Three Little Numbers: A History of Credit in America
FICO Founders Bill Fair and Earl Isaac
America’s love-hate relationship with credit is no new phenomenon. In fact, it began before the turn of the 20th century. The earliest and most typical form of credit was shopkeeper loans. It’s a common myth that borrowing was unheard of in those days; when money was tight, hardworking Americans ran tabs to buy groceries, furniture, and even farm equipment. It’s true, many disliked like the idea of debt, but borrowing became a necessity and a way of American life.
The practice of lending goes back over 5,000 years. In the ancient civilization of Sumer (today’s south central Iraq), consumer loans were utilized for agricultural purposes dating back as far as 3,500 BC. In 1,800 BC, the Code of Hammurabi formalized the first known laws around credit and established maximum interest rates. As European explorers and merchants traveled to new lands, the need for credit increased. In 1545, England became the first country to set a legal interest rate of 15 percent.
In 1899, the United States adopted the lending practice with the founding of the Retail Credit Company, a business which compiled an extensive list of creditworthy customers. (Controversially, they also collected political and social preferences as well as rumors about people’s personal lives.) The Retail Credit Company changed its name to Equifax in 1975, solidifying the three credit bureaus as we know them today: Experian, Transunion, and Equifax.
During the turn of the 20th century, another well-known lending corporation was formed. The Model T automobile took the country by storm, but was too expensive for most families to purchase with cash. To solve this problem, the General Motors Acceptance Corporation (GMAC) was created, allowing consumers to buy a new car with a downpayment of 35 percent. Many other companies followed suit, offering appliances, furniture, and radios on installment plans.
In 1938, the Federal National Mortgage Association (Fannie Mae) was formed, creating a national network to connect investors, lenders, and mortgage borrowers. The first credit card was the Diners Club card, released in 1950, and was largely used for travel and entertainment. (Borrower beware: the balance had to be paid in full every month.) Within only three years, there were 60 credit cards available in the United States, and lenders quickly became savvy to the opportunity to collect interest. The revolving credit standard, where credit cards aren’t required to be paid in full each month, was introduced in 1958.
Around the same time, engineer William Fair and mathematician Earl Isaac revolutionized the lending model with a mathematical algorithm. In the late 1950s, they founded Fair, Isaac and Company (FICO) and sold their first credit scoring system within two years. The algorithm was designed to predict a consumer’s chance of repayment on any given credit. This score was broken into risk levels, beginning with a score of 300 (a high risk of default) to 850 (a low risk of default). While the actual algorithm is private, trademarked, and copyrighted, the best accepted model is the following:
35% of your score is calculated by your payment history
30% by the amounts you owe
15% by length of credit history
10% by new credit
10% by types of credit or the credit mix
In 1995, Fannie Mae and Freddie Mac mortgage lenders began using FICO Scores to determine whether a consumer qualified for a home mortgage.
The FICO Score has long endured a monopoly on credit scoring. However, in 2006, the three major credit reporting agencies created a new score in competition with FICO called the Vantage Score. It started with a different credit score range, but eventually adopted the 300 – 850 model and is now used widely by lenders to determine creditworthiness. In response, FICO redeveloped its scoring formula to keep pace with this changing credit landscape, ensuring that it remains an intuitive predictor of credit risk.
Today, credit is a major part of our lives and it’s important to stay on top of your credit by regularly checking your report and score. Credit issues can derail real estate transactions in a heartbeat. However in today's consumer-centric markets, prospective homebuyers have access to more information than ever, including their own credit scores, which can help solve credit issues. Your FICO Score may only be three numbers, but those three numbers can be the difference between a good home and your dream home..