Education, Fear of Debt and Credit Scores

There have been a number of recent studies that have established a strong correlation between demographic characteristics such as age, educational level and race and consumers’ credit scores and financial behavior in the U.S. Some findings are more intuitive than others, but all of them have interesting implications.

Going over these papers, I found myself beginning to modify my long-held position on the amount of control people have over their credit scores. I’ve always believed, and still do, that there is a very straightforward set of rules for maintaining a solid FICO score that everyone can follow, irrespective of their demographics. At its core, maintaining a good credit score is all about living within your means and that is all people need to do. Life, however, tends to complicate things. I learned, for example, that consumers with a larger family size have lower credit scores. And of course that makes sense, not just because having more children leads to a lower per-capita family income, but also because there is a greater probability for some adverse event (say, an illness) that would necessitate emergency borrowing, damaging the parents’ credit scores in the process. What do you do about that? You can’t just reduce your family size. And then there is education, which is one of the most important determinants of financial behavior and one over which we should have somewhat more control. But it seems that our best weapon for improving credit scores could be a basic human condition.

How Age, Education, Income and Race Affect Your Credit Score

Here is what two Fed researchers – Fumiko Hayashi and Joanna Stavins – found in a recent paper:

Older consumers and higher-income earners tend to have a higher credit score. Consumers with lower educational level than a college degree tend to have a lower credit score; however, after controlling for financial difficulty variables and card status, the effects of less than high school and high school dummies become insignificant. Contrary to the finding in Avery et al. (2010), black consumers tend to have a lower credit score. The discrepancy may arise from the fact that the SCPC contains some – but not all – financial difficulty variables that comprise the FICO score, and the possibility that race may serve as a proxy for the omitted variables. Consumers who were separated or divorced have a lower credit score than married consumers. Consumers with a larger household size are more likely to have a lower credit score. Having Internet access at home is positively correlated with credit score.

As I said, some of these findings are more intuitive than others. Now, there are things to be said about each of these factors, but what I find particularly interesting is the relationship between education and credit scores. Another recent paper — by Shawn Cole, Anna Paulson, and Gauri Kartini Shastry — gives us some specific data on the effects of education on consumers’ borrowing and credit behavior:

Some of these effects are less dramatic than the effect of education on financial market participation: an additional year of schooling raises an individual’s credit score by 8 points (roughly 9% of a standard deviation). Others are even more dramatic: one year of schooling reduces the probability of bankruptcy by 3.3 percentage points, from a base of 14.4%.

So it seems that all we have to do is educate ourselves just as highly as possible and we will be in good shape. But then the researchers quickly dampen our enthusiasm by reminding us that not everyone has the right “innate cognitive abilities,” which they’ve found to matter for a greater number of financial instruments than the “acquired abilities.” So there is, after all, only so much that education can do for us.

The Takeaway

We do know that the Great Recession took its toll on Americans’ credit scores and there is no recovery in sight yet. However, as mortgage foreclosures have fallen to their lowest level since before the crisis began and credit card delinquency and charge-off levels are now in record-low territories, we do get a reason to hope for better news in the months to come. Yet, rather than being the result of improved education, rising credit scores are likely to be the byproduct of the fear of debt that has been gripping Americans since the fall of Lehman and that is showing no signs of dissipating. Fear is indeed a powerful motivator.

Image credit: Pixmule.com.