How a Failed Credit Card Created the Credit Score

Today it’s taken for granted that credit scores are important, but they didn’t always play a central role in consumer finance.

The history of the modern credit score, which helps determine whether someone can qualify for a mortgage, open a credit card or get a loan, started with a struggling luxury credit card.

In 1958, Conrad Hilton launched Carte Blanche, a premium charge card. The company approved consumers that other credit card issuers rejected. Adoption was strong, but the permissive business strategy also led to large credit losses when cardholders didn’t repay their balances.

Carte Blanche hired two researchers to build software to track bills and payments. The duo, Bill Fair and Earl Isaac, analyzed the data and discovered patterns among the consumers who defaulted. They turned these insights into Fair, Isaac and Co., later known as FICO, and helped pioneer a standardized credit-risk model that became the foundation of the modern credit score.

In this episode of “Footnotes of Finance,” Aven looks into how the credit score became the foundation of consumer lending in the U.S.

What is a credit score?

A credit score represents a consumer’s creditworthiness. The numeric score helps lenders and other companies assess how likely a borrower is to repay their debt based on their past track record with credit.

Lenders, insurers and other companies might use credit scores to decide whether to approve a consumer for a product, setting interest rates or other financial decisions based upon the applicant’s FICO score and other factors.

What does FICO stand for?

FICO stands for Fair, Isaac and Co., the company founded by Bill Fair and Earl Isaac in 1956.

FICO is best known for developing and popularizing credit-risk models and credit scores used in the consumer lending industry in the U.S.

How was the FICO score invented?

Bill Fair and Earl Isaac analyzed consumer repayment data and identified patterns which correlated with credit risk. Their statistical analysis and modeling eventually became the modern credit score, which lenders sometimes use to help understand whether someone might repay debt.

When was the FICO score created?

Fair, Isaac and Co., or FICO, was founded in 1956. The first industry-wide, standardized FICO score was introduced in 1989, after its model was incorporated by the three major credit bureaus in the U.S., which independently collected and aggregated payment behavior and financial account information.

How did lenders evaluate credit before credit scores?

Before credit scores became widely used, some lenders relied on subjective factors, such as someone’s reputation in the community, personal references, personal relationships with the local bank and loan officer, and other local knowledge. Approval for credit products was less standardized and were more dependent on individual judgment.

What factors affect a credit score?

There are many credit scores, including scores not developed or affiliated with FICO. Credit score models vary, but most credit scores consider payment history, credit history length, credit limit utilization, credit account types, recent inquiries or credit applications.

What is a good credit score?

Credit score ranges vary by model, but, generally, higher scores are better and indicate lower lending risk.

A common credit score range is 300 to 850, and a credit score of 660 to 740 is considered good or “prime.” A credit score higher than 740 might be considered very good or “super prime.”

How do credit bureaus use credit scores?

Lenders and some other companies report account information to the credit bureaus, who then collect and aggregate the information on a credit report. A credit report includes this consumer borrowing, repayment history and a calculated credit score.

Lenders, insurers and other companies may use a credit report and a credit score when evaluating applications or determining eligibility or interest-rate pricing.

What is the difference between FICO and other credit scores?

FICO develops credit score models. Credit bureaus, such as Equifax, Experian and TransUnion in the U.S., collect consumer credit data and offer credit reports that may include FICO or other credit scores. For example, the VantageScore is an alternative to the FICO score and was created by the three major credit bureaus.

Why are credit scores important?

Credit scores help some lenders and other companies evaluate applications. Many lenders and companies view credit scores as a fair, non-discriminatory way to assess an applicant’s risk.

Credit scores are used in the credit card, mortgage, loan and insurance industries. Sometimes, they might even determine whether someone can rent a home or job eligibility in some geographies.

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Watch the full video: How a Failed Credit Card Created the Credit Score

“Footnotes of Finance” explores the inner workings of the consumer finance industry. Every financial product has an origin story, and Aven breaks down the real story of how things work.

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Video transcript: How a Failed Credit Card Created the Credit Score

Did you know that a luxury credit card that was on the verge of collapse is the reason why you have a credit score today?

The year was 1958, and Conrad Hilton of Hilton Hotels launched Carte Blanche, a luxury credit card meant to compete with American Express and Diners Club.

And, in order to grab market share fast, they would hand out cards to people that the other companies already turned down. No approval process. Literally just vetting off of vibes.

And, of course, it blows up immediately, but it starts losing money just as fast.

Hilton personally pumps in $5 million into it just to keep it alive, and so, to clean up the mess, they hired two guys from the Stanford Research Institute: an engineer named Bill Fair and a mathematician named Earl Isaac.

And their job was to build a new billing software and track who owed what. While they were building that software, they did something nobody asked them to do. They looked at that data and noticed a pattern. The cardholders who would max out their credit limit were almost always the ones who eventually stopped paying entirely, and that bad behavior left a predictable trail.

They realized human financial behavior could be mapped mathematically, not guessed or judged.

So, with this, they started to build their own algorithm for their company, Fair, Isaac and Co., or FICO for short.

For the next 30 years, they leveraged their new algorithm one client at a time, and each client had their own algorithm. It was slow, and it was impossible to scale.

But then, in 1989, they cracked it. They built a universal algorithm that could work across all industries. And Equifax, Experian and TransUnion agreed to print it on every credit report they produced moving forward.

And the two engineers changed the American financial industry forever.