Credit reports and FICO scores

Credit scoring was created in the 1950s to help lenders determine if an individual was credit-worthy.  The CA company that developed the credit score was Fair, Isaac and Company, and it titled its product – FICO score. 

FICO scores became controversial in the 1990s when car-insurance companies started using FICO scores to calculate an individual’s car-insurance rates.  As a lawyer for a large insurance company during that time, I spent a lot of time trying to justify this practice to legislators and regulators.  I argued that people with good credit deserved preferred rates because it was a statistical fact that they were less likely to have accidents.  Of course, that wasn’t the problem.  The problem was that people with bad credit deserved higher rates because they had more accidents.

Consumer groups rose to the defense of those with bad credit.  Their two principle arguments were that (1) credit scoring has a disproportionate negative effect on the poor and minorities because they are more likely to have been subjected to predatory credit practices, and (2) it is not fair for an individual to be judged a bad risk on the basis of something that has nothing to do with driving.  Ultimately, however, legislators and regulators have grudgingly accepted the use of credit scores in insurance pricing and underwriting.  If it’s OK to rate and underwrite based on age or sex (things over which you have no control), then it’s OK to consider your credit record, which you can control.        

What’s next for FICO scores?  A recent column by Washington Post columnist Michelle Singletary reports that FICO scores are often being considered by employers before making hiring decisions.  See http://www.washingtonpost.com/wp-dyn/content/article/2010/10/23/AR2010102300314.html?hpid=topnews.  Michelle reports that over 60% of employers use credit reports with some hiring decisions and 13% use them in all decisions.  Consumer advocates are urging the EEOC to prohibit this practice, and, déjà vu, they are making the basically the same arguments that were previously made to and rejected by insurance legislators and regulators. 

Michelle, however, does not consider this matter to be resolved, res judicata.  Instead, she tweaks the arguments and urges a different answer.  According to Michelle, allowing the use of credit scores in hiring decisions will inevitably let to a vicious cycle – people with bad credit (poor and minorities) will be prevented from getting a job, and their inability to get a job will drive their credit scores further down.  Michelle also claims that the essential question is “whether workers with money troubles have a propensity to steal from their employers,” and then she asserts that there is independent research to answer the question. 

Michelle’s question is missing the point.  A FICO score does more than indicate the likelihood of an applicant being a thief.  It might also indicate whether the applicant will do a good job and be responsible.  Is it such a leap to think that individuals who are responsible with their finances will be responsible workers?  What is wrong with rewarding a job to the applicant with a responsible credit history over the applicant with an irresponsible credit history?  One of the most important economic principles is that incentives matter.  I believe the American way of life will be enhanced if there is more incentive for living responsibly.