Increasing Financial Inclusion and Credit Access in the United States
Access to the financial system enables individuals to save, make market transactions, buy insurance, get a mortgage, and more. An abundance of research suggests that financial inclusion leads to beneficial consumption smoothing, investment in education and business, health improvements, and female empowerment. Financial exclusion, on the other hand, prevents individuals from reaching economic stability and traps them in poverty. Credit access proves to be one of the most important aspects of financial inclusion. Despite the clear benefits, traditional lenders in the United States have historically restricted underprivileged communities’ credit access and, consequently, have excluded them from financial resources.
With a limited or non-existent credit history an individual rarely can access financial services. This results in a poverty trap. Today, 40% of Americans lack $400 in savings. When an income shock, such as a job loss or health emergency, happens, they must resort to their next safety net: Borrowing. And, without credit, many rely on payday lenders. The national average annual rate on these loans is nearly 400%, so if one is unable to quickly payoff this loan, their debt spirals. This proves devastating for low-income borrowers.
If, for example, on the way to work, one’s car breaks down and requires a $500 repair, using a credit card and paying back on a normal interest rate could result in a $510 total cost. On a payday loan, though, the cost could easily double to $1,000, at which point a person will have to decide how to save an additional $500: Cut back on food, work extra shifts, forgo medical treatment?
Understanding why these groups lack credit access and how to solve their challenges requires unpacking the formulation of credit scores. Lenders obtain credit scores through FICO. FICO, a company, generates scores using a FICO score algorithm, which analyzes a borrower’s credit history. Until recently, the algorithm has relied on only traditional credit data, including student loans, credit cards, mortgages, and auto loans. FICO obtains this data from credit bureaus, which collect reported data on a potential borrower’s credit history, including credit card, mortgage, and auto loan payments.
Consequently, low-income people, and, often, people of color lack credit data because of their lack of access to the traditional credit. Rather, their bill history is limited to daily necessities: Rent, utility, and cellphones. The most recent model, FICO 9, now includes more data, such as rent and utility payments, which have each been shown to, on average, increase scores by over 28 points. However, landlords and utility companies do not report data automatically, so low-income consumers themselves have to pay for their data to be reported. Moreover, many lenders have yet to switch to FICO 9, instead using older models of the algorithm.
Several short-term reforms can help the credit system become more inclusive. Credit access can be improved through three other ways: Government intervention to force structural change in traditional credit, private sector investment in helping underserved communities build credit safely, and partnerships between governments and startups or nonprofits to build more inclusive credit products.
Government intervention in the mortgage market can increase access to traditional credit. An obvious reform would be for government-sponsored entities, such as Fannie Mae, to immediately adopt FICO 9, enabling new types of payments to qualify for credit. The government could also mandate that credit companies pay landlord and utility companies for non-traditional data so that FICO 9 scores are comprehensive. Alongside an update in the FICO system, government reforms can work to increase equitable access to homeownership with efforts like the Community Reinvestment Act.
Beyond these reforms, both the private and public sector can help underserved communities build credit safely. The first step is often the hardest for potential borrowers without credit histories as they fail to qualify for credit cards. Credit providers can help by issuing secured credit cards to those who fail to qualify for normal credit cards. These secured cards, backed by a security deposit, enable borrowers to build a credit score without risking losing more than their deposit. In addition to these secured cards, credit unions can issue credit builder accounts, which let borrowers place a small loan to themselves in a Certificate of Deposit Account and earns credit history.
Lastly, the government can incentivize startups and nonprofits to build innovative, inclusive credit products. Several organizations have already started doing so. Petal issues a no-fee credit card and the company judges credit worthiness using income, savings, and bill payment data. UpSolve helps those who are insolvent file for bankruptcy, which provides a new financial beginning and boosts credit scores. Such efforts can also target communities who face unique challenges as Nova Credit and American Express both do by helping immigrants utilize their international credit history.
With these reforms, underserved borrowers will be able to build their credit scores. Now, when someone’s car breaks down on the way to work, the situation is manageable. She will have a credit history and access to financial products and services that will prepare her to navigate and reduce such income shocks. A car repair will be just a hiccup on the road, not a decision between the repair, meals, or missing a doctor’s appointment.
A longer version of this essay was the winner of a recent essay competition.
Samarth graduated from Harvard College, where he studied Economics. His undergraduate thesis focused on the intersection of healthcare and housing. Outside of his thesis, he researched the causes and consequences of eviction under Professor Matthew Desmond and police use of force under Professor Roland Fryer. He has spent previous summers interning at the White House Council of Economic Advisers, the Consumer Financial Protection Bureau, the City of Boston, and the Boston Consulting Group. He plans to focus his dissertation on the variation in quality and the financing of long term care across OECD countries.
The views expressed in this article are the author's own and do not necessarily reflect any editorial policy.