INSIGHT: Credit Scores Fail in Accuracy, Unjustly Impact Minorities

Two powerful and interacting forces are reshaping U.S. society: the Covid-19 pandemic and the Black Lives Matter movement for racial justice. Both require urgent re-examination of the status quo and both have exposed how our credit scoring system is failing us—not just in terms of accuracy and reliability, but also in terms of justice, equity, and fundamental fairness.

It is essential that alternatives to this outdated system be supported as political leaders and candidates put forward economic recovery proposals and the Consumer Financial Protection Bureau takes up modernizing the country’s fair lending laws and open finance framework this fall.

It’s time to stop using credit scores and start using available data for “cash scores” to assess the creditworthiness of millions of consumers who don’t have a credit score, or have a score that’s inaccurate or outdated—disproportionately young, Black and Hispanic, first- and second-generation immigrant, and/or low- and moderate-income consumers.

Rising Credit Scores Are Not Good News

The Wall Street Journal recently noted that banks are “flying blind into a credit storm” and pulling back sharply on lending to U.S. consumers. The reason? Banks can no longer tell who is creditworthy.

Credit scores have continued to rise on average through the pandemic, even as the real economy has suffered the worst quarterly decline in modern history. Due to the fast onset of the crisis, and the numerous payment extensions banks are granting to consumers, delinquencies aren’t materializing on credit reports and won’t for months.

Since lenders can’t spot which applicants are unable to repay, they have little choice but to tighten their standards and slow lending. That means fewer new customers for banks and less credit available for everyone, at a time when many need it most.

In a stable economy, credit scores (when available) provide a reasonable measure of a person’s relative likelihood of paying back a loan. But in times of extreme economic volatility, they’re proving totally unreliable.

Credit Scores Fail Equality, Justice Standards

And credit scores aren’t just falling short in their accuracy through Covid. They are failing to meet important standards of equality and justice brought to the forefront by the Black Lives Matter movement.

The reality is that our current credit system has long disadvantaged Black people and other people of color. We can trace this back to the practice of redlining in the 1930s—the systematic denial of credit in Black neighborhoods and other areas where people of color lived.

Though federal laws were subsequently enacted to fight this kind of overt discrimination, the practice has left an enduring legacy and a compounding impact over generations. If your parents couldn’t get credit decades ago, they may not be able to serve as guarantors or co-signers for you now, and the cycle continues.

In fact, decades after the end of redlining, people of color are still disproportionately likely to have an inaccurate credit score or to lack one entirely, effectively shutting them out of mainstream credit. More than 27% of Black and Hispanic Americans are “credit invisible” or “unscorable”, compared to just 16% of white people.

In a world where you need credit for everything from financing a car or qualifying for a small business loan to even getting a job, the consequences of credit invisibility are huge. By some estimates, lacking a credit score can cost you tens or even hundreds of thousands of dollars over the course of your life.

An Alternative: Cash Scoring

We cannot accept this status quo. Our current credit system is proving unreliable during periods of economic volatility, and inequitable amid important demands for racial justice. But it doesn’t have to be this way: a just and effective alternative is emerging.

Credit scoring was developed 50 years ago when very little financial information was available to make fast approval decisions. Since then, access to financial data has proliferated and powerful new statistical methods have been developed to analyze it. Regulation is even catching up. Just last month, the CFPB began the process of developing a U.S. “open finance” framework, which would allow consumers to safely share their electronic financial records and more easily access services that rely on this information.

As an industry, we now have the tools we need to look beyond credit scores and more holistically evaluate an applicant’s financial picture, including their income, savings, and bill payments. This shift would provide a more inclusive and more accurate assessment of creditworthiness.

At my company, Petal, we call this analysis cash flow underwriting—or “cash scoring” for short. Cash scoring has the potential to assess the creditworthiness of millions of consumers who don’t have a credit score, or have a score that’s inaccurate or outdated—disproportionately young, Black and Hispanic, first- and second-generation immigrant, and/or low- and moderate-income consumers.

And we know cash scoring works; a similar approach has been used successfully for years in small business lending to provide capital to deserving but underserved small businesses.

Using cash scores for consumers isn’t just the right thing to do, it’s the smart thing for financial services companies seeking to accurately assess risk. According to a recent study by FinRegLab, cash scores are just as good (if not better) at assessing creditworthiness, they perform equally well across demographic groups, and they may do a better job of serving historically underrepresented borrowers.

Unlike traditional credit scores, which take months to reflect changes in financial circumstances, cash scores incorporate real-time changes in income, expenses and savings—a critical capability amidst the economic volatility of Covid-19.

The financial services industry has long been resistant to change, but the events of 2020 demand that we discard outdated assumptions and challenge ourselves to do better. Now more than ever, we have a responsibility to ensure that credit is equitable and accessible for the millions of people who deserve it.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Jason Gross is CEO and co-founder of Petal, a New York-based credit card company on a mission to make credit honest, simple and accessible. He has served as a member of the Consumer Financial Protection Bureau’s Consumer Advisory Board, and previously practiced law at Gunderson Dettmer and Sullivan & Cromwell, representing tech firms and financial services companies.