How Does Credit Karma Make Money?

You ever see those internet memes where a cat adopts a mouse? Funny enough that’s what popped into my head when I started researching Credit Karma.

How does credit karma make money?

Image: pixelvector via Reddit

Credit scores are an industry built around the misery and mistakes of human beings. I make no comment on whether that is right or wrong, I am simply noting that somewhere out there, there is a long list of every electricity, gas and mobile phone bill you forgot to pay. That sets out in great detail how many times you had to move because your landlords are genetically predisposed to being jerks. Perhaps there is even a side story about that time you almost married somebody whose Fico score was so low the bank’s computer said “you must be joking!”

And then finance companies buy and sell this data like cats looking for their next meal.

But Credit Karma just about manages to persuade us (well me at least), that it isn’t a cat. Or rather that it is a cat that has learned to love.

Because they pay for your credit report and give it to you for free.

Someone always has to get paid, but Credit Karma is as close to nice as you will get in consumer finance. They hope to make money by advertising to you credit cards and loans that should LOWER the cost of your debt.

And along the way the information they provide gives you a chance to clean up all the nonsense that builds up. Because the miseries listed often do not even belong to you.

The History of Cator Woolford

Cator Woolford historyIn 1898, Cator Woolford started gathering information on the customers at his grocery store in Chattanooga, Tennessee. Mr Woolford and his brother Guy, would visit fellow merchants and ask about the people that frequented their stores. Simple comments such as “Prompt”, “Slow”, or “Requires Cash” would be scribbled into a ledger.

Image: Cator Woolford, Equifax

In 1899 he formed Equifax’s forebear, Retail Credit Company (RCC), and published “The Merchant’s Guide” filled with these fun facts for $25 a copy. The firm was a huge success and rapidly expanded into other areas such as life and auto insurance.

The power and horror of credit bureaus are readily apparent. On occasion, ratings were based on little more than rumors and slander. Rumors that you would not be allowed to discover yourself unless you paid up like Woolford’s other customers. And yet this ledger was hugely effective at increasing the chances that lenders and insurers got their money back.

RCC would have two brushes with its regulator the Federal Trade Commission. Once around accusations that it was paying bonuses to its employees for finding dirt, and later for monopolistic practices. Although both times the charges were dropped, it ultimately split its credit bureau and insurance investigation businesses. Like a college student starting their first job, RCC decided a re-brand was in order and renamed themselves Equifax.

Equal before the facts geddit.

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Turning Your Dirty Laundry Into a Data Point

Credit bureaus like Equifax, Experian and TransUnion sold credit reports. It was Fair Isaac who invented the FICO credit score you know and love (sic). The mathematician William R Fair and an electrical engineer Earl Isaac introduced their first scoring system in 1958. Its evolution and resilience speak to the ability of computers combined with your data to predict whether you will pay on time, pay late, or not pay at all. Fair Isaac would later develop a successful system that helps the IRS decide who to audit, and a less successful system to determine who to hire.

Fico Scores

Scores are crazy because you cannot express any human being as a single point of data. They cannot describe your qualities as a person.  It does not understand how you missed paying a bill because you were playing Pokemon Go. How you have always wanted to start a restaurant. They cannot explain the time you lost your job and your wife ran away with your accountant.

How does a fico score make money

Image: CafeCredit.com via Flickr Commons

My favorite divorce story isn’t really a story and it isn’t even a stat. If you get divorced three times, you don’t end up with a quarter of your money. You end up with an eighth of the money you started with. A half of a half of a half is how you turn $100 into $12. Don’t do it people! Marry late and marry right!

But Fico scores are not here to tell your life story. They are just trying to say whether or not you are likely to behave.

One socially positive feature of credit scores is that they actually reduce discrimination. Factors like age, sex and race are largely excluded from their calculation. I say largely because having a credit card for twenty years likely precludes you from being any younger than thirty-eight.

Credit scores work for the payment of bills, the chances that you have taken too many tax deductions, the likelihood that you will claim on your auto insurance and even in recruitment.

According to the Society for Human Resources Management, half of employers surveyed said they credit check candidates.

Disgusted? Don’t be.

A Harvard Study by Shoag and Clifford indicated that banning the use of credit scores when hiring actually hurt those with (1) mid-to-low credit scores, (2) those aged under 22 and (3) black people. It appears that without a credit score data point, recruiters tended to circle back to other data points, such as education and experience, where the privileged are even more dominant.

What Does Fico Have On You

Your Fico Score has five components

Fico components make money

Image: HowDoesItMakeMoney.com

Fico gets your data from the credit bureaus and then crunches it with an algorithm. Each of its business customers can adjust the algorithm to suit their own particular preferences. This is why individuals may have dozens of credit scores. Each bureau may have a slightly different record of your history and then the company thinking of lending to you always swears by its own secret sauce. Any credit bureau can provide THEIR credit score on you, but at least if you are in the United States there is an underlying Fico score they may not be sharing with you.

However, honestly this score does not necessarily means anything. Recruiters who use Fico scores understand that it is just one data point and you should too. If anything your credit history is much more interesting.

Judge, Jury and Prisoner

You’re sitting on a train reading this on your iPhone. What if I told you that the guy next to you has spent two years in prison?

Are you scared? You would be if I told you he conspired with his wife to murder a hitchhiker and got off easy on a plea bargain where he sold out his better half.

What if I said that his only crime was protesting a chemical spill in a pristine piece of wilderness, and then a corporation sent in a bulldozer that he had to damage in order to protect his friends?

Or how about if his crime was to assault the teacher who molested his children? The average person might even shake his hand.

It is a joke how easy it is to prove that a number, and I mean a freaking serious number, not this joke thing we call a credit score, is nothing compared to the story behind it.

How your story makes money

Image: David Bleasdale via Flickr Commons

Paying For Your Data

This illustrates the power of information. Imagine you are sitting on a train and YOU are the guy who has spent two years in prison and YOU have to pay to know what your crime is.

Imagine you are in your thirties and you have lived your life as best you can and you have no idea what is on your credit report.

Unless you pay for it.

And it gets worse. An FTC study found that one in five had an error on their credit report. That is somebody else’s bullsh*t mistake hurting your credit score.

These are the horrible pain points that Credit Karma and their competitor, Credit Sesame, are trying to resolve.

The Credit Bureau Business Model

  1. Collect all the data on an individual’s payment history and outstanding credit from banks, utilities and insurers.
  2. Use an algorithm to convert this data into a score that predicts future behavior.
  3. Sell this to banks, finance companies, utilities, insurers, and employers for use in decision making.
  4. Charge the individual to see their data.

Things are slowly improving. As part of the Dodd-Frank reforms from 2010, borrowers have a right to their credit rating if they do not get a loan or the best possible rate.

In India the dominant credit checking bureau is Cibil, which is owned mostly by TransUnion International and a selection of the largest Indian banks.

Conversely, the Philippines does not have a centralized credit reporting organization and therefore banks maintain their own records using internal and external data. The Credit Information Corporation CIC, a state owned firm, is slowly building its way towards this role.

Credit Score Horror Stories

There are just too many. An apartment complex takes a guy to court over unpaid rent. They win a civil court judgement against him and presumably has debt collectors chasing him down. This man’s credit score goes down the toilet. Except after getting a lawyer involved, he discovers that somebody with the same FIRST name as him is the cause of all this. Read it and weep they did not even have the same surname. And that man did not move into the same building, merely into the same complex.

amex_visa_philip_taylor

Image: Philip Taylor via Flickr Commons

A friend of mine got rejected for a mortgage. After some research, she discovered that it was because an ex-boyfriend of hers had an outstanding credit card bill. They hadn’t even moved in together – but he had sneakily put her address down for a bunch of applications he made.

No one can deliver a 100% accurate and 100% secure database.

As the story about recruitment suggests, banning credit scores is not a solution. But there is the opportunity to help people, and make money.

Because Reducing Interest Payments Makes Money

There is one number in your credit score that really does matter to your quality of life. It is your total borrowing. If you saw my total borrowing (the mortgage on my house), your eyes would water.

Your credit report specifies who you borrowed this from. This makes it easy to figure out how much you are paying on your debt.

Sick and tired of automated calls asking if you would like to refi your mortgage?

Good. That means you already refinanced.

I love US 30 year fixed rate mortgages. They are so consumer friendly. Outside of benefiting from the dual government subsidies of Fannie / Freddie Mae and mortgage interest tax deduction, you can refinance it if interest rates go down and do not bear any risk of rates going up. That’s why even Zuckerberg takes out a mortgage. It is a no brainer.

How do banks make money

Image: Aaron Jacobs via Flickr Commons

The US Government is forcing the banks to help their customers refinance into lower rates, which explains the endless calls and junk mail. But did you know that even though over 3 million Americans have refinanced under Obama’s Home Affordable Refinance Program HARP, more than 300,000 are eligible to and yet have still not done so (mid 2016). Every single one of those people are leaving significant amounts of money on the table.

Hate Government spending? Sometimes I do too. I am happy to fight against subsidies, but I’m pretty sure I would refinance under HARP too.

How to Improve Your Credit Score

  1. Take out some credit and be sensible with it.
  2. Get old.
  3. Register to vote.
  4. Pay your bills on time.
  5. When you apply for credit, research what you need and apply once. Each hard pull on your credit report impacts your credit score negatively. Some companies offer a soft pull that doesn’t damage your score, but its never obvious who they are.
  6. If you actually want some hard advice and not the wishy washy stuff like 1-5, try this. Run a balance on your credit card where it is set to debit the minimum required payment. Now every month, make an ADDITIONAL payment that is double your minimum payment. The benefits of this are threefold. The balance you are borrowing flags you up as profitable. The extra payment flags you up as extremely committed to paying it off. The double amount or more indicates that you are earning more than you are spending. You have just become the perfect credit card customer.

Credit Karma’s Business Model

  1. Subscribe to an individual’s credit report and credit score from TransUnion and Equifax.
  2. Provide this to individuals for free.
  3. Review the individual’s total borrowing and likely cost.
  4. Advertise credit cards and loans that offer rates lower than what these individuals are currently paying.

Credit Karma's full credit report

Image: Credit Karma

Many users do not sign up for these offers. But that is what is so beautiful about this model. They are making people smarter, giving them more control, and finding a way to get paid. And as anyone who reads my blog knows, making money is the best way to develop a sustainable business.

Safety warning: one of the reasons I am open to trusting Credit Karma is they do not ask for your credit card details. Be super suspicious of anyone who asks for your credit card details. They are the easiest way for others to take a payment from you – whether fairly or unfairly. They are also what destroyed the Ashley Madison users following that website’s hacking. As a side note, be careful around anybody who works in finance. They are cats, not mice.

I am an affiliate partner with Blinkist. This is an app I use every day to read short summarized non-fiction and I cannot recommend it highly enough.

As a personal update, I am going to be starting some postgraduate studies at the end of the month, so unfortunately the frequency of blog posts is probably going to decline. Please do subscribe to my mailing list so when I do get around to writing, you are one of the first to hear.

Yuen Lo

3 Comments

  1. Another excellent article. I am thankful for Credit Karma and all the ways they help people. However, a company like Credit Karma should not have to exist at all if the 3 credit reporting firms had adequate transparency. We all know that there should be much more consumer protection in this area. The US credit reporting system is such a racket that it spurs me to escape their “Matrix.” We don’t have to live with it forever. By minimizing and eliminating all personal debt by having a substantial savings rate (at least 50%) of take home pay, this is possible if one is motivated. Once all debt is eliminated, cash reserves can be accumulated and used for future minor and major expenses. This is essentially the philosophy of FI (Financial Independance) and MMM (Mr. Money Mustache). MMM, although radical, it my favorite personal finance blog. So, use resources like Credit Karma to monitor potential dangers in the Credit Matrix until you escape. This is certaintly possible for anyone who is at least in the middle class or higher.

  2. Hi Ryan, I just got back from a trip to Madrid and feeling very refreshed! That’s a great comment, the most secure way of living our lives is definitely to live without debt. Never heard of the credit matrix before, what a cool phrase 🙂 What interests me is that credit karma’s model hasn’t been replicated in many other countries i.e. arguably only in America do people have enough debt to make this business model comfortably sustainable. I saw a survey along the lines of, those with savings, like you and me, enjoy saving. Those without savings enjoy spending! Solving this is easier said than done. Its too easy for non smokers to tell smokers to stop smoking. Debt and the credit matrix is just so much hassle to me, but the other perspective is that a nice car is just so much fun.

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