Origins of Credit Scoring and Credit Reporting
In 1956, Bill Fair and Earl Isaac founded Fair Isaac to show that through the use of computational formulas and predictive algorithms, the likelihood of default on a debt could be predicted with greater accuracy and fairness than any method in place at the time. Credit scoring was born.
This formulaic approach had a certain appeal because until that point, credit scoring and lending assessments were made based upon factors such as income, history with the lender, length of time employed and how long someone had held their current address. This all took place behind closed doors and more often than not, the credit applicant had no idea what to expect.
This information asymmetry remained a large problem well after the spread of predictive credit scoring algorithms. The key point to understand here regarding the birth of automated credit scoring systems is that instead of relying on the history of just one person, the aggregate credit histories of millions of people are taken into account when predicting how likely one person is to pay off their debt.
Economic Impact of Credit Scoring
The ability to predict with a certain level of confidence, through the use of a credit score, whether or not an individual will default on a loan is extremely valuable in the eyes of a lender. With this information, the marketing and pricing of credit is much more precise and the ability to scale its distribution is much simpler for the lender.
All of the credit card solicitations you likely receive in your daily mail are based on a calculated risk. On average, lenders can quantify the risk associated with lending to the average version of yourself…and in turn, they market to you appropriately.
Some remarkable statistics which can be attributed to the widespread adoption of credit scoring systems include:
- Consumer loans (everything except mortgages) doubling between 1990 and 2000, at which point the total was $1.7 trillion.
- Outstanding credit card debt rose from $173 billion to $661 billion between 1990 and 2002.
- Home equity loans over the course of ten years beginning in 1993 rose from $261 billion to over $1 trillion.
Clearly, automated credit scoring has fundamentally changed the way the financial game is played in this country and it’s critical to be educated as to precisely how the system works and its probable impact on your own personal finances. If you don’t know your credit score, I urge you to take action right away and access your free credit score report by clicking below: