Credit Scoring Is Changing, So I Asked An Expert What's Coming Next
If you're in the US, odds are you've had your FICO credit score pulled to rent an apartment, apply for a credit card, or get a loan. FICO scores are used in about 90% of major lending decisions and they might feel like a fact of life, but, like Taylor Swift, they've actually only been around since 1989.
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And we may be heading into a new era of credit. Last month, the Wall Street Journal reported that several large banks and lenders are beginning to look beyond FICO credit scores, and president Biden has also discussed plans to shake up the credit scoring industry. And believe it or not, these changes have potential to be pretty good news for anyone who's working on building their credit scores.
BTW, if you're a little foggy on how credit scores work, we got you. Check out this handy guide to all things credit.
I talked with Cynthia Chen, cofounder and CEO of the free credit-building tool Kikoff to learn more about the future of credit scoring and what the move away from FICO could mean for you.
Building your FICO credit score from scratch can be pretty tricky because you kinda need to have credit to get credit. Cynthia Chen calls it a "chicken-and-egg situation."
There are also a lot of myths and misconceptions about credit scores out there. Combined with a lack of financial literacy education, you've got a recipe for a whole lot of credit confusion.
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Credit scores are supposed to show lenders that you can be responsible and pay your bills, but they're not super intuitive to figure out. For example, you might *think* that paying off your student loans would be good for your credit. In fact, your FICO scores can actually drop when you pay off a loan because it no longer shows up on your credit report as active. So if you haven't been educated about the ins and outs of this wonderland-style logic, you can find yourself at a strong disadvantage.
Experiences like this are part of what motivated Chen to start her company. "I immigrated to the US when I was 17 to attend college on scholarship. I didn’t have parents to teach me about credit or add me to their credit cards, so I had to navigate the credit system on my own," she explains.
So why the move away from FICO scores? For one thing, pandemic student loan and mortgage pauses made it a lot harder for banks and lenders to judge creditworthiness from FICO scores alone.
Additionally, the kinds of data that FICO credit scores are based on disproportionately blocks Black and Hispanic consumers from gaining access to credit, so a credit scoring model that's truly inclusive is deeply needed.
Your race isn't supposed to be a factor in calculating your credit scores. However, the lasting economic impacts of slavery and discrimination against people of color in America still show up in the credit scoring process and there continues to be a deep racial wealth gap. Last summer's Black Lives Matter protests called more much-needed attention to this issue, and banks and lenders should take notice. One thing that experts and activists say can help level the credit score playing field is factoring rent and utility payments into our scores.
Chen also points to programs like Project REACh, where participating banks look at info like a consumer's account balance and overdraft history instead of FICO scores to make lending decisions. This program is designed to help people with no credit scores get access to loans, mortgages, and credit cards.
Plus, personal finance (and the entire world) has changed A TON since 1989, so it makes sense that credit scores could use a makeover in 2021.
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"For example, most rent payments, utility payments, subscription services, and non-traditional loans are not captured on FICO reports," says Chen. "A modern Gen Z'er who rents a shared apartment and relies on carsharing could very well be completely invisible to the FICO scoring model, despite having a high-paying job and years of on-time payments to subscription services." Experian's Boost feature, which adds on-time streaming service and utility payments toward credit scores, is one example of the steps that credit bureaus and banks can take to be more inclusive.
For another solution, Chen says that banks are looking into partnering with companies like Plaid so they can get a better picture of consumers' rent, utility, and other bill payments. But she says that's just a start. "We should consider what other consumer behaviors are signals of financial responsibility and solve for how that data can be accessed in order to provide a more complete picture of creditworthiness."
So, as banks and lenders shift away from basing decisions on FICO scores alone, they're looking for more information to get a holistic picture of your finances.
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When banks and lenders determine who they'll lend to, they use a process called underwriting. Chen says that in many cases, you can "think of underwriting like college admissions, and FICO scores like an SAT score. It’s no doubt an important factor, but most admissions will want to see a more holistic resume — just as lenders want a more complete financial picture to better assess creditworthiness." At the same time, some banks are creating their own proprietary credit scores, while others are leaning more on the VantageScore credit scores that you see in many financial apps like Credit Karma.
So, credit decisions are going through changes, and if things like rent and utilities get factored in, it could be way easier to build up a healthy score in the future. But we're definitely still in a transition period, so what should the average person do to get or keep a healthy credit score, no matter what model is being looked at?
First, don't get too hung up on a particular score. Instead, Chen says that it's better to keep up on your bills as best you can and use credit responsibly. "Scoring models can and do change, so people should focus on making sure they have a healthy mix of tradelines and that they are acting responsibly with every item they have. If you are making all of your payments on time, that is the sort of creditworthy behavior any lender would like to see."
She also recommends checking your credit reports from all three bureaus regularly, taking steps to protect yourself from identity theft, and being a lifelong financial learner. "The more you learn and practice healthy financial habits, it will shine through in your actions, and lenders will see this. Budgeting and goal-setting is a great place to start," she advises.
What kinds of changes would you like to see in the world of credit scoring? Share your thoughts in the comments!
And for more stories about life and money, check out the rest of our personal finance posts.
