How race impacts credit: the history and effect on lending practices

Credit scores help lenders assess someone’s risk of defaulting on borrowed money. The higher your credit score, the less of a risk you pose. High credit scores make accessing credit lines with better interest rates much easier. But is everyone treated the same in credit scoring?

A study from the Federal Reserve Board shows that Black, Hispanic and Native American borrowers generally have lower credit scores today, even when researchers control for other factors like education and income. Studies like these may lead people to wonder if race plays a significant role in credit scores, and if so, how that affects the borrowing power of different ethnicities and racial groups.

A brief history on lending practices

In the past, gender and race were both factors lenders used to discriminate against people seeking financial services. For example, practices like redlining — a discriminatory practice in which institutions refused or withheld financial products like mortgages from people in financially “high-risk areas” — made it almost impossible for people of color to get home loans.

Lending practices changed due to the diligent work of activists, who inspired the laws that prohibit bias in lending. Both the Civil Rights Movement and the Women’s Movement contributed to anti-bias legislation in the 1960s and 1970s.

One such law is The Equal Credit Opportunity Act (ECOA), which Congress passed in 1974, to protect against discriminatory lending practices by prohibiting creditors from using race or gender to make lending decisions. Instead, creditors use factors like your income, debt, recurring expenses and credit history. Credit scores as we know them became commonplace in 1989 when FICO created its credit-scoring model. Now, lenders use your credit score to determine approval for things like credit cards, mortgages and auto loans.

Though the government has enacted laws to keep discriminatory practices at bay, the long-term impact of past discriminatory practices and disparity in lending continues.

What is a credit score?

Your credit score is a three-digit number that represents your creditworthiness. More than anything, it acts as an indicator of your ability to repay your debts. Credit-reporting agencies determine your credit score through various factors including your payment history, credit history and your credit utilization ratio.

The two major credit scoring models are FICO and VantageScore. FICO is by far the most popular, with 90 percent of lenders using the scoring model. Both FICO and VantageScore use information that the three credit bureaus (Experian, Equifax and TransUnion) collect to determine your credit score. This number will affect your ability to get a loan or a mortgage, and will also determine the terms and interest rates on what you borrow.

Below is a breakdown of the different scoring models and credit ranges:

Does race affect your credit score?

Due to protections outlined in the ECOA, race is one of many factors prohibited from influencing credit scores. Other excluded information includes religion, national origin, gender and age, among others. Elements that do go into calculating your credit score include your payment history on credit accounts, amounts owed, length of credit history, credit mix and new credit.

While race cannot legally affect credit scores, credit score disparities still exist among various racial groups. The Urban Institute collected a series of statistics that indicate white communities have the highest median credit score at 727, which falls well into the good range on both FICO and VantageScore models. Native American communities have the lowest median credit score at 612, hovering in the fair range for both scoring models. Credit score averages for Black and Hispanic communities fall somewhere in the middle. The average score for Hispanic communities reaches into the good range at 667 and the average score for Black communities reaches 627, in the middle of the fair range.

A host of systemic issues point to why these score disparities may exist. Black Americans are often well behind white Americans in generational wealth, due to the country’s past slavery and segregation practices. Many Native American communities have experienced historic forced migration and land displacement, among other issues. Today, Native Americans who live on reservations often have limited access to financial institutions.

Hispanic, immigrant and refugee communities also tend to have less access to financial services, compared to white communities. Some other examples that can hinder many marginalized people from building credit include:

• Language barriers
• Employment discrimination
• Decreased access to online financial services
• Lack of financial institutions in rural and low-income areas or “banking deserts“
• Tribal trust laws

VantageScore and FICO both state on their websites that they do not include race as a factor when calculating credit scores. However, lenders can access your personal information on loan and mortgage applications, which may lead to discriminatory practices.

How race has influenced lending practices

Discriminatory lending practices are hard to pin down. A lender may not directly look at race to decide whether someone can receive financial services, but that doesn’t mean it can’t come into play.

Even though credit scoring models don’t include race as a factor, a 2019 University of California Berkeley study showed that lenders rejected minority applicants more often than white applicants. Additionally, the study found that lenders tend to charge Latino and Black borrowers 6 to 9 basis points more in interest, leading to $750 million in extra mortgage interest a year. This lending behavior extends to Native communities as well, since many Native Americans often pay more in interest and fees, even when the value of their homes is less than other groups.

Another report concluded that the average deposit required to open a checking account at a bank and the minimum balance needed to keep it open are lower in communities with a white majority.

Major banks also have a documented record of discriminatory lending practices based on race. One of the most notable is Wells Fargo, which settled with the Department of Justice (DOJ) in 2012. Wells Fargo and the Justice Department reached the second-largest fair lending settlement in the DOJ’s history to compensate qualified Black and Hispanic borrowers who applied for mortgage loans. Wells Fargo allegedly charged Black and Hispanic borrowers higher rates and fees than white borrowers. The bank also allegedly engaged in another illegal housing discrimination tactic called steering, where it directed — or “steered” — qualified Black and Hispanic applicants into subprime mortgage loans.

“Whether consciously or unconsciously, lenders have historically perpetuated discriminatory lending practices, resulting in unequal opportunities for women and minority entrepreneurs,” says Charles Inokon, founder of Cadence Cash, an alternative funding company that specializes in helping women- and minority-owned businesses.

These practices have, unfortunately, created holdover biases in the financial sector. “Minority-owned businesses face higher loan denial rates, and when they do get a loan, it’s often for less money and with higher interest rates,” Inokon says.

While biases in the financial sector exist, you can still control some factors in your credit score. Actions like paying your bills on time and keeping your debt low have some of the biggest influences on your credit score. Protections like those within The Equal Credit Opportunity Act give you support when reporting to regulatory agencies about lenders that are being unfair in how they offer financial services.

Predatory financial products to avoid

Due to the history of discriminatory practices in financial services, some minority groups don’t trust financial institutions. Also, since many of these groups have difficulty accessing financial services due to systemic oppression and other factors beyond their control, it’s hard to know where to turn for financial help.

Some lenders are quick to take advantage of these vulnerable groups. Predatory lending is the practice of lending money with terms and conditions that are unfair to borrowers and built to benefit lenders as much as possible. The most common examples of predatory lending products include most payday loans and some debt settlement services.

Check-cashing services often replace traditional banks in minority and low-income communities where banks are scarce or the majority are unbanked. These services may offer an alternative to people who don’t have a checking or savings account but, ultimately it is another factor that prevents credit building.

Predatory lending products often charge excessive fees and extremely high interest rates, which could push you into a cycle of debt. It’s important to be aware of all options available, and having this extra knowledge could save you money and save your credit.

How to build your credit score

If you are interested in building credit, you have more than a few ways to get started. Applying for a credit card or a personal loan are two of the more common ways to work toward building your credit score, but they aren’t the only options. Here are some other ways to help build your credit score:

Try a credit builder loan

If you have poor or no credit, lenders may be willing to offer a credit builder loan. Lenders offer these loans specifically to help people build their credit. Once you have approval for a credit builder loan, your bank will deposit an approved loan amount into an interest-building savings account. You’ll make monthly payments for an agreed-upon term to pay off the loan. At the end of the term, you receive the loan’s funds, minus any fees. Each payment you make on your loan will directly impact the payment and credit history factors in your credit report.

Become an authorized user

If you can’t — or aren’t ready — to get a credit card in your own name, you may be able to build your credit by becoming an authorized user on someone else’s card. Make sure the primary cardholder is someone you trust and who already has a solid history of good credit practices. If you or the main cardholder overspend or default on the card payments, you will both see a hit to your credit scores.

Tap into alternative reporting data

Paying off your credit card or loan isn’t the only way you can build your credit score. With programs like Experian Boost and ultraFICO, reporting agencies will add your bill payments to your credit report to help your score. To get started with these programs, you simply have to create an account with your program of choice and document the other financial activity you’d like to include in your reporting, such as paying your cellphone bill, utility bills and rent.

More credit resources

The knowledge you need to have a more successful and fulfilling financial future is out there, no matter your background. If you’re interested in building your financial knowledge, you want to get started building credit for the first time or you’re ready to start over, these resources could come in handy.

• Search for accredited, reliable credit counselors at the National Foundation for Credit Counseling.
• Look for a Financial Empowerment Center (FEC) in your area. FECs offer free professional, one-on-one financial counseling as a public service.
• Research consumer experiences with financial services companies through the Consumer Complaint Database from the Consumer Financial Protection Bureau.
• Access your annual free credit report from all three credit bureaus and get a look at where you stand.
• Explore specialized financial education tools and resources for multilingual communities, newcomers, Native communities, people with disabilities and more.

The bottom line

Lending practices over the years have gone through many changes. While people of color still face real issues when it comes to discrimination, protections now exist to help address them. One of the best ways to combat racial inequality and close the racial wealth gap is to arm yourself with knowledge. Read up on The Equal Credit Opportunity Act and how you can take action to advocate for change. And if you’re ready to build your credit score, start by getting a copy of your credit report so you know what factors within your control you should work on first.