You know you need good credit to take out a loan, a mortgage, or your friend with expensive taste. But did you know your credit score can actually make a big difference in your rates? We did some digging into the hows and the whys credit scores affect car insurance premiums, and the answers might surprise you.
As of July 1, 2017, some 12 million Americans have seen a bump in their credit scores –and that’s a welcome change for a number of reasons. Here at The Zebra, we immediately see how this could mean car insurance savings for most drivers across the U.S. Why might that be?
But first things first—let’s get a few definitions out of the way.
What exactly is a credit score?
A credit score is a three-digit number somewhere between 500 and 900 that’s a marker of your financial fitness. Institutions and companies use this number to determine how likely you are to repay your debts. It’s based on your past credit history, among other things.
New York’s Department of Consumer Affairs explains: “A good credit score shows that you have a high probability of repaying loans on time. Therefore, a good credit score will help you take out loans more easily and even get better interest rates.”
When creditors take a gander at your credit score, they’re assessing whether you’re a low- or high-risk borrower. “A low-risk borrower is someone who most likely would repay their loans, while a high-risk borrower is someone who most likely will be unable to repay their loans on time.”
But what does your credit score have to do with car insurance?
Here’s where things get a bit stickier. Turns out, for the past 20 years or so, car insurance companies have been using credit scores to determine premium rates (aka how much money will be coming out of your pocket each month.) So what on earth do the two have to do with one another?
There’s a statistical correlation between your credit score and how likely you are to file a claim, and insurers use this correlation as the reason for the practice of raising rates for drivers with bad credit.
A 2003 study done by the nonpartisan Bureau of Business Research at UT’s McCombs School of Business, confirmed this correlation. Study author Bruce Kellison explains that there is a relationship between how much a consumer costs an insurance company (aka incurred losses) and that customer’s credit score. Kellison and his colleagues examined more than 175,000 separate policies, and found that the average loss per policy, across the entire dataset, was $695. But for those policies in the lowest 10 percent of credit scores, the average shot up to $918.
There’s an interesting subpoint to this practice: Insurance companies often don’t use the FICO credit scores available through Equifax, Experian, or TransUnion. Instead, they have the capabilities to create their own versions of these scores. Kellison spells it out in his study: “Individual insurance companies can (and do) use individual credit histories to create their own models and credit scores. If an individual insurance company can create a “better” (more predictive) credit score model, the relationship between credit scoring and losses will be even stronger than that found in this study.” Crazy, huh?
Study: Poor Credit Will Cost You Double for Car Insurance
Because we like to dig into the issues here at The Zebra – and because we’re so fond of data – we partnered with CreditSesame to examine the impact of credit on car insurance rates more closely. (See the full study here.) Some key findings:
- Most Americans think they have good credit — but most are wrong.
- 69% of people incorrectly assess their own credit health.
- Nearly 3/4 of Americans (73%) think their credit scores qualify as Good, but only 41% of Americans actually have Good credit.
- About the same amount of folks have Poor credit (42%) as have Good credit (41%).
- Some folks have better credit than they think; while 11% of Americans think they have Excellent credit, 17% actually do.
- Nearly 1/3 of Americans who have poor credit don’t know it.
- Although 42% of Americans have Poor credit, only 11% of Americans think they do.
- People who think they have Good credit and are wrong (32%) likely have Poor credit (because the majority of people who think they have Excellent credit actually do, so the remainder would have Poor credit).
- States with the largest percentage of residents with Poor credit (for example, Mississippi, where with 52% of residents have Poor credit) are typically the worst at accurately assessing that they have low credit (only 12% of those with Poor credit know they have Poor credit).
- Americans with poor credit pay twice as much for their car insurance as those with excellent credit.
- On a national average, car insurance premiums for those with Poor credit cost more than twice as much as premiums for those with Excellent credit.
- Improving credit from Poor to Good will save drivers an average of 32% in auto insurance premiums.
- Improving credit from Good to Excellent will save drivers an average of 27% in auto insurance premiums.
But is using credit to determine car insurance rates fair?
Now just because this is common practice doesn’t mean people think it’s right. In fact, there are three states where the practice has been banned altogether: Hawaii, Massachusetts, and California. Their stance: shouldn’t your driving record be the biggest predictor of, well, your driving record?
Consumer groups, including the Consumers Union, have come out in opposition to the practice. Check out this particularly cranky bit from their report:
Consumer Reports sought and obtained scoring models filed with regulators in Florida, Michigan, and Texas used by 9 of the 10 largest U.S. auto insurers. CR found that there are no standards. Each company uses different models and weighs different credit-report information. Some big companies find scoring useful only for new customers, not renewals, while others may use it for both. Moreover, CR notes that the credit data from which the scores are derived have a reputation for being inaccurate and out of date.
Advocates from Consumers Union (which is the publisher of Consumer Reports) have tried to urge legislators and regulators in several states to ban the use of credit scoring in auto (and home insurance, where it also happens.) Insurers, perhaps not surprisingly, have fought back.
Kellison’s own study addressed this opposition. The study notes, “A common criticism of credit scoring and its use in underwriting decisions is that it may discriminate against low-income and/or minority applicants, and that its use, in effect, amounts to “red lining.””
(If you’re not familiar with redlining, good old Wikipedia defines it as the “practice of denying, or charging more for, services such as banking, insurance, access to health care, or even supermarkets, or denying jobs to residents in particular, often racially determined, areas.”)
Indeed, in a 2007 FTC study, “The FTC cited other studies that found tying insurance rates to credit scores tends to discriminates against low income and minority consumers because of the racial and economic disparities inherent in scoring.”
No matter your opinion on the issue, it does affect you, so the best steps you can take involve keeping your credit as squeaky clean as possible. This means:
- Tracking your credit report – you can do so for free with CreditKarma
- Paying what you owe
- Not skipping any payments
- Paying on time
- Looking into any possible errors on your credit report
So what are your thoughts? Is this practice fair, or shady?
Article updated July 2017.