Have you ever wondered where and when the practice of credit scoring started? Probably not, but I’m going to tell you anyway. If you’re like me, you may have just assumed that credit scores have been around forever, but believe it or not the phenomenon of credit scoring started more recently.
Before credit scores or any credit ranking system, merchants had to gauge a borrower’s responsibility from past experience and word-of-mouth information from other merchants. That “reputation” system worked well in small, localized communities but when merchants began trading far and wide it fell apart.
Actual credit bureaus started around 1860, where the first list appeared of customers and their credit reliability. The list was sold to merchants and basically just provided a written account of the same reputation system.
In 1866 UTLX, which would later become Transunion, launched as a railroad car company that ranked their creditors. In 1898 two brothers, Cator and Guy Woolford, launched Equifax as a retail credit company, and in 1901 TRW, which later become Experian, was founded by the Cleveland Cap Screw Company, though neither of these firms resembled their current format.
The birth of the modern credit scoring system could be traced to 1956, when two friends, Bill Fair and Earl Isaac, founded the Fair Isaac Corporation to develop and sell their credit scoring concept. They saw that banks and lenders were still using their past anecdotal and lending experience when gauging which borrowers should get a loan, a system rife with human error and the imbalance of familiarity in small towns.
From their small apartment in San Rafael, California, bursting with paper and statistics, Fair and Isaac came up with a point system that brought a measure of impartiality to the matter, which substituted many of the subjective factors with actual credit use statistics. In those early years they sold this credit rating data to financial services companies so they could make more accurate decisions about patterns of consumer repayment and default.
They would collect and review information about a set of loans granted to certain consumers at the same time, sometimes a million people, to determine who paid back their loans and who did not based on variables and demographics. They found common variables for defaulters at the time of the loan’s issuance, like if they had past late payments or were already over-extended in debt. Their statistical model was therefore designed around highlighting these certain variables, or leading indicators.
Not until 1989 did they introduce an automated, computer-generated scoring model with advanced software. Of course the servers at that time took up whole rooms and many industries, including real estate, counted on printed books published every few weeks for updated statistics and data. The new software credit tools became wildly popular with credit card companies, and the company continued to grew. But it really wasn’t until 1995 when FICO wasn’t just ON the credit scoring map but DREW the map, when the mortgage giants Fannie Mae and Freddie Mac mandated that lenders needed to use Fair and Isaac’s scoring model in all lending decisions.
Since those humble beginnings, Fair Isaacs has grown into a publically traded company on the New York Stock Exchange with annual earnings over 600 million dollars with an advanced credit scoring model known as FICO.
Since then FICO does have several other competitors, like Vantage, but just about every mortgage lender still uses FICO. There are several variations of scoring models based on predicting home loan default, auto loan default, credit card default, commercial loan default, etc.
Fair Isaac, their predecessors, and the individual credit bureaus revolutionized the industry with their credit model process – now they could collect and analyze hard data for use in lending decisions. They were, essentially, trying to predict the future by studying the past, extracting a pattern of defaults and repayments, then laying that pattern on top of future credit decisions as a framework of standards.
The factors in this framework include the total debt, types of account (revolving vs. installment), number of past late payments, and age of accounts for a borrower. These indicators act as either balloons or anchors for one’s credit score depending on if they are seen as positive or negative indications if past consumers in their statistical situation repaid their loans.
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