.
Lenders have always been looking for the most promising way to assess people's trustworthiness & the likelihood that they'll make good on their commitment to repay the money lent to them. Lending money is an extremely lucrative business for banks & financial institutions, but only if borrowers pay. Clearly, this makes determining the probability of prompt and complete repayment one of their top priorities.
Enter the American Credit Scoring System. From the 1800s until today, American lenders have experimented with various methods for determining the creditworthiness of an individual. Beginning with simple character assessments & evolving to more statistical credit scoring, it's been a long and continually evolving process.
Imagine a system where strangers decide to trust you (or not) based on factors that are completely out of your control. Maybe it was your family, your appearance, your skin color, your personal skills or your social circle that decided your fate when asking for a loan - regardless if these factors held any logical basis on the ability to repay your debt. These tactics were used throughout the ages to varying degrees. Sometimes based on the region or country, your home's location, or maybe cultural norms and other ideals. Regardless, the practice of credit scoring has taken a long and tireless a journey from overt discrimination to highly advanced digital data algorithms and everything in between.
Perhaps it's possible that understanding the history of this system could shed some light on why credit scoring matters as much as it does today in America.
The History of Debt
When did the push & pull between debt and credit begin? A long time ago. In fact, it was a really, really long time ago.
The Agrarian Empires of Mesopotamia, Pharaonic Egypt, Bronze Age China, and the Indus Valley once kept tabs on debt by determining the equivalent of different crops to the value of silver. However, payments in silver were not mandatory and often not common, but it was the value appended to silver which acted as a base for cost. Payments could have been made in barley or anything else readily available & accepted by the lender.
We've definitely come a long way since then. Can you imagine keeping a record of your debt etched into a cuneiform tablet rather than tucked inside a manila folder, or within a bank app on your smart phone? In ancient credit-based societies, long-before centralization, this is the way things worked. And generally, both parties kept their own record - especially for large debts. Two stone tablets seems like a lot of work for recording a loan, however, it may have been and seemingly easier and less frustrating process than dealing with lenders in modern times. A downside? For nearly 2,000 years, the standing interest rate was (roughly) a whopping 20%.
As time passed, peasants started becoming deeply indebted to wealthy lenders & had to surrender their farms and family members to pay their dues. When this became a widespread problem in a society, many rulers began to forgive debts, essentially giving people their lives back (and allowing them to return to their families). An interesting fact? The first recorded word meaning "freedom" was the Sumerian word amarga, which meant "return to mother".
Unfortunately, the tradition of lending money at interest spread forward from early civilizations without the original checks and balances that once restored people and property to a fair status. It remained a personal practice, but one that offered lenders a great deal of information & control over their borrowers. Civilizations and sometimes even whole nations began to forge new strategies to track people's debt, record their payment histories, and even compile information on one's moral character to determine whether it would be wise to lend them money in the first place.
Origins of American Credit Scoring
What did this credit tracking look like in early America? In 18th-century, country store owners asked reputable neighbors to share a good reference with bank owners and merchants to help build a good name for themselves. When urban creditors received credit applications, they would search high and low for acquaintances who would be willing to dish out the facts on the applicant's life choices or general trustworthiness. It was very much a word-of-mouth type of scenario.
The period eventually came when the need to modernize this time-consuming system arose, which was sometime in the 1820s. Experiments began to create more streamlined & standardized commercial credit scoring, most of them resulting in slow but sure progression.
One man in particular, a merchant named Lewis Tappan suffered severe financial hardships during the panic of 1837, a depression provoked by nothing more than the overextension of credit by merchants. When he finally recovered and repaid his debts two years later in 1839, he figured it would be an excellent idea - at least for his financial benefit at the time - to begin offering credit to his existing customers.
Tappan began by keeping makeshift credit files containing the character traits and perceived credit worthiness of various customers. He then founded the Tappan Mercantile Agency in 1841. When he first began to utilize these records to offer loans, some people felt it was insulting or a gross invasion of privacy. But by 1844, business was booming and they had 280 clients spread over Boston, Philadelphia, and Baltimore.
Tappan had an abolitionist network across the Union who were also providing him with up-to-date credit information about people in their communities. These correspondents were generally part-time, unpaid workers. A decade later, the company had 2,000 full-time correspondents.
The company changed hands from Tappan to Benjamin Douglass in 1849, then to Robert Graham Dun in 1858. Several decades later in 1933, R.G. Dun and Company merged with its biggest rival, Bradstreet. Together, they formed the world's largest credit reporting company, Dun & Bradstreet. We're sure you've hear the name, and Dun & Bradstreet continues serving businesses with critical credit data and other record-based insights today.
Credit Reporting Before Modern Credit Bureaus
Mercantile agencies were actually the first credit reporting agencies; they reported on various businesses throughout the Union. Tappan's Mercantile Agency for example, employed 30 people in their New York office who recorded and read people's credit records to customers who inquired about potential borrowers. By 1870, R.G. Dun and Company had grown to 28 branches in several major cities and served nearly 8,000 clients.
The Mercantile Agency was the solution to a longstanding business problem: how to know who to trust with credit. At this point in time the leading banking, importing, manufacturing, and wholesale merchants in the United States and Canada utilized the agency's credit reports.
While many American business people had positive sentiments this credit reporting system, some had major complaints about inaccurate information shared by correspondents who weren't compensated or held accountable. Reports might include:
- A person's marital status
- Church affiliation
- Estimated financial worth
- Supposed bad habits
- Information about late payments
People's official credit reports could also contain gossip or rumors - information that wasn't necessarily accurate but would ultimately impact their lives and businesses. In addition, credit reporters were typically white men, so the racial, class, and gender biases of the times often shone through in their reports.
In 1870, Dun published reference books containing the most up-to-date information on 400,000 businessmen. Between the reference books, full-time reporters implementing more systematic-based methods, branch offices, the telegraph, and the typewriter, credit reporting agencies became more firmly planted and widely utilized in America.
Until the establishment of the first credit bureau in 1899, the mercantile agencies had been the go-to for business credit information. Yet, it would still be nearly another 50 years before credit reporting benefited consumers; up until this point, it was exclusively a business resource.
The First Consumer Credit Bureau Issues
Businesses had already taken a deep dive into the world of credit reporting by the time consumers finally got a chance to dip their toes in.
In the early twentieth century, new products inundated retail stores, and consequently, many retailers began to offer credit to help people buy more stuff than ever before. Win-win, right? By 1912, various retail credit managers joined together to form an association to develop standard practices for collecting, sharing, and codifying data. They learned from the methods of Dun & Bradstreet and combined efforts to establish a trail through the retail credit wilderness.
Who can we credit for these early advancements in retail credit? Atlanta's Retail Credit Company (RCC) was one who left a considerable impact, developing credit files for millions of Americans between 1899 and the 1960s. They compiled credit, capital, and character data plus chronicled people's social, political, and sexual choices. But when the RCC decided to computerize the records in the 1960s, many critics were enraged because doing so would make it impossible for people to outrun their past mistakes. Without a doubt, judgments against individuals' personal lives would begin to disqualify them from financial opportunities.
However unfair, moments of hardship, personal choices, and even social choices were all fair game for credit companies, and the records followed people from one city to another.
The RCC changed its name to Equifax in 1975 & kept its eye on the prize: computerizing those credit scores. Today, Equifax is one of the 'Big Three' consumer credit reporters, alongside Experian and TransUnion.
Fair & Isaac Solve the Issue
Credit cards appeared in the 1950s, and lenders often granted credit access on a personal basis only. However, this resulted in many borrowers defaulting on the payments. On the other hand, conservative lenders continued to discriminate potential borrowers based on age, sex, ethnicity, and marital status. This practice of determining creditworthiness based on unfair judgments & biases was cruel and demeaning.
But in 1956, an engineer named Bill Fair and a mathematician named Earl Isaac conspired to find a more intelligent way to employ data and help businesses make better decisions. After seeing how past systems allowed room for error and discrimination, they wanted to use efficient statistical algorithms and computer technology to create a more dependable process for credit scoring.
Fair & Isaac introduced their first scoring system, Credit Application Scoring Algorithms, in 1958. The system was intended to statistically predict the payment behavior of credit holders, including whether they'd pay on time, late, or not. It's exactly what retailers & lenders needed to know.
In 1960, Fair & Isaac launched a new INFORM product, which could build newer and more reliable scoring algorithms based on a customer's past borrowing behavior. In the same year, they incorporated Fair, Isaac and Company. Now, companies could use these algorithms to make fair lending decisions instead of relying on personal references, third-party gossip, or discriminatory biases.
Hesitancy to Adopt the New System It sounded like a perfect plan, but many lenders resisted in changing their ways. First, Fair & Isaac's system required computer access, which was still making its way into the mainstream. But, in the seventies, faster microcomputers made the Fair & Isaac credit scoring system more accessible, automating the entire process.
Old habits die hard, and throughout the 70's lenders struggled to let go of their discriminatory practices. But, in 1974, a new law insisted that it was time. It was called The Equal Credit Opportunity Act, and it barred any discriminatory factors from playing a role in the credit scoring process. So, the antiquated reporting systems were not only unjust; now they were illegal, and the new automated Fair & Isaac process would become the new standard almost overnight. Fair & Isaac were now ahead of the times, ahead of the game, and ahead of their competition. Finally, every North American would finally have a fair, codified financial identity that nearly anyone could access. It sounds like a dream come true, right?
FICO Scoring Becomes a Widely Used Practice
In 1989, the FICO score was released to the public and enabled people to receive objective evaluations when applying for credit, mortgages, or loans. The days of zip code, moral decisions, and social status were finally factored out of the equation and the consumer could see a number that is representative of hard, financial-based data sets.
From ancient times until today, debt and credit reporting often find their places in creating social hierarchies. The algorithms used today in credit scoring are certainly less discriminatory, but their general existence can still keep people with low scores (or no scores) from easily making forward progress. This is why starting early (although it's never too late) is an important factor in building good credit, expanding your financial opportunities, and ultimately utilizing your credit score as a powerful resource to improve not only your stability but flexibility as both an individual and a consumer.
While everyone makes errors, we all make them in different ways, and in different areas of life. For those who have made credit errors or fell on hard financial times that led to extensive debt, there are many methods of credit repair. Sometimes it's just a simple mix of time and dedication. Other times, it's a matter of utilizing the law to your best ability - this includes the right to buy tradelines to increase your credit score.
Regardless, we can only hope that through innovation, compassion, and collaboration, credit scoring can be a tool for personal freedom, or "amarga", and the ability to rediscover a quality of life that goes uninhibited by financial restraints.
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