From Inherent Racial Bias to Incorrect Data—The Problems With Current Credit Scoring Models – Forbes Advisor
A good credit score is a gatekeeper to wealth, career opportunities and housing in the U.S., but some say current scoring models aren’t always fair.
Credit scores have gotten attention over the past few years from critics decrying their accuracy and their use of data that is reflective of historical bias while omitting certain types of data (rental and cell phone payments) that might include a broader swath of people, including Black and Hispanic consumers.
Other complaints include the lack of public scoring model options and the fact that scores are used to determine things that have nothing to do with credit, like getting a job.
And suppose you’re one of the approximately 26 million Americans who are “credit invisible,” meaning that you have no credit history with any of the nationwide credit reporting agencies. In that case, you’re essentially locked out of the current credit scoring system. According to a report by the Consumer Financial Protection Bureau (CFPB), Black and Hispanic people and those living in low-income neighborhoods have higher credit invisibility rates.
Data shows that more than 1 in 5 Black consumers and 1 in 9 Hispanic consumers have FICO scores below 620; meanwhile, 1 out of every 19 white people are in the sub-620 category.
Credit scores range from 300 (poor) to 850 (excellent). Although there are many credit scoring models (lenders might have their own proprietary model), the two most common are the FICO Score and VantageScore; the latter was created by the three main credit bureaus: Equifax, Experian and TransUnion.
A Long History of Discrimination Affects the Data That Credit Scoring Models Use Today
The purpose of today’s credit score system is to eliminate bias. Before credit scores, borrowers were deemed creditworthy by lenders using factors such as income, referrals and even home visits. In 1974, the Equal Credit Opportunity Act disallowed credit-score systems from using information like sex, race, marital status, national origin and religion.
Today, FICO considers payment history, amounts owed, length of credit history, new credit and credit mix in its model. But that data may be influenced by generational wealth that many Black and Hispanic borrowers did not have equal access to, says Frederick Wherry, professor of sociology and director of the Dignity and Debt Network at Princeton University.
“We’re often told to stop talking about history, but history won’t stop talking about us,” Wherry says. “The data used in current credit scoring models are not neutral; it’s a mirror of inequalities from the past. By using this data we’re amplifying those inequalities today. It has striking effects on people’s life chances.”
Many Americans have inherited wealth through homeownership, one of the prevailing ways people accumulate wealth. However, for Black Americans, a history of redlining—a discriminatory practice that makes financial services like mortgages unattainable for people of a certain race or geographic location—and outright discrimination has precluded them from buying a home.
An egregious example of discrimination is how millions of Black service members were denied the benefits of Servicemen’s Readjustment Act of 1944, or more commonly known as the GI Bill. The bill was designed to reward service members with benefits that would increase their social mobility. These benefits included higher education financing, as well as housing and unemployment benefits. However, eligible Black service members trying to cash in on the bill were either met with resistance or denied benefits altogether.
So a white service member might have been able to buy an affordable home and pass that home down to their children, who could then benefit from the home equity and the positive financial gains of their ancestors’ ability to purchase a home through benefits like the GI Bill. These are direct results of racial bias, which can undoubtedly alter the path of someone’s financial life.
“On a macroscale, you have one group that benefited from government support. So white service members had the GI Bill and could live in high-opportunity neighborhoods like Levittown where mortgages were a fraction of rental costs, but Black service members were denied these opportunities,” says Chi Chi Wu, a staff attorney at the National Consumer Law Center. “So now you have this racial wealth gap because of that, white families built up equity in their home, inherited wealth, while fewer black families were able to do the same.”
The burden of poverty can trickle down to children who are at a disadvantage when it comes to being scored using today’s methods. Data points like credit length and payment history might not be the same for Black consumers as it is for their white peers, given the enormous disparity in wealth-generating opportunities.
“Children of wealth have been in the system for a long time. Their parents might open a credit card in their name and help them make payments each month. Children in poverty do not enter the system at an early age and, if they do, it’s to inherit debt from parents. Plenty of parents in financial difficulty take out credit in their children’s names,” says Aaron Klein, senior fellow, economic studies at the Brookings Institution.
Rent and Utilities Should Be Data Points in Scoring Models
Researchers suggest that instead of using past behavior (that might stretch back several years or more) to predict future repayment behavior, credit scoring models should also look at cash flow and payment history on rent and utilities. Cash-flow underwriting is based on how much money is in your bank account each day over the year.
FinReg Labs, a nonprofit data testing center, analyzed cash-flow underwriting and the results showed that head-to-head it was more predictive than traditional FICO scoring. Their analysis also showed that using both the FICO score and cash-flow underwriting together offered the most accurate predictive model.
“What makes cash-flow underwriting an improvement on current models is that it’s about their current status, not their past. Credit scoring is great at showing financial distress, such as divorce, which is felt more in incomes of color,” Klein says.
Rental payments are another critical metric that could help boost Black and Hispanic consumers’ credit scores, says Talia Gillis, Harvard Empirical Law and Finance Fellow.
Currently, there is an enormous gap between Black and non-Hispanic white homeownership rates.The Black homeownership rate was 44% at the end of 2020 compared to the 74.5% rate for non-Hispanic white consumers. Since credit scoring models look at homeowners’ housing payments and ignore renters’ rental payment history, Black consumers are at another disadvantage, despite both types of payments falling under the same category of “housing.”
Even people with enormous disadvantages pay their rent, so to maximize fairness, credit scoring companies should “find out what’s important to them and find ways to track those payments. That might be rent or a cell phone bill,” Wherry says.
One recent development that may help balance credit scores is Experian’s Credit Boost, which takes bills such as cell phone and cable into account when looking at a credit score.
Although some newer scoring models do look at rental payments, many still don’t. For example, the FICO score has gone through several iterations, and there are even FICO scores designed explicitly for auto loans and bank cards.
Each version might have a different algorithm that weighs information differently. Older versions of the FICO score used by many mortgage lenders, including those who originate Fannie Mae- and Freddie Mac-backed loans, do not consider rental and utility payments in their models.
Mistakes in Credit Reports Might Disproportionately Impact Black Consumers
Your credit score is determined by private, for-profit, publicly traded companies, which means that their No. 1 goal is to turn a profit, which can be at the expense of consumers.
Credit bureaus are under no legal requirement to be accurate, and “today’s credit reporting bureaus make a tremendous amount of mistakes at the consumers’ expense,” Klein says. However, under the federal Fair Credit Reporting Act (FCRA) the credit bureaus, as well as the entity that provides your credit information (for example Visa, Old Navy or Verizon), must investigate and fix any inaccurate information.
A 2013 Federal Trade Commission study of the U.S. credit reporting industry discovered that 5% of consumers had errors on one of their three major credit reports. Since this is the latest and most comprehensive report on consumer credit accuracy, there’s no way of knowing if accuracy has improved.
However, a recent Congressional Research Service report stated that “consumers sometimes find it difficult to advocate for themselves when credit reporting issues arise because they are not aware of their rights and how to exercise them.”
The report goes on to state that “the Consumer Financial Protection Bureau (CFPB) receives more credit reporting complaints than complaints in any other industry it regulates.”
“There’s an Aaron Klein that didn’t pay his AT&T bill, but it’s on my report. One can understand the level of errors in the system is also correlated,” Klein says. “The credit scoring system has every economic incentive to provide as much data volume as possible with as little cost to provide accuracy as the market will tolerate.”
If what Klein says is true, then figuring out which Aaron Klein is on what credit report is expensive, so allowing for a certain number of errors in the name of profitability is more desirable for these credit reporting agencies. The result can be devastating for consumers.
Moreover, Black consumers bear most of the brunt from lawsuits related to debt collections, according to a Pew Research paper, which states that in New York City, 95% of consumers with default debt claims judgments entered against them lived in low- or moderate-income neighborhoods, more than half were in mostly Black or Hispanic communities.
Additionally, “court judgments over five years in St. Louis, Chicago, and Newark, New Jersey, found that even after accounting for income, the rate of default judgments in mostly black neighborhoods was nearly double that of mostly white ones.”
“People don’t appreciate the impacts of a small claim judgment. If this is on your record, you’re not going to get a housing loan or a car loan, and it impacts other areas of your life. And all for a very small debt claim,” Peter Holland, a consumer attorney in Maryland, stated in the Pew report.
There have been recent efforts to promote precision in credit score data. In 2020, the U.S. House of Representatives passed the Protecting Your Credit Score Act (H.R. 5332), which would amend the federal Fair Credit Reporting Act (FCRA). The bill’s primary goals are to improve credit reporting practices by requiring stringent guidelines around data accuracy and giving consumers broader access to their information and more say in correcting false information on their credit reports. The bill never passed the Senate, dying in the last administration.
A Public Credit Scoring Agency Would Help Promote Fairness
Critics also believe the three credit reporting agencies have formed an oligopoly. Consumers have no say in which companies can access their data, and they have no choice in which company is used to provide their credit report to any entity that might require it.
If your score is being dinged by mistakes on one of the credit bureau’s reports, consumers still have no say in which credit bureau or credit score to use. It’s like forcing someone to ride a bike with a flat tire in a race. It’s the only bike available and you have to get in the race.
Credit reporting agencies have almost limitless access to your consumer information. They can get reports on everything from your credit card payment history to bounced checks to filling out a mortgage application. This data is then monetized and used to determine whether you qualify for anything from a credit card or bank account to an apartment or a job.
“I’m not saying we need to eliminate private credit scoring companies but I think it’s a win if you create a competitive environment with consumers by having that public option available,” Wherry says. “It’s like USPS and FedEx. I have the choice to go with a cheaper public mail carrier or get special services from a place like FedEx. We create a public entity for something like the post but not something as monumental as your credit score.”
Effects of Credit Scores on Your Quality of Life
People with high credit scores (often referred to as prime borrowers) are lavished with low-interest rates, access to the best credit cards, housing and even career opportunities.
Subprime borrowers—or those with credit scores typically in the 580 to 669 range, can be denied loans, housing and jobs. They’re often left with higher credit card and mortgage interest rates compared to their high-scoring peers.
Using data that reflects bias perpetuates the bias, critics say. A recent report by CitiGroup states that the racial gap between white and Black borrowers has cost the economy some $16 trillion over the past two decades. The report offers some striking statistics:
- Eliminating disparities between Black and white consumers could have added $2.7 trillion in income or +0.2% to GDP per year.
- Expanding housing credit availability to Black borrowers would have expanded Black homeownership by an additional 770,000 homeowners, increasing home sales by $218 billion.
- Giving Black entrepreneurs access to fair and equitable access to business loans could have added $13 trillion in business revenue and potentially created 6.1 million jobs per year.
What to Do If There Are Errors On Your Credit Reports
Although credit scoring models still have a ways to go in terms of fairness for all people at all times, consumers should be vigilant about making sure their data is correct. You are currently entitled to free weekly access to your credit reports by Equifax, Experian and TransUnion.
If you see an incorrect event on your credit report, be sure to dispute it immediately, in writing, to both the bureau and the original source, according to the FTC. For example, if you’re making on-time car loan payments and your credit report inaccurately states that you were late on a payment, contact both the bureau that reported it and your car loan lender.