Why Credit Scores Are Racist

If there’s one thing every business owner needs, it’s financing. Loans are the bedrock of starting or growing a business, and to get one, a borrower needs a good credit score. This system ranks a person’s financial history on a scale of 300 (poor) to 850 (excellent), a number that plays a major role in whether a business owner can get the capital they need.

This system is supposed to be a neutral, fact-based way to decide whether to approve a loan application. But the U.S.’s history of economic racism puts BIPOC people at a disadvantage in credit score calculations, codifying discrimination into data and producing more discrimination as a result. Rather than leveling the playing field, credit scores serve as gatekeepers to wealth-building for communities already facing the highest barriers.

Despite creating inequity, this system is still an improvement on what came before. Prior to the 1974 Equal Credit Opportunity Act (ECOA), overwhelmingly white, male bankers had total discretion over business loan approvals and regularly denied BIPOC applicants based solely on their race. The passage of the ECOA mandated that banks use credit history, not any part of an applicant’s identity, in deciding whether to approve a loan. Credit reporting agencies began calculating number scores in 1989, using a formula created in 1959 by two white men that’s now known as FICO.

But the financial activity that credit agencies use in scoring — mortgages, student loans, car loans and credit cards — is inherently biased against BIPOC borrowers, because it’s based on financial instruments that economic racism has kept out of the reach of racialized communities for decades.

For most of the 20th century, redlining kept applicants of color, particularly Black folks, from getting mortgages and building wealth through home equity. Although it was officially outlawed by the 1968 Fair Housing Act, it continued informally, more recently in the form of subprime lending. As a result of this history and many other factors, the Black homeownership rate is just 44%, compared to 74% for non-Latinx white people.

Employment discrimination has kept the same communities economically precarious; even today, about half of Black Americans live paycheck-to-paycheck. Since the majority of credit score calculations are based on payment history and credit use, unstable income can quickly tank a credit score. Auto loans, too, disproportionately impact Black folks’ credit scores because many dealers charge them more for cars and place higher interest rates on their accounts.

Notably, most credit scoring agencies don’t factor in payments for phone bills, utilities or rent, which are broadly used across under-resourced communities and good indicators of whether a borrower can consistently pay their bills.

“The data used in current credit scoring models are not neutral,” Frederick Wherry, a Princeton sociologist who studies financial racism, tells Forbes. “It’s a mirror of inequalities from the past. By using this data we’re amplifying those inequalities today. It has striking effects on people’s life chances.”

Unsurprisingly, racist data leads to racist outcomes. A 2015 report from the Consumer Financial Protection Bureau found that poor, Black and Latinx people were far more likely to either have no credit history, or so little that they could not get a credit score. According to research from the Urban Institute, majority-Black communities and majority-Indigenous communities have the lowest median credit scores; residents of reservations have credit scores averaging 30 points lower than those in surrounding areas.

Because personal credit scores are taken into account for business loans, having a low score is a major barrier to securing the capital needed to start a new venture or grow an existing one. The ideal loan for small businesses is a government-backed loan called an SBA 7(a). It has a long repayment period and low interest rates. But to qualify for this loan, applicants usually need a credit score of at least 680; the same goes for private bank loans with favorable terms.

Loans for people with lower credit scores come with much higher interest rates that add hundreds or thousands of dollars in payments over the lifetime of the loan. Under 600, the only options for most people are cash advance loans, which come with the highest interest rates — sometimes above 50%. So, just as economic racism positioned BIPOC people to have lower credit scores, it now puts them at higher risk for expensive, sometimes predatory lending.

Credit scores, ultimately, are a shortcut that claim to be fair but don’t seek true equity. They use data with a racist history to guess whether a person will repay a loan, instead of getting to know that person and supporting them to ensure their financial success. There is an alternative to credit scores that replaces shortcuts with relationships: character-based lending (CBL).

CBL doesn’t use credit checks or collateral (another financial practice with racist implications). Instead, it relies on community knowledge to determine creditworthiness. This year, Common Future introduced a pilot program for CBL, distributing $800,000 in low-interest, flexible loans to applicants referred by Common Future’s network partners. Through this pilot, we hope to spark a transition from the discrimination of credit scores to a community-first system that works for everyone.