The Affinity Hub

Hard vs. Soft Inquiry

One of the least understood areas of fintech is credit reporting — namely, which parts are a legal requirements, and which parts are just industry standard.

Credit pulls and reporting is governed by the Fair Credit Reporting Act (FCRA).

The FCRA has two parts to it:

(1) how does one obtain someone else’s credit report;

(2) how does one report on someone else’s credit behavior.‍

Fairly straightforward:

If you’re going to obtain personal details, like someone’s credit history or credit score, you need a good reason to do so.

And if you’re going say good or bad things about their credit behavior, you better be accurate.

Let’s use an example. Our friend, Milly Mango, just got a new job and has decided to apply for a new credit card from Cool Finance.

Cool Finance decides to pull Milly’s credit report to take a look at her credit.

This is, of course, normal. Cool Finance is giving Milly credit, and they have a right to know whether she has kept a good credit history.

Under the FCRA, Cool Finance needs a permissible purpose, or a legally acceptable reason, to pull Milly’s credit. The two most common types of legally acceptable reasons are:

• You’re pulling someone’s credit report to assess their creditworthiness
• You’re pulling someone’s credit report after they’ve given you written authorization

Here, Cool Finance probably has both purposes checked

‍(Note: In most cases, parties will obtain a written authorization as a back-up which is why if you’ve ever applied for credit, somewhere in your long list of fine print agreements you’ve consented to having your credit report pulled)‍

Now, when pulling her report, Cool Finance has two options. They can do a “hard inquiry” or a “soft inquiry”. The difference:

A “hard inquiry” means the fact that Cool Finance checked your credit becomes public for all other creditors to see.

A “soft inquiry” remains hidden on the public credit report such that only Milly would be able to see Cool Finance’s inquiry

A “hard inquiry” also usually results in a small decrease in credit score and a “soft inquiry” doesn’t.

Why?‍

With a “hard inquiry”, other creditors can see that Milly has applied for credit, and the fact that Milly has applied for credit means she might be on the verge of accruing debt, making her a riskier borrower.

But, wait a second, you say….

In either case, Milly is apply for credit, and so a potential riskier borrower, and so what difference does it make that her inquiry is public?

Yeah, good point.

Like many things with the credit reporting system in the U.S., the difference between a “hard inquiry” and “soft inquiry” makes little sense.

In fact, there’s no legal basis for a hard or soft inquiry. The FCRA, the main law governing credit reporting, doesn’t mention either a hard or soft inquiry.

And so myth #1: A hard inquiry is a legal requirement

Fact: A hard inquiry is merely the creation of the credit reporting agencies.

‍They can’t really compel you, as a fintech or creditor, to do a hard inquiry.‍

And so let’s take a step back:

Hard inquiry: Results in lower credit score, gives access to credit report

Soft inquiry: Does not result in a lower credit score, gives access to credit report

The credit report you get between a hard and soft inquiry is virtually the same (there are differences but, for the most part, you’re getting what you need on both reports).

So why in the world would any creditor do a hard inquiry if it’s detrimental to the borrower?

The answer is that while CRAs can’t legally force a creditor to pick one type of inquiry over another, they can strongly encourage, cajole, persuade you into doing a hard inquiry.

Why is it important to them?

CRAs sell data. A credit report where all of Milly Mango’s creditors are publicly listed is more valuable than one where only some or few are publicly listed.

This makes sense if Milly Mango applies for a credit card or a mortgage once every few years.

But Buy-Now-Pay-Later has made access to small dollar credit ubiquitous. Milly can take out multiple 10 $100 loans as opposed to 1 $1000 credit card.

In that case, the CRAs won’t distinguish on the size or type of loan. They would just report 10 hard inquiries, suggesting that Milly is on a debt accruing binge.

The BNPL industry has fought hard against hard inquiries, and for good reason.

There is an argument that hard inquiries generally help the industry against fraud and “debt stacking” (applying for multiple lines of credit in a short enough time such that none of your creditors would pick up that you’ve applied for credit elsewhere).

But, for the most part, the hard inquiry makes little sense in the world of embedded credit where small dollar credit is easily accessible. And if you think traditional finance generally moves slow, try getting one of the CRAs to adapt a model here that actually makes sense (good luck to us).

Credit Reporting:

Myth #2: I must report on good or bad payment behavior to the bureaus

Fact: Credit reporting is strictly voluntary. If you choose to do it though, the requirements are very strict and technical, and inaccurate credit reporting is one of the biggest sources of litigation.

If you are a fintech, keep in mind that credit reporting is a high operational activity. You will need policies, procedures, and someone who has the patience to work with Metro2, the software CRAs use, which is about as sophisticated as software built in the 90s.

When would you want to prioritize credit reporting:

• Negative credit history: You are lending to riskier borrowers (sub-prime, thin file, novel underwriting) and you need an extra stick to keep your default rates low. If you are seeking debt capital, having credit reprting in place may also reduce your cost of capital.
• Positive credit history. Part of the core premise of your product’s value proposition is to help your customer’s build a positive credit history.

Like so much about the credit reporting system, what doesn’t make sense here is that so many of the other parts your creditworthiness don’t get taken into account n the reporting. For example:

• Your income. CRAs have models for calculating your DTI (debt to income) ratio but none are that reliable, and they don’t factor into your credit score (partly because income is hard to verify). Shouldn’t your riskiness as a borrower be directly tied to your ability to pay off your debt?
• Your rent. You can pay your rent on time for 10 years and have it make zero impact on your credit score.
• FICO is historical, not forward looking. For thin file applicants, recent college grads, new immigrants, this is all too familiar. You have all the right indicators to demonstrate that you are not a risky borrower but you need a credit history to, well, build a credit history. Reminds us of the entry level job that requires prior work experience.

The credit reporting system was built for a different era and the CRAs are slow (dinosaurs) to catch up, partly because they have a pseudo-monopoly on the system.

Fortunately, fintech is the ultimate disruptor, and there are many fintechs out there working to modernize the system and make it make just a bit more sense.

*******************

While we hope you found this post helpful, please note that the information in this post is not intended to be legal, regulatory, or relationship advice.

Fintech Law and Compliance 101 is affiliated with https://www.itsaffinity.com/ a compliance learning management platform built specifically for banks and fintechs.

‍