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History of Lending and Credit Scoring

Over the past 50 years, the use of consumer credit in America has grown exponentially. We are quickly evolving into a cashless society where credit is now more of a necessity than a privilege. Goods and services are more readily available than at any other time in history.

The credit process

Until a few short decades ago, potential borrowers would have to apply for a loan in person, usually with his/her neighborhood bank, preferably one that he/she has accounts with. The applicant would have to answer questions such as; who he/she is, educational background, job history, current address, how long at that address, etc. Then a short interview with a loan officer would take place.

Using the information gathered, the loan officer would base his decision whether or not to lend the applicant money on the 4 "C's" of credit.

  • "Credit" - How well has the applicant paid prior loans other credit obligations.
  • "Capacity" - The applicant's ability to repay a loan.
  • "Collateral" - The item(s) the borrower will pledge to the lender in exchange for credit.
  • "Character" - Whether or not the applicant is the "type of person" who will meet his/her obligations.

There are several drawbacks to this process. One, it would take years of experience to become a credible loan officer. Second, personal interviews are extremely time consuming; as is personally analyzing and processing the information against the set criterion. Third, is the potential for bias. A lender may approve or deny based on such factors as race, gender, religion, or any other illegal reason. Most often, however, bias takes the form of turning down applicants the lender "doesn't like", approving applicants who may not meet credit criteria but are "nice guys", and turning down someone who applies late Friday afternoon to avoid the paperwork.

The Birth of Credit Scoring

To help reduce these problems, a credit score card was introduced. The introduction of the computer into the business environment, with its ability to process data quickly, consistently, and relatively cheaply, made the development of credit scorecards inevitable. Credit scorecards are exactly what they sound like: a scorecard that assigns points for various credit factors. Positive points are given for "good" behavior and negative points are given for "bad" behavior. The fact that these scorecards look at exactly the same things that lenders do judgmentally made scoring very popular in the credit industry.

The Advent of FICO

In 1956, friends Bill Fair and Earl Isaac saw a need for further development of the credit scoring process. They founded Fair Isaac Corporation to develop and market their ground breaking credit scoring model known as FICO. In the beginning, Fair Isaac marketed their scoring model to financial service companies that were seeking to make faster and more accurate credit decisions. In 1989, as businesses were discovering the power of automation, Fair Isaac introduced a credit scoring software package that was quickly adopted by credit card issuers. The biggest boom came in 1995 when mortgage giants Fannie Mae and Freddie Mac mandated mortgage lenders to include FICO scores in their approval process.

From there, other credit scoring models have come on to the scene, but FICO continues to the most widely used.