Over the past decade, there has been much discussion about credit scores, what they mean and how they are used. Consumers are now aware that credit scores are widely used and that credit scores will have an effect on their application.
Scoring has the advantage of statistical accuracy and the ability to predict credit behavior, but it has the disadvantage of seeming like a magic black box to those who don't understand how it works. Because consumers (and some lenders) don't understand credit scoring, the use of scores has generated controversy.
Consumers know that a low score will hurt their chances in getting credit. Some consumers have learned that a low score will increase the interest rates they can obtain. Because consumers don't understand how scores are developed, they tend to be suspicious of how scores are used - especially when the use is to the consumer's detriment.
FACTA has entered the arena. The new act imposes several requirements related to credit scoring. Unfortunately for the lending industry, these requirements are likely to prove the most complex for compliance.
There are two primary components to the credit score disclosure requirements. The first component falls on credit bureaus and the second on creditors themselves.
Credit Bureau Duties.
FACTA revises section 609(c) of the Fair Credit Reporting Act to provide that consumers have a right to obtain and dispute information in their credit reports and a right to obtain a credit score. It directs the Federal Trade Commission to develop a model summary of rights for consumers that will explain when and how they may obtain copies of their credit report. The notice must also explain how often the consumer may obtain a free copy of their report.
This notice to consumers will include information about credit scoring. The notice will advise consumers that they have a right to get a copy of their credit score from a consumer reporting agency. It will also tell consumers how to go about getting their score.
When it comes to using the Internet, Congress has finally seen the light. FACTA directs the FTC to make consumer rights notices as widely available as possible. It specifically directs the FTC to post the notice conspicuously on its Internet website. FTC must also use other means, including providing copies upon request, to distribute the notice.
By using the FTC to make consumer rights information available, the act provides this information before something happens to the consumer. Having the information should help consumers react promptly when and if identity theft occurs. It should also help consumers take steps to prevent identity theft.
FTC must also issue regulations governing credit bureau actions under this new provision. The regulations will deal not only with notice content, but when and how credit bureaus must provide information to consumers.
What A Credit Score Is
FACTA defines credit score as a numerical value or categorization derived from a statistical tool or modeling system. It is used by a creditor to predict the likelihood of credit behaviors. Unlike the Regulation B definition (demonstrably and statistically sound, and empirically derived), the definition does not incorporate statistical accuracy. Instead, it is based on method of development and use of the score.
The definition specifically excludes any score or automated system that includes more than the credit history of the applicant. Scores or systems that include underwriting factors (debt ratios, loan to value ratios) are excluded from this definition. In other words, this definition and its related rule apply only to the credit history and performance of the applicant. The rule does not apply to any other credit scoring system.
Disclosing Credit Scores
Upon a consumer's request, the credit bureau must provide the credit score along with explanatory material. Yet another notice, this information will include advice to the consumer on the significance of the score as well as the factors that were detrimental to the score. The notice will include the following information:
the consumer's current or most recent credit score,
the range of all possible credit scores (high and low ends),
all of the key factors that adversely affected the score, up to a total of four, listed in the order of their adverse effect on the score,
the date the score was created,
the name of the person or entity that provided the score or the file upon which the file was created, and
a statement that the credit score provided by the bureau may be different from the score that was actually used by the lender.
There are several interesting elements to this notice. The most significant is that the notice must identify all of the key factors that adversely affected the score. There will be no selecting just one. Only someone with absolutely perfect credit will have only one or no reasons.
The other interesting feature is that the law itself limits the number of reasons to four. This reflects the policy interpretation in regulation B but goes further by prohibiting more than four reasons.
There are also likely to be definitions of how a factor is adverse. Based on the FRB's previous experience with credit scoring systems and selecting reasons for adverse action, we can expect ideas and opinions to come out of the woods and out of the woodwork. Rulemaking should be a very interesting process.
FACTA contains a definition of "key factors" that contribute to low (less than perfect) scores. Admittedly, the definition is somewhat circular. A key factor is a relevant element or factor that adversely affects the credit score for the particular consumer. While this isn't much clearer than defining reasons under Regulation B, there are mathematical means for identifying factors which credit bureaus currently use.
Creditors that use credit scores from bureaus in the loan decision-making process will have to send notices to customers. The coverage extends to any person who makes or arranges loans and who uses a consumer credit score as defined by FACTA.
Covered loans will be a closed-end loan or a HELOC for consumer purpose. The coverage turns on a purpose test so business purpose loans will not be covered. Be careful here, however. The coverage exists by inclusion - application of a consumer for a consumer purpose loan. Coverage does not exist by exclusion as it does for purposes of Regulation Z and RESPA.
As a final coverage element, the loan should be secured by a 1-4 unit residential property. Timing for the creditor notice is "as soon as practicable," whatever that means.
The notice must contain several required elements of information, including the credit score and primary reasons as obtained from the credit bureau, and a statement that the information was obtained from the credit bureau and used by the creditor. The act also contains a required notice which is dictated by the act itself.
This notification requirement does not apply to automated underwriting systems, but only to the credit score obtained from a credit reporting bureau which the automated underwriting system may use. However, if the automated underwriting system generates a numerical credit score, that score must be disclosed in the same way as a credit bureau score.
Rates and Scores
The most complicated of FACTA's credit score rules is that dealing with risk-based pricing. FACTA amends FCRA to require notices to applicants whose credit scores adversely affected the rate of the credit available to them.
The risk-based pricing notice applies to all types of credit. It is not limited to mortgage related credit. This would trigger disclosures for risk-based pricing on car loans, credit cards, and other types of credit.
The risk-based pricing rule applies only to consumers. It is, after all, a part of the Fair Credit Reporting Act. The coverage of FCRA turns on consumers rather than on the type of credit.
The rule has several triggers. First, the question is whether credit was offered on terms that are measured as "materially less favorable." The standard by which to measure "materially less favorable" is the credit terms offered to "a substantial portion of consumers" from that creditor. This means that there will be some sort of standard to establish the standard by which most customers obtain credit.
Refinement of these definitions will be up to regulations. It is not unreasonable to expect that the standard by which to measure this is the best price offered. Consumer groups have lobbied for this notification because they want consumers to know if their credit score resulted in higher interest rates. In order to answer the question "higher than what" the most logical place to start is at the best rate offered.
The rule requires a notice be given to the affected consumer. The notice may be oral, written or electronic. Regulations are to be issued jointly by FTC and the Federal Reserve Board. These regulations will deal with the form and manner of providing notices. There are likely to be model formats for these notices. The difficulty in compliance will be finding all situations that trigger the notice.
Notice content is specified by the act. Notices must include:
a statement that the terms offered are based on information in the consumer's report,
the name of the consumer reporting bureau that furnished the information,
statement that the consumer may obtain a free copy of the report, and
contact information for the credit reporter.
Regulations may specify additional information. The act specifically invites the regulation drafters to provide clarification on what credit terms are material and when credit terms are materially less favorable.
Clearly, timing for these notices will be a critical issue. The act specifies that the notice may be provided at the time of application for the credit or at the time of approval. How a creditor can provide a notice explaining that the rate offered was adversely affected by a credit score is difficult to figure. There may be models for this if the early notice includes a disclosure of the best rate to which the customer can later compare the offer.
The provision will not apply to denials. When an application is denied, the consumer should receive reasons for denial in the adverse action notice required by Regulation B.
The only good news here is that the statute specifically prohibits civil actions for failures to comply with this rule. The rule will be subject to administrative enforcement only.
Your participation in the draft rule and comment process will be critical. There will be two agencies involved with very different agendas.
We learned from the privacy regulations that there is much more to notices than compliance. This new notice must communicate effectively to consumers. When regulations are proposed, be prepared to act on them promptly. Think through the process that will be required, discuss it with lenders and branch staff. Take model notice drafts and test them on friends, neighbors, and tellers so that you get some feedback on how typical consumers will understand the notices.
Plan now to provide copies of the consumer Summary of Rights under FCRA. Use your lobby, web site, and statement mailings to distribute the information widely.
Review your process for using credit scores, giving special attention to how and when the scores are used for mortgage and HELOC lending.
Review the adverse action process and begin preparations to expand the notifications.
Look at the underwriting process and procedures to identify when and how FACTA notices should be sent and who should send them.
Surf some web sites, including FTC's, HUD's, and those of other lending institutions. Look for good and bad presentations of information. Then look at and improve your institution's website.
Think about timing and delivery for credit score notices and be prepared to comment. In particular, be prepared to suggest a procedure that will work and explain why.
Meet with lenders to learn how they price loans. Listen carefully and find out whether any risk-based pricing is used. Also discuss how to determine what the most favorable price for a loan product should be.
Discuss automated underwriting and credit scores with mortgage and HELOC lenders to understand thoroughly how the systems and information are used.
Now meet with consumer lenders (non-mortgage) to learn how credit scores are used in their decisions. Then determine how FACTA will affect this process.
Review your institution's loan policies to see whether they provide for favorable rate adjustments for special customers. Any such procedures must provide a benchmark for the "substantial portion of consumers" for measuring rick-based pricing.
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