The History Of Credit Scores

If you don’t entirely understand credit scores, you’re certainly not alone. Plenty of Canadians puzzle over how to navigate the modern credit industry as the seek to get a car loan or other forms of credit, which at times can feel confusing.

As they say, knowledge is power. The more you know about the credit industry, the better you can manage your credit score and in turn write your financial destiny. This includes knowing how credit scores even came about. While a history lesson might not seem powerful, as you learn this interesting knowledge, you will see how it can help you to better understand your credit score, why it even exists in the first place, and what you can do to improve it.

After all, credit affects so many areas of your life. It can determine if you get a car loan, where you can live, and even what you pay for insurance coverage each month. Some jobs will even periodically pull your credit file to see what’s on there. Ignorance in this area can cost you dearly.

The Beginning

Before our modern credit industry arose, times were far simpler. You could go into a store or bar and get different items on your tab, based solely on your reputation. In many rural areas of Canada, everyone knew everyone else, so the people who had a tendency to not pay their debts had a reputation business owners were well aware of.

When business owners in those rural areas wanted to get a loan from a creditor in one of the cities, they had their rural neighbors and customers vouch for them. It was kind of an early form of the current credit system, only it was more of an honor system where people kept each other in check.

Of course, being an outsider, you would struggle to get credit. This is why it was important for people who wanted to get ahead to settle down in a specific area and establish a well-known reputation.

In the cities, a person would apply in person at a bank for credit. How the applicant was dressed, spoke, and even their body language factored greatly into the decision. Bankers were notorious for scrutinizing every detail about a person who came in the doors and sat at their desk to ask for a loan. They didn’t have a credit score to go off of and many times there was no lending history for the banker to look at, so they relied on these other indications. To say it was a method which was less than precise would be accurate.

Changes

With populations growing and people moving more often, this word-of-mouth credit system didn’t really work anymore. Not only was there the problem of people not having an established reputation with their neighbors as much as before, the sheer volume of credit applications had increased dramatically. It wasn’t practical to ask neighbors and others in a community about someone’s reputation, because the process was cumbersome.

There was another challenge to the old system: newer bankruptcy laws in North America. Creditors were facing greater risk when extending credit, because the recipients of that money could possibly walk away without paying much of what they owed.

Banks knew they needed to keep lending money to people wanting to establish businesses, but that the way they had been doing it needed to change dramatically. What followed was a series of experiments in evaluating a person’s creditworthiness. These different methods were anything but perfect, however it’s important to know about them so you can understand how we arrived at the system that’s in place today.

Mercantile Agency

One of the earliest examples of a standardized credit system sprung up in the United States in 1841. Called the Mercantile Agency, it was the dream of Lewis Tappan, a businessman who had taken significant financial damage in a depression back in 1837. That depression was the result of merchants extending too much credit to their customers, which backfired in a big way.

Tappan’s idea was to get information about debtors by mining informants spread throughout the United States. That information was put into ledgers stored in New York City, where the country’s major banks were based. This system was open to all kinds of personal interpretations, with informants lacing their reports with their own bias towards certain groups in the population. It’s not difficult today to see how that was problematic, but at the time the Mercantile Agency was seen as a breakthrough in evaluating the creditworthiness of various individuals.

Many of the reports from the Mercantile Agency, as well as rival the Bradstreet Company, proved to be difficult to interpret. It wasn’t uncommon to find information the reports that today would seem completely irrelevant to a person’s ability or willingness to pay a debt. It might include details about an individual’s shopping preferences, known past times, and even the general demeanor of the applicant. Some credit applicants had conflicting information in their reports, thanks to multiple sources providing their completely subjective opinion about the person, leaving potential creditors wondering whether it was a good idea to extend a line of credit to them or not.

Starting in 1857, the Bradstreet Company started working on an alphanumeric rating for different borrowers. It was still based on the biased and often unintelligible information that had been gathered from informants, but it was easier to reference, and so creditors responded better to the system. The Mercantile Agency, which had been renamed R.G. Dun and Company, helped hammer out this new method of credit reporting, which took on a more solidified form in 1864. Nothing like it had ever been done, so while not perfect, it was revolutionary in every way.

Private companies were gathering all kinds of information about commercial borrowers of credit. That information was then pooled into reports that creditors could pay to access, helping them to assess if someone was a good risk or not. To make the reports easier to understand, a rating was assigned to each person, so creditors didn’t have to read line after line in the full report.

This was the first time that a commercial borrower had a reputation which would follow him no matter where he moved in North America. As a result, many believed this new system had the ability to eliminate much of the dishonesty that plagued the old way of doing things.

Consumer Credit

The system developed in the United States was only used for commercial borrowers, people wanting to establish businesses or expand them further. Consumers weren’t included in these reports because business owners still knew their customers well enough and goods didn’t cost too much, making it unnecessary.

That all changed with the labor movement that started in the late 1800s. Workers were making more money and didn’t spend as much time in the workplace. That meant a greater interest in goods and items previously considered luxuries. Department stores quickly supplied everything a person could want to outfit a house, including furniture and other expensive items.

In the early 1900s automobiles were transforming how people got around and even worked. These expensive machines required a line of credit for many consumers to afford one, and the banks saw an opportunity in the form of offering a car loan to borrowers.

Unlike in commercial lending, there wasn’t a single reporting agency or even two which worked to provide a report on the creditworthiness of consumers. Instead, what evolved was a fractured and disjointed network of competing private enterprises which tried to track consumers and their borrowing behavior. Many large retailers had their own credit tracking services which worked in-house to determine whether a customer should be extended credit for a purchase or not.

Over time, these various groups started to pool information on consumer borrowers. Eventually, consumer credit reporting agencies were formed, patterned after the model created for commercial loans. That meant information which was collected went well beyond just people’s borrowing behaviors and financial means, extending into their sexual, religious, and other private practices. This understandably angered many consumers, who felt that these types of details had no bearing on their creditworthiness.

With social and political pressure mounting, laws like the Fair Credit Reporting Act (FCRA) were passed in Canada. These laws controlled how consumer data is collected, distributed, used by potential creditors, employers, landlords, and more.

Evolution Under Law

Instead of the FCRA in Canada, or a very similar law with the same name in the United States, killing the credit industry as some feared, it transformed it in many ways. Some jumped out of the credit reporting business, but new entities were created that followed the new laws closely.

Two of these new credit reporting bureaus were Equifax and TransUnion, which are still widely used in Canada today for things like qualify for a car loan. These agencies weren’t tracking information outlined as illegal by law, but they were still struggling how to easily portray to creditors if consumers applying for a loan were a good risk.

For one thing, it was difficult if not impossible for creditors to interpret and compare the credit reports generated by these bureaus. This led to the creation of the Fair, Isaac and Company, or what we know today as FICO.

This new tech firm had a fancy credit-scoring algorithm which would combine information from the credit bureaus. Creditors would receive a simple-to-read report as well as a score to help them decide if someone was a good risk or not.

What you might not realize is FICO had been around since 1956, thanks to engineer and mathematician Bill Fair, who had a dream of creating an automated credit rating system. His credit score algorithms were at first a huge failure because the credit industry didn’t see the value in them. Still, Fair and his company worked to refine the approach, eventually turning to computers to help crunch the numbers accurately and with greater speed. The emerging credit bureaus were storing consumer information on index cards, which understandably was cumbersome to manage and could only be accessed in a central location. That meant the entire application process for something like a car loan had to be performed by hand, including deciding who would be approved or denied.

Thanks to the advent of new government regulation, creditors needed a system which would be perceived as fair and unbiased, which was the promise of FICO. It was a big leap forward for the credit industry, because unlike before, decision to extend credit and the terms for different loans were made mathematically using the same factors for all applicants from coast to coast.

The FICO score caught on quickly as creditors realized the value of this unbiased and thorough method for evaluating consumers.

Credit Scores Today

Overall, the FICO score has seen relatively little change from that original algorithm. Various factors play a role into the calculation of a three-digit score ranging from 300 and 900, such as payment history on a car loan, current balances on items like credit cards, and credit utilization.

Despite many thinking there is only one credit score for each individual, there are multiple scores. They are used for different purposes, like applying for a car loan, assessing risk for insurance, or applying to rent an apartment.

While the credit score of today is based on mathematics and cold, hard numbers, it seeks to achieve what the original credit system from way back also attempted to discern who is able and willing to pay their financial obligations.