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As a European citizen I am somewhat puzzled by how American credit scores work. The US is one of the few, possibly the only country where such a strong focus is put on the utilization history of personal credit (cards), to the point where people try to work out the best strategy to optimising their credit score.

As I understand it most other countries would build a credit report based on debt payment history (utilities, taxes, bills), income and the presence of any registered instances of non-payment. However, as stated in this article, that's only a minor element of an American credit report:

There are those (such as Dave Ramsey) who will tell you to avoid all credit cards. This is nonsense. Graduate college, get a good job, save for a house, and you’ll find that without any credit history your options to get a mortgage will be limited despite the nice downpayment and low debt to income that new mortgage would cost you.

While I understand that this type of credit score will easily weed out true bad apples, I cannot see the advantage in this type of scoring for ranking people with no history of non-payment.

While I can't speak for all of Europe, in my experience the majority of credit cards are never used except for online purchases or in places where debit cards are not accepted. People then generally set-up direct debit to pay off the balance automatically each month. These cards never accrue interest and likely see a limit utilization of 0-5% per month. Owning a credit card is also still not that common.

In the end, it seems to me like the credit score boils down to having a proven track record of spending your money. This just does not strike me as a particularly effective metric. What then are the reasons that this system is still being used?

I struggled somewhat with writing my thoughts on this down. Note that I'm not looking for a debate but want to find out how and why this system of credit scoring came about and if it is actually proven effective. I've read statements from banks that "it does" and I'm sure it works for non-payers but have found little about its value for the rest of us.

  • Utilization is an indicator of how well an individual manages his or her purchases. FICO scores are 35% payment history, with 30% amounts owed (utilization). – Noah Jul 1 '14 at 17:03
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FICO is a financial services company, whose customers are financial services companies. Their products are for the benefit of their customers, not consumers.

The purpose of the credit score system is two-fold. First, the credit score is intended to make it easy for lending institutions (FICO's customers) to assess the risk of loans that they make. This is probably based on science, although the FICO studies and even the FICO score formula are proprietary secrets.

The second purpose of the credit score is to incentivize consumers into borrowing money. And they have done a great job of that. If you think you might need a loan in the future, perhaps a mortgage or a car loan, you need a credit score. And the only way to get a credit score is to start borrowing money now that you don't need.

Yes, someone with a good income and a long history of paying utility bills on time would be a great credit risk for a mortgage. However, that person will have no credit score, and therefore be declared by FICO as a bad credit risk. On the other hand, someone with a low income, who struggles, but succeeds, to make the minimum payment on their credit card, would have a better credit score. The advice offered to the first person is start borrowing money now, even though you don't need it.

I'm not anti-credit card. I use a credit card responsibly, paying it off in full every month. I use it for the convenience. I don't worry at all about my credit score, but I've been told it is great. However, there are some people that cannot use a credit card responsibly. The temptation is too great. Perhaps they are like problem gamblers, I don't know. But FICO and the financial services industry have created a system that makes a credit card a necessity in many ways. These are the people that get hurt in the current system.

  • Sounds like mortgage providers would actually benefit from paying less attention to FICO scores. The question is: why don't they? – Michael Borgwardt Jul 3 '14 at 7:23
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    @MichaelBorgwardt I think the reason is that FICO makes it easy. For example, I can apply for a new credit card online and get an answer instantly, with no employment verification. They just see the score and accept/reject. For large mortgage providers, they don't have to trust their employees to do the manual underwriting process correctly before approving a loan. They just pick a score threshold and go with it. Easy, but not if you are the one with a low score. However, there are mortgage providers that still do manual underwriting and approve mortgages without a FICO score. – Ben Miller Jul 3 '14 at 7:53
  • Maybe our lender was a peculiar exception, but when my wife and I applied for a mortgage a couple of months ago, they did everything but turn us upside down and shake out our pockets. Before it was all done, I seriously just wanted to give them all my bank logins and say "here, get all the information you need". It would have been ten times easier on us that way at least. They wanted proof of employment, pay stubs, checking/savings account statements, investment account statements, 26 forms of ID, etc. And we have good FICO scores (and a prior mortgage in good standing, no less). – Matt Peterson Jul 30 '14 at 20:41
  • "the only way to get a credit score is to start borrowing money now that you don't need" isn't quite accurate... I mean, technically, you're borrowing it in the sense that they're technically giving you a no-interest loan for 30 days, but I don't really think of it like that, I just think of it as a bill you have that long to pay. If you go to the doctor and they bill you a hundred dollars and say they'll send you the bill, is that a loan cause you don't have to pay until you get the bill in the mail? I guess, technically? Not really though... – neminem Jul 21 '15 at 20:24
  • @MichaelBorgwardt You can request a mortgage qualification review where they look at the numbers independent of the FICO score. They take debt to income ratio, credit history, a personal interview, etc. into account for determining whether to extend credit. Basically, old school lending. This primarily works well only where you and your family have been customers of the bank for a long time, and the community is small enough where they know your reputation. – Xalorous Jan 11 '17 at 21:48
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Dan's link (he deleted his answer, BTW) is fine, it showed the components of the score FICO offers.

Each input has data behind it, a bell curve of the behaviors and risk of the person behind it. For example, we've discussed utilization many time here. The ideal utilization is not 0%, but 1-19%. This does not mean paying interest, or carrying charges from month to month.

Say I had just one card with a $10K limit. I'd want to be sure I never ran a bill above $2000. If I did, I'd see a slight drop in my score, and next month, it would go back to normal. In my case, I have enough available credit that going over 20% is rare, and if it happened, I'd pay the bill down before the bill was issued, just make a mid-cycle payment. FICO decided that those who go over 20% have a higher risk of default. And it gets higher as it goes up. Same with every aspect of the score's components.

You are comparing US to non US use. In the US, it seems far more common to use our cards. In my family's case, we use very little cash, and run most of our spending through our cards.

As far as The David is concerned, one should separate those who carry a balance from those who pay in full. The pay in full users are better off for their habits and responsible card use. In the US, it's not easy to rent a car or book a hotel with no card. Cards offer a cash rebate that adds up fast, and purchase protection from fraudulent vendors. They also offer extended warranty coverage.

The David, and others, claim that "studies prove those using cards spend 10-15% more than cash buyers." This is a proven fact from scientific studies. Only they don't exist. The best I've seen proves that college kids given a $20 bill spend more carefully than those given a $20 credit card. This doesn't extrapolate to a family budget, and never will. But that quote has a way of being repeated as fact. Yes, it's non-sense, thank you for reading and quoting my blog, I recognize the quote.

The report also shows accounts that have gone to collection. An electric bill isn't a regularly reported item, it's assumed your lights are on. But if you stop paying the bill and they send your account to a collection agency, you'll see it hit your report.


In response to the comment below - Journal of Experimental Psychology: Applied article titled Monopoly Money: The Effect of Payment Coupling and Form on Spending Behavior runs 13 pages but on the first page offers "Do consumers spend differently when using one payment mode relative to another mode? For example, do consumers spend more when they receive $50 in the form of a gift card than in the form of cash? If indeed they do, then why? This research addresses these issues."

$50? A $50 gift card is a nuisance, I try to use it up within hours of getting one. As I stated above, the behavior of a person with such a card doesn't scale to a many-thousand-per-month budget. Such articles, in my opinion, are nonsense, proving nothing.

Unfortunately, this is a bit of a tangent to the original question, and if I put up a stand-alone "Is it a fact that people spend more if using a card than cash?" the question would result in being closed as one that's seeking opinions, not facts.

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    The part of the question I find most interesting, which your answer doesn't address, is why the credit score only includes credit-based purchases, rather than financial obligations which are not credit (e.g., utility bills, rent). One would imagine these would also be good predictors. Are they not used simply because it was too difficult to set up a system for reporting them? – BrenBarn Jul 1 '14 at 18:17
  • "Only they don't exist" Really? There are many studies: Journal of Experimental Psychology: Applied, Dunn & Bradstreet, the list is long. Also, there is at least one that measures brain activity between using cash or credit. Google is your friend. – AbraCadaver Jul 1 '14 at 21:36
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    @AbraCadaver - As I wrote, most of the studies I've seen are tiny experiments that don't scale to real life. The others are not sufficiently sound. A true study would separate the pay in full group from those who carry debt. You can't tell me that a couple who has not paid a cent in interest in 30 years is subject to the same 'overpaying' as those who are in over their heads. You tell me to Google, but offer not one valid study. I have the JEP article. And edited my answer in response. – JoeTaxpayer Jul 1 '14 at 22:23
  • "FICO decided that those who go over 20% have a higher risk of default. And it gets higher as it goes up." Yes, and getting an extra credit card that you don't need or use will lower your risk of default? – user102008 Jul 2 '14 at 22:54
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    @AbraCadaver I just read that study and you mentioned (the only one in your apparently "long" list) and it's abundantly clear that it's a case of faulty methodology leading to flawed conclusions. There's a reason why gift cards are sold at about 70% of their face value. How this got extrapolated to derive the conclusions they did is a mystery to me. And it wasn't even a proper CC gift card that you could use anywhere. Just a store gift certificate. I've never seen so many leaps in logic in a scientific paper. – NullUserException Jul 28 '14 at 22:05
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Let's say you own a store, and you are looking to hire a front-counter person. You'll be leaving this person alone with the cash register on a regular basis, so you want someone trustworthy. You have two candidates:

Bob has never stolen from a cash register in his life. He has spent the last three years working a job where his employer regularly leaves him alone with the cash register.

Ann has never stolen from a cash register in her life. She has never had a job where she was left alone with a cash register.

All else being equal, Bob is the slightly safer choice because he's had more opportunities to fail and hasn't, while Ann is a more unknown quantity.

By the same token, a person who regularly borrows money and pays it back is somewhat safer to loan money to than someone who's never borrowed money before, simply because the latter is a more unknown quantity.

  • Although I like your analogy, in your example you choose one person over another. Most companies that make decisions based on credit scores are not limiting their customer base. You would need to modify your analogy to say something similar to: You want to hire as many people as possible. So you definitely hire Bob. But should you also hire Ann? – TTT Sep 26 '15 at 22:11
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First I want to be sure Op understands how "Credit Utilization" is scored as this confuses many folks here in the US. There is no "reward" for charging money or carrying balances, only penalty. If you have one credit card with a $10,000 limit and owe $8,000 you have an 80% utilization which will signal to banks that you are having financial difficulties. (Anything over 30% on a single card is usually penalized significantly.) The ideal utilization is something around 0, which is in the ballpark of the 5% Op mentioned. Again there is never any direct benefit to your credit of spending a penny on any of your credit cards.* Banks offer the best rates to people that pay off their balances each month or don't use their cards in the first place. Why?

Despite the system being imperfect in many ways, utilization is a good indicator. Example: If you have a card with a $10,000 limit and pay it off every month that speaks to you being a good risk. If you compared this person to the person above, who do you think would be the most likely to pay back a car loan?

Finally, Utilization is a small part of the credit score. I would call it more of a "hurdle" than a factor, at least concerning good rates and approvals. Most of your credit, is based on length of history, paying on time, and having multiple types of credit.

Real life example:

I had a relative that had perfect payment history for decades. They got divorced and started accumulating a balance. The person got other cards with 0% apr to avoid the interest, but their balance only grew. -They had to use the card to make ends meet, etc. (3 kids, single parent) They ended up filing a sizable bankruptcy a few years later. This was one of the most responsible people I've ever known. (Yes that statement will seem far fetched to someone else. It was almost impossible to get them to file bankruptcy, even though there was no way to ever pay the money back.)
The point? Utilization shows a more 'current' picture than some of the other portions due. - Had those banks used the high utilization as a warning sign they would have saved a lot of money.

A 'fun' way of looking at credit: Sometimes I describe credit score as a popularity contest. If you really 'need' money banks are not going to help you. However if your credit shows everyone is lining up to loan you money, other banks are going to want in too. "Banks only make loans to people that don't need them."

*** Spending a lot on Credit Cards does sometimes have the indirect effect of getting balance increases that could have a slight increase in your score. This happens less than it did prior to the financial fiasco. Also the effect of this is on the score negligible unless carrying a balance. ( And the person carrying a balance also has a lower score anyways.) Additionally someone charging less could probably get a similar raise if they asked for it. (Raises vary greatly by issuer.))

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Here is a less scientific view of why there is a focus on credit utilization, it is the easiest to control by doing something.

The focus on utilization is coming from the people asking the questions regarding how to improve their score, some even have an obsession with trying to wring a few more points even though they have no immediate need for a loan.

Look at the other factors:

  • Payment History: 35%
  • Length of Credit History: 15%
  • New Credit: 10%
  • Types of Credit Used:10%

That means that for 70% the best advice is either wait for your history to get longer, don't open a new line, or don't close an old line.

Therefore the only thing they control is to get their utilization score down. If they pay off balance that saves them interest, if they ask for or are award an increase in credit line that also brings down their utilization number.

If it is the easiest to improve, it will garner a greater focus from consumers, therefore it seems that the credit industry focuses on it. In reality each consumer has to look at their situation to see which part of their overall score they need to focus on.

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Here's my crude reasoning: Let's say you have just one recently acquired credit card with a $5000 limit. The company that issued the credit card set the $5000 limit based on however they assessed your risk.

Now if you're using a significant portion of of the $5000 limit, it means (at least for them) that you are stretching your wallet. Even if you've been paying monthly consistently and since you are heavily using your limit, it also means that if you lose your primary source of money for even one month, (income etc.), then your risk to the lender increases sharply. Had you been making more money (compared to this $5000 limit) then either you'd have used less % of your available credit or you would've gotten your limits raised by asking your bank to re-evaluate your risk and increase the limit.

Also your statement "Why is a US credit score based on credit utilization?" is slightly incorrect. As per FICO, Credit utilization has 35% weight while your payment history has a weight of 35% http://www.creditcards.com/credit-card-news/help/5-parts-components-fico-credit-score-6000.php

To sum it up, we can debate if the weight for credit utilization should be higher or lower but unfortunately as others have pointed out, these scores are meant to help lenders not consumers. So whether we like it or not, the secret algorithms to calculate the scores and the actual weights (variables and rules) they use are completely out of our hands.

  • But it encourages people, even if they have more than enough credit limit to cover their spending, to apply for more extraneous credit cards that they don't intend to use, so that their percentage of utilization would go down. Does that make sense? I guess you would argue that even if this person doesn't intend to use this extra card, having that extra credit reduces the risk of default because they can borrow more in the short term? – user102008 Jul 2 '14 at 22:50
  • Why should using the full plafond be considered a risk? Maybe they decided they're not gonna spend more than $5K a month, and they're sticking to that. If one time they need to go over that amount, they can just use their debit card or a regular bank transfer instead. There's probably some bias there as most people don't even have one credit card here (Italy), and in fact I just got my first one at 25. Before that, I always paid with bancomat (an italian-only debit card circuit) and so does everyone else. – Demonblack Jun 12 at 4:26

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