Credit scores without debt? Fintech cards baffle credit industry

Millions of Americans have opened these so-called credit-builder cards since the first major ones came onto the market around the start of the pandemic. Customers deposit money into these accounts to pay bills or make purchases, much like with a debit card.

Here’s the twist. Fintechs report some of these transactions to the credit-reporting companies as credit activity, or borrowing, even though no credit is ever extended to the customer.

Fintechs tout credit-builder cards as a way to smooth out flaws in a credit-scoring system that, to some, makes little sense. Under normal circumstances, the only path to build a credit score is to borrow money. In other words: People need to take out loans to establish credit scores, but they need credit scores to be approved for loans.

Credit-builder cards, on the other hand, often don’t require credit checks at all, much less a particular score. The cards are also designed to mainly report positive data. For example, the cards offered by Chime and Credit Sesame make it difficult or impossible for customers to become delinquent.

How it all works

For decades, nearly every decision in U.S. lending has revolved around the little three-digit numbers known as credit scores.

The credit-reporting companies—Experian, Equifax and TransUnion—gather reams of data on individual Americans and turn that into credit reports. Those data points are then fed into algorithmic models from Fair Isaac or VantageScore to produce credit scores, which are designed to predict the likelihood that a borrower will become delinquent on a loan.

Lenders pay for credit data and scores to help decide who can get a loan and how much interest they will have to pay, but the scores are even more important than that. Employers might consider them when deciding who to hire. Landlords might look at them when deciding who gets to rent an apartment.

That very system is under scrutiny. On one side, regulators say it locks out people who have limited credit histories—maybe because they are new to the U.S., or have largely used cash and debit. Consumer advocates say the scores are unfairly opaque, making it hard for people to even guess why their score might go up or down.

Banks, for their part, are becoming more skeptical of the usefulness of traditional credit scores. For example, the pandemic inflated credit scores for many borrowers. In recent years, banks have started to incorporate more of their own internal data and models into credit decisions.

‘A win-win’ or an unhealthy approach?

The world of traditional credit hasn’t exactly embraced credit-builder cards, which banks and other industry players say don’t accurately reflect the ability and willingness to repay. At some larger banks, underwriters don’t give the cards as much weight on borrower applications, people familiar with the matter said.

Even the three credit-reporting companies can’t agree on how to deal with the cards.

Jeff Softley, group president of consumer services at Experian, called the cards “a win-win scenario." Experian has its own credit-builder card.

“Consumers are getting a more comprehensive and enhanced credit profile," Softley said, “and lenders are getting access to a broader swath of consumers who are eligible for their products and offers."

Equifax said it incorporates credit-builder cards into its reports as long as they meet certain industry guidelines.

Some credit-builder cards are also listed on TransUnion credit reports and fed into FICO and VantageScore algorithms, said Paul Siegfried, TransUnion’s head of card and banking. But only “a handful" of those cards meet requirements to be included in TransUnion’s own credit scores, he said.

“There are a number of entities that are looking to report what we would consider noncredit data to TransUnion as credit data," Siegfried said. “We don’t believe that approach is a healthy approach for the lending ecosystem as a whole."

What FICO and VantageScore say

FICO said it is still studying what credit-builder products mean for its scores, including how they relate to the likelihood that consumers will make payments on “credit obligations in the future," said Jim Wehmann, executive vice president for scores.

VantageScore, which likes to bill itself as a more-forward-thinking alternative to FICO, said it has started to work with industry players to “help them understand how to improve in the most beneficial way possible the consumer’s credit score," according to CEO Silvio Tavares.

But even he is still wrapping his head around how exactly to do that. “The challenge is, of course, not all the credit-builder products are the same and so there is some variability in the impact."

The business models and terms vary from fintech to fintech. The cards generally don’t charge interest. But they can bring in revenue for the fintechs through interchange or other fees, as well as new customers and data.

James Adair, a retail associate outside of Seattle, opened a Chime credit-builder card around a year and a half ago after a slim credit file and several unpaid bills dinged his score. His score jumped dozens of points to just under 600 over the first three months, but then started to level off.

Adair opened another credit-builder card with a different fintech and, eventually, traditional credit cards with Capital One and Discover. His score has since increased another 75 points, he said. But, he acknowledged, there’s no way for him to tell how much of that was driven by the fintech cards and how much by the traditional credit cards.

“There was a little sprint," said Adair, 47 years old. “But credit scoring is a marathon in the end."

Write to Gina Heeb at gina.heeb@wsj.com