Fundamental Issues in Our Credit System

Banks utilize the credit scoring system in our country as a tool to measure risk for lending money to consumers.  In essence, they designed the credit score using a virtually top secret algorithm that produces a 3 digit number that reflects a borrower’s ability to repay a loan.  We refer to this method of consumer lending risk-based lending.  Consumers borrow money from lenders at varying interest rates as determined by the risk associated with their credit score.

Introduction

If your score is high, you are deemed a lower risk because your score indicates there is a high probability you will make your payments.  If your score is low, you are considered “risky” and will be required to pay a much higher interest rate — or will be denied credit altogether.  Unless, of course, we time warp back to somewhere between 2003-2007 at a time when you did not need a job, verifiable assets, or remotely decent FICO scores.  If you had a pulse you were approved.  We will save that conversation for another article.

The Problem

Here is the problem with risk-based lending for consumers — CREDIT REPORTS ARE NOT ACCURATE — therefore, gauging someone’s ability to repay a loan, and the interest to be paid, based on a credit scoring system inconsistent in it’s ability to perform it’s basic function is unconscionable.  There have been several “hush-hush” studies into this problem.  The Public Interest Research Group (PIRG) found that 79% of credit reports have detrimental errors on them.  8 out of 10 of us have errors on our reports — scary!  More recently, the FTC concluded a 7-year investigation into the inaccuracies in credit reporting data, and flaws in the processes of correcting the errors.

One shocking element of the study highlighted how many consumers spent countless hours requesting the bureaus correct mistakes. In 70% of cases, the bureaus failed to correct the items.  Meaning, the majority of people did not get the errors corrected and were forced to live with inaccurate data on their credit reports.  Thus, costing them thousands of dollars in unnecessary interest, potential loss of employment opportunities, or worse yet, the shame of not being able to provide a home or car for their family.

In Conclusion

What is the incentive for the banks or credit bureaus to correct errors that are causing the credit score to be lower?  There is NONE.  Lower consumer credit scores means they will pay higher interest rates, which means more money for the banks.  More money for the bank to make new loans.  New loans translates to more money for the credit bureaus since the banks pay the credit bureaus to report consumer data.

The banks also purchase a tri-merge credit report from the bureaus each time they take a new loan application.  Just like most things in life, if you follow the money-trail and understand “incentive”, you can get a pretty good idea of what’s going on.  The banks and bureaus have little incentive to be sure consumer credit reports are accurate and correct them if they are not. In the case of our credit scoring system, the consumer is screwed.