Life as we know it in 21st-century America is dictated by your credit score. Those mysterious three digits — decided in secret, and as vulnerable to simple accounting mistakes as to willful misdeeds — are the biggest factor in whether the bank decides to give you that life-saving loan; whether the dealership will sell you that car; whether the store will give you that credit to tide you over till payday. All of that can seem arbitrary, unfair and mysterious. Of course, we can’t help with the first two — the arbitrary and unfair nature of it all — but we can help clear up the mystery as to how these three little numbers have come to define our lives.
Where the Credit Score Originated
In the early 1900s, merchants who wanted to sell stuff to customers on credit found that the best way of figuring out which customers would pay on time was simply to talk to other merchants. “City merchants realized that if they could pool their knowledge of which customers could be trusted and which could not, they would all benefit by being able to extend more credit and make more sales, while having fewer losses from the deadbeats who wouldn’t pay,” says Adam Jusko, CEO of CreditCardCatalog.com, a credit card comparison and information site.
The first American credit company, Retail Credit Company, went from merchant to merchant collecting their customers’ payment habits, simplified into one of three categories: “Prompt,” “Slow” or “Requires Cash.” They then compiled this information in a pamphlet called “The Merchant’s Guide,” and sold subscriptions for $25 a year (a giant sum of money at the time).
Demand soon skyrocketed, and as communication systems in the U.S. became more advanced, they found themselves able to collect information on more and more consumers across the country. Eventually, Retail Credit Company became Equifax, while TransUnion and Experian — the two other companies that, with Equifax, make up the big three of the contemporary credit rating game — arrived on the scene as competitors.
It wasn’t until the second half of the 20th century, however, that the credit landscape we know today started to take shape. Up to this point, credit reporting agencies were neither regulated in what information they could collect, nor required to reveal what data was collected that might lead lenders to deny a loan. Even more, they weren’t just collecting data on payments, but also “lifestyle” (i.e., information such as sexual orientation, marital status, drinking habits and cleanliness).
After enough public uproar, the government passed the Fair Credit Reporting Act of 1970, which forced credit reporting agencies to be more consistent in the way they rated consumers, limited how much information they could keep (and for how long) and forced them to be more transparent about how they scored things. After much trial and error, the Fair, Isaac and Company (FICO) score was born. It’s basically an algorithm that analyzes consumers’ past behavior to predict future behavior — or omniscient data that decides, just like those olden-day merchants, whether or not you’re a respectable, trustworthy citizen.
What the Numbers Mean
Since the majority of lenders in the U.S. use the FICO score, your consumption habits — including how timely you are with your bill payments — are run through that algorithm, which spits out your position on a spectrum between 300 and 850 (the closer you are to 850 the better). The FICO equation is often altered to better reflect contemporary spending habits, but generally, the score weights certain behaviors more heavily than others:
- 35 percent of your score is based on your credit history — more specifically, how much of a delinquent you are. You can get dinged for foreclosure, bankruptcy, tax liens and consistent late payments on things like rent and bills. These incidents can take up to seven years to stop affecting your credit score.
- 30 percent of your score is related to how often and to what extent you utilize your current credit card. So if you’ve got a limit of $1,000 and consistently spend $750, you’re at 75 percent utilization rate. To lenders, this looks like you’re thirsty to spend every penny you’re given, which like anything that could be described as “thirsty,” is a risk. According to FICO, the sweet spot for utilization is 30 percent. So even if you’re paying off your credit cards on time, consistently maxing them out is a bad idea.
- 15 percent is based on how long you’ve had credit lines open, so don’t be too hasty to close old, unused credit cards.
- 10 percent is how many credit cards you have open, since lenders like to see that other lenders have trusted you. Since this is a lightly weighted factor, though, it doesn’t mean you should say yes to every cashier offering you a store credit card.
- The remaining 10 percent of your score is based on inquiries into your credit — not inquiries you’ve made yourself, but inquiries made by other lenders. If lenders see you’ve recently applied for a ton of credit cards or loans, they’re going to think you’re either untrustworthy and take your score down a notch.
The Future of the Credit Score
Since the 1980s, our consumption behaviors have moved from paying cash at local shops to digital bank accounts at global online retailers, and our ability to process data has improved exponentially. Naturally, the FICO score has evolved alongside these habits — through five generations, to be precise. The current iteration, FICO 8, is slightly more forgiving of any rare late payments, and weighs your most-used credit card more heavily than others.
Since lenders will always want the most information they can get to help mitigate risk, this system will continue to evolve and incorporate new streams of data. The bad news for compulsive oversharers is that, as the data from our social media and online browsing habits becomes more widely available (especially with recent FCC protections on data collection being rolled back), even this information may start being factored into our credit scores.
“If credit scoring agencies find trends or indicators that help them determine creditworthiness with greater accuracy, there’s no doubt they’ll want to use it,” says Ian Atkins, an analyst for the small-business lending site Fit Small Business. China, for example, is rolling out what’s been described as an “Orwellian” social credit score that will negatively mark people for activities well outside their spending habits, including unpaid traffic tickets, academic degrees and even, for women, whether or not they’re on birth control, alongside other things that the Chinese government is currently refusing to disclose.
Here in America, lenders are also getting increasingly cautious: Smaller lending agencies that have popped up recently — such as Able Lending and Backed — require friends and family to prove your trustworthiness by investing their own money before the lender will agree to do the same. Likewise, if a data scientist somewhere manages to show a correlation between your penchant for lengthy Facebook rants and how often you’re late on the rent, it’s a safe bet that the larger credit companies will view you as unreliable and start to ding your score accordingly.
So if you want to get a head start now by tweeting about how punctual you are with your monthly payments, we won’t judge.