Four things you don't know about the business of credit reporting

Recently, the three largest credit reporting agencies agreed to make some changes to their policies and procedures following an investigation by the attorneys general of 31 different states. In response to this story, we received a number of (often heated) questions about the business of collecting and reporting credit information.

“Why does the consumer have to pay for his or her own information?” asked Bryan.

“How is it that three companies have different numbers for a credit score?” wondered Elizabeth. “Why isn't it mandated that they calculate all info the same?”

It’s understandable why the subject of credit reporting can get people a bit riled up. Your credit report – and maybe even more importantly, your credit score – plays a huge role in everything from borrowing money to buying a house to finding a job and so on. Just exactly who are these people who hold so much power over our lives? And how is it even possible that they can all have different information and arrive at different conclusions about the same unique consumer?

I’m not sure that I’m going to be able to alleviate your frustration when it comes to credit reporting and scoring, but hopefully the following will shed a little light on why credit reporting is the way it is.

Credit reporting is a product…and you are not the intended customer

For starters, credit reports don’t exist for your benefit. They weren’t originally intended for use by consumers. Instead, credit reports are, and have always been, designed to provide businesses with crucial information to help them make certain business decisions.

To keep the origins as basic as possible, merchants used to extend credit based purely on their experiences with particular customers. If you owned a store and you knew a customer well, you might be inclined to let them make purchases they couldn’t pay for at the time, because you felt confident that they would pay you back.

Eventually that system just didn’t work anymore. Credit bureaus were created to track how customers were using credit – not just in one store, but everywhere they could use credit. The credit bureau would then sell that collected information to businesses who were considering extending you credit. The central idea was that by examining how a consumer used credit in the past, a lender could evaluate the risk associated with lending to that consumer again.

Credit scores were created as a means of distilling all the information down into something simple, objective, and uniform. Rather than requiring a lender to review all the information in a report in order to evaluate the risk of a consumer, the report would come with a score, which would make it easier for lenders to make their lending decisions.

So while the information in your credit report is about you, it isn’t really intended for you.

Credit reporting is a competitive marketplace

Since your credit report is a product it shouldn’t be too much of a surprise to learn that multiple companies are vying for credit reporting supremacy.

Sometimes a product dominates a marketplace so thoroughly that the company name becomes synonymous not just with the product, but with the market itself. If you’ve ever made a “Xerox” or left a “Post-It” or thrown a “Frisbee” or asked for “Kleenex” regardless of whether or not you were actually using those specific brands, you’re familiar with this phenomenon.

That's also the case with credit scores and FICO, which is the most dominant score in the market, but is far from the only product available.

With lenders looking to reduce risk more than ever, it makes sense that the marketplace would be open to new (and potentially better) products. If a new credit scoring model can help a lender better evaluate risk, then they’d be inclined to try that model out.

This can create confusion (and a fair amount of agitation) for consumers. Which score is the “right” score? Well, in truth, they’re all attempting to measure the same thing – how risky it is to lend you money. And by and large, they’re using many of the same factors. As a consumer the best you can do is cultivate a positive credit history by using credit wisely. Theoretically (theoretically) a strong credit history should translate, no matter which scoring method is used.

The information is yours, the database is theirs

So why do you have to pay for any of this credit information, anyway? Technically everything in your credit report is about you – so why should you have to pay someone else to get that information? Well, ultimately you aren’t paying for the information – you’re paying for the collection of the information.

Think about it this way: if you fell off the roof and broke your ribs, you might think that you’re entitled to know that you broke your ribs. And, in a way, you are, but you still have to pay for an x-ray. When I take my dog to the vet, they charge me for the heartworm test. They don’t charge me for the information the test reveals.

So yes, it is your information, and if you wanted to collect it on your own you can do so. Credit bureaus, however, collect your information professionally, which is why they charge you for a report. Fortunately you are entitled to a free credit report every year from each of the three major credit reporting bureaus, which you access easily through AnnualCreditReport.com. And maybe someday your credit report will always be free. But for now, you have to pay.

Credit reporting will never be perfect

Your credit report ultimately exists not to show people what you’ve done, but to help them predict what you will do in the future. In that regard, credit reports – and especially credit scores – will never be perfect, because as educated as they may be, in the end, predictions are always guesses.

Think about standardized tests, like the SAT or the ACT college-readiness assessment. Standardized tests exist largely because the curriculum and quality of education at high schools across the country were simply too variable. College admissions couldn’t accurately judge the merits and potential output of students from different schools. So standardize tests were created to be a common metric.

As the complaint often goes, however, standardize tests can only tell you one thing with any accuracy: how good you are at taking standardized tests. In fact, the SAT is undergoing a major overhaul for 2016, aimed at closing the perceived disconnection between the test itself and what the test is supposed to be measuring. Many colleges have stopped using these standardized tests in their admissions process altogether, feeling that these tests are not a reliable predictor of future performance.

So it goes with credit reporting and scoring. Scoring models are tweaked regularly to increase their predictive abilities, but a guess is still a guess. It’s entirely possible that at some point in the not-too-distant future, credit scores won’t exist at all. Maybe someday we’ll develop a better, more accurate method of determining risk. Or maybe the very nature of lending itself will have changed so drastically that risk won’t matter nearly as much as it does right now.

At the moment, though, your best bet is to understand the system and do your best to work within it. It’s important to remember, however, that your credit score says nothing about who you are or what your value is. It’s just the solution to an (admittedly imperfect) equation. It’s the SATs all over again. Study up. Work hard. The results might not always match up with your effort, but more times than not it will, and you’ll end up with the credit you deserve.