Vicious cycle of bad credit, inequality

The other day, I got to wondering something: What is the effect of automated payments on credit scores? Automated payments, I reasoned, reduce late payments among the people who are basically responsible budgeters but terrible at remembering to mail their bills on time every month. Those people should see their credit scores increase as they rack up fewer late payments to creditors.

Alas, the Internet seems to be silent on this point, or at least my Google-Fu was not good enough to discover any research that could shed light on my theory. But I did stumble across an interesting paper put out by RAND Corp. last year on the impact that credit scores have on auto lending.

Credit scoring has been around for a while — the Fair Isaac Corp. was founded in the late ‘50s — but it wasn’t until the information technology revolution of the 1990s that companies got enough data storage and computing power to start slicing and dicing their loan portfolios by credit score. The auto-financing company that RAND studied used uniform pricing and traditional interviews for loan issuance as late as 2000.

Here’s what happened when it shifted to a more sophisticated credit-scoring model: higher interest rates and down-payment rates for risky borrowers, better rates for those with better scores.

Essentially, we see a microcosm of what happened in the larger economy over the past few decades: People with steady payment histories and low levels of outstanding debt relative to their available credit got better loan terms, and were therefore able to borrow more money. They got bigger, nicer cars, and auto lenders became more profitable.

The financially marginal, on the other hand, found that their financial lives got harder still. Their poor credit histories meant that they could no longer get loans, or they could get them only at painfully high rates of interest. They would have had to drive less car or whatever they could afford to pay cash for.

Credit has long been thought of as a democratizing force. It enabled ordinary Americans to buy houses, cars and other amenities that had previously only been available to those with substantial capital. But over the last few decades, that process has been reversed.

Financial irresponsibility is one of the things that drives a bad credit score. But so does unstable, low-skilled employment and a thin margin of financial error between you and the basics of American middle-class life. So what we’re seeing is a redistribution of benefits not just from the financially irresponsible to the financially responsible, but also from the labor market’s “have nots” to its “haves.”

Those on the left see this problem and call for the reinstitution of usury laws to cap the amount that those with low credit scores can be asked to pay. And, of course, that would keep those 25 percent interest auto loans from bleeding the family budget dry. But loan companies would still know that these people are bad risks. They would substitute even higher down-payment requirements — or outright denial of the loans — for the higher interest rates they’re now charging.

Knowledge is power, as they say. But that power is not necessarily equally distributed.

Megan McArdle is a Bloomberg View columnist who writes on economics, business and public policy.

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