When were credit scores invented? A brief look at the long history behind credit reporting

Your credit score is one of the most important three-digit numbers in your financial life. Whether you're applying for a mortgage or a credit card, lenders likely look at your credit score before giving you a loan. A good credit score can give you the financing required to achieve many of your goals and milestones, while a poor credit score may give you a harder time securing financial help.

If you've used any credit before, you likely have a credit score and credit report. You may ask to present it to creditors and lenders, employers, or landlords as part of an assessment of your financial soundness. Credit scores have long been the benchmark for measuring your financial well-being and are used globally with different credit reporting agencies and credit scoring models.

While we're familiar with the modern-day credit score system, where did this number come from, and how did it become one of the main ways financial institutions qualify you for consumer lending? Let's dive into when credit scores were invented and the history behind our current modern credit reporting system.

The 1800s: The rise of credit reporting agencies

The modern-day credit reporting system has only been around for about 50 years. However, credit reporting has been a practice since the 19th century. Similar to how your credit score determines your risk as a borrower, commercial lenders in the early 1800s used credit reporting to "score" potential business customers to determine the risk in providing them credit.

The first credit reporting agencies that scored business customers were merchant associations. Merchant associations provided goods and services, encouraged commercial activities, created job opportunities, and supported commercial growth. They collected financial and personal information about various business customers and sold it to lenders. The lenders used this information to offer funding to qualifying organizations to fund their business operations.

The start of consumer credit reporting in the early 20th century

Modern credit bureaus developed in the 20th century and evolved into what we know today. Retailers started to offer loans and consumer credit products directly to individuals who needed to borrow money. These retailers had credit managers responsible for gathering financial data on the borrowers to determine their creditworthiness. Individuals with high creditworthiness were granted consumer credit, while individuals of high credit risk were denied.

As the need for borrowing money increased, the need for a more centralized and efficient way of gathering information and assessing credit risk increased. Eventually, the retailers grouped to form a national association aimed at creating a standardized method for collecting, sharing, and scoring information on debtors applying for loans. It allowed for better credit risk management, and lenders were able to make more informed decisions when approving loans to borrowers.

The three major credit bureaus were formed later - TransUnion, Equifax, and Experian - and still operate today to provide credit reporting and credit scores to borrowers. They worked together to further develop consistencies in credit scoring models and create a more automated way of credit reporting and credit scoring.

The Fair Credit Reporting Act

The Fair Credit Reporting Act is a federal legislation that protects information collected by credit bureaus and other consumer credit reporting agencies. It states only companies and individuals who have a rightful reason to access your credit report, as outlined in the Act, can view your information. The Act also states credit reporting companies must investigate disputes, and companies are required to provide individuals with notice before taking adverse actions based on their credit report for credit, insurance, and employment purposes.

There are also several protections put in place to protect the security of financial information collected and reported to credit bureaus, lenders, creditors, employers, and other financial institutions. For example, the Act removes data related to an individual's race, sexuality, and disability from credit reports. Credit bureaus also remove negative remarks from your score after a period, so credit mistakes don't have a permanent impact on your credit score.

FICO scores

FICO stands for the Fair, Isaac, and Company and the scoring model it developed. Most Canadian lenders and financial institutions use FICO scores to determine if an individual qualifies for a mortgage, credit card, line of credit, or loan. Originally, FICO's credit scoring algorithm was designed specifically for individual businesses and their specific customers. It was difficult to apply the scoring model across different businesses as they had different needs.

In 1989, FICO released a universal credit scoring model lenders can use to assess all businesses and individuals. Instead of getting a custom-designed credit scoring algorithm, lenders, creditors, and other financial institutions use the universal FICO score to assess borrowers regardless of their customer base.

Calculating your credit score

The credit scoring model assigns weight to five categories to assess your credit report and give you a score:

• payment history: 35%

• credit utilization ratio: 30%

• length of credit history: 15%

• credit mix: 10%

• new credit inquiries and accounts: 10%

Lenders report your activity in each of these categories to credit bureaus, which use the FICO scoring model to give you a three-digit score based on their findings.

Credit score vs. credit report

You may see credit score and credit report used interchangeably as they both relate to your financial well-being and can assess your eligibility for loans. Is there a difference between the two terms, and how can you understand your credit and report?

A credit report is step one in determining your financial health. Your report is an ongoing document that compiles historical information on your financial transactions and status. It includes your personal information, like date of birth and name, credit accounts, like credit cards and lines of credit, and information on companies that pulled your credit report.

With the information from your credit report, the national credit bureaus give you a three-digit credit score. Factors that affect credit score in Canada include credit utilization, payment history, length of credit history, types of credit, debt-to-income ratio, negative remarks, and new credit inquiries. Credit bureaus calculate your credit score based on the weight of each category. For example, payment history makes up 35% of your credit score, and credit utilization makes up 30%, the two highest categories of the credit scoring algorithm.

What is a high credit score?

The average credit score in Canada is 680. A higher credit score indicates you have less credit risk and are more likely to repay debts. A lower credit score can indicate poor credit management skills. Credit card issuers and other lenders may not be as willing to lend you money if you have a bad credit score, or they may give you a smaller loan. The credit scoring model has five categories based on scoring ranges:

• Poor credit: 300 to 579

• Fair credit: 580 to 669

• Good credit: 680 to 739

• Very good credit: 740 to 799

• Excellent credit: 800 to 850

Traditional lenders like banks typically look for borrowers with good to excellent credit scores. If you have a lower credit score, you can still qualify for loans by improving your score or working with lenders specializing in bad credit.

The use of credit scores today

Credit scores today are used in many ways. In addition to assessing your creditworthiness and approving you for loans to support your goals, many employers and landlords also use it to assess your financial stability when applying for jobs or housing. Based on your score, lenders determine if you get the loan, the interest rate charged, monthly payments, and credit limits. Someone with a higher limit will likely get a lower interest rate and better payment terms. They may also get a higher credit limit to borrow more money from the lender.

Problems with modern credit scoring models

While modern credit scoring models are a universal way to measure someone's credit history and risk as a borrower, there are some concerns with the system. Part of the problem is our credit scoring model can often have biases that prevent certain demographics from getting a fair credit assessment. For example, some lenders may associate no credit history with poor credit.

Newcomers and individuals in immigrant communities may not have formal credit reports or credit scores. Without a credit score, it can be difficult to secure financing with low interest rates and good terms. Without credit products, you can't start building a credit report or score, or lenders offer suboptimal loans, which reflects poorly on your credit report. It's challenging for these communities to get out of this negative cycle and work towards a better credit score to secure the loans they need to reach their financial goals.

Alternatives to credit scoring for better inclusion

Many factors influence an individual's ability to access financial tools and support. In addition to biases with the credit scoring system, some people don't have access to formal financial services products or have support from friends and family that give individuals an advantage and a headstart in building a strong financial foundation. Credit bureaus need to supplement the modern credit scoring system with additional data to ensure better inclusion.

Using alternative data ensures credit bureaus give a more holistic view of an individual's current financial health and accurate prediction of their future. Some credit bureaus and lenders consider payment history for rent and utilities and historical banking information, like avoiding overdraft fees, having savings, and paying bills on time. These factors give lenders and creditors a better understanding of your FICO score, especially for people who don't have easy access to credit-building products or opportunities.

How to improve your credit score

Unless you see 850 on your credit report, there's always room to improve your credit score. The higher your credit score, the easier it is to secure consumer lending at a better rate. You can also access a wider range of financial products. Here are steps to improve your FICO score over time.

Reduce your credit utilization ratio

Your credit utilization ratio measures how much of your total available credit you spent. Aim for a maximum of 30% credit utilization rate each billing cycle to keep your credit score in good standing and pay off your credit statement in full each time. For example, if your credit limit is $5,000, aim to spend no more than $1,500 on credit.

Pay your bills on time

From mortgages to credit card bills and cell phone plans, paying your bills on time and not carrying an outstanding balance is one of the easiest and most impactful ways to improve your credit score. Your payment history makes up 35% of your credit report and score. Consistency in paying your bills by the deadline builds your payment history and shows lenders you can manage your debts responsibly. It also shows you're less likely to default on loans.

Use credit monitoring services

Credit monitoring services review your credit report on your behalf and update you on key changes like new accounts, credit inquiries, and limit and score changes. These services also alert you of fraudulent behaviour to your profile and personal information and provide tips to improve your credit score. Not only can you work on improving your credit score, but you can also dispute any suspicious activities to avoid identity theft.

Don't apply for too much credit

It can be hard to manage too many credit accounts at once, making it easier to miss a payment. Each new credit application also typically starts with a hard credit check. While a diverse credit mix has a positive impact on your credit score, too many hard credit checks can lower your score. Consider whether you can responsibly manage another credit account, why you're opening a new credit account, and whether you have the means to manage it responsibly.

Credit history length

Creditors and lenders look at the length of your credit history, which starts when you open your first credit account. Even if you don't use a credit card or line of credit anymore, it's a good idea to keep it open so it reflects positively on your credit report.

Improve your credit score with KOHO to gain financial freedom

A strong credit report results in a strong FICO score. A strong FICO score opens many doors in the financial world to help you reach various goals. Whether you're looking to become a homeowner, buy your first car, or splurge on a big present for yourself, your FICO score influences how much financing you can get from lenders.

Building your credit with KOHO starts with good credit management skills. Learning to manage your money, stick to a budget, and pay bills on time can improve your credit report and score. A great way to better your credit management skills is with the help of a virtual credit card. There are no credit checks or waiting, so you can spend instantly and work towards a good credit score.

Pay your credit statement on time and keep a low credit utilization ratio to slowly increase your score. If you're worried about going over your credit limit, you can sign up for overdraft protection coverage. Overdraft protection coverage lets you borrow up to $250 with zero interest to spot you whenever you're low on cash. You can pay back the amount anytime.

Learn about how KOHO can support your financial journey every step of the way, whether you're looking to earn interest on savings, earn cash back while spending with your credit card, or get a free credit score to monitor your financial health.