Credit Data Supports Risk-Based Pricing

Ms. Smith is director of the Federal Reserve Board's division of consumer and community affairs. This viewpoint is an excerpt of her recent congressional testimony.

Credit scoring has become an important tool in the credit granting process. Credit scoring models, which typically are proprietary to individual institutions or consumer reporting agencies, use credit bureau information and other data to construct mathematical scorecards that can accurately predict levels of creditworthiness across various populations.

These models assign positive and negative weights to items of information that have demonstrated statistical usefulness for the evaluation of credit risk. Credit scoring enables creditors to evaluate, quickly and inexpensively, the risk of lending to credit applicants, and promotes the making of expedited credit decisions in a safe and sound manner. Consumers benefit from the increased availability and lower cost of credit made possible by the use of credit scoring models. Credit scoring also may help to reduce unlawful discrimination in lending to the extent that these systems are designed to evaluate all applicants objectively and thus avoid issues of disparate treatment.

Credit evaluation systems rely on information gathered by consumer reporting agencies on consumers' borrowing and payment experiences to measure the credit risk posed by current and prospective borrowers. Risk-based pricing, which has become increasingly common in all sectors of the credit industry, is a mechanism by which the rates offered or charged to consumers reflect the creditworthiness and risk posed. Risk-based pricing is made possible because creditors have available to them data from consumer reports, including credit scores, which permit them to assess the risk profiles of individual consumers.

For example, a consumer demonstrated to have an extremely low risk of default or delinquency, based on a consumer report, would likely be offered a very favorable interest rate. A consumer with a marginal credit history, on the other hand, may also be offered credit, but at a higher rate.

Risk-based pricing permits creditors to offer credit products tailored to the consumer's individual risk profile.

Under the FCRA, if a creditor denies credit or takes other "adverse action" based on information in a consumer report, the creditor generally must give the consumer a notice of that fact. Among other things, the notice must also tell consumers of their right to obtain a free copy of their credit report and to dispute inaccurate information. The FCRA incorporates the definition of "adverse action" contained in the Equal Credit Opportunity Act and its implementing regulation, the Federal Reserve Board's Regulation B. Under the ECOA and Regulation B, consumers are entitled to a notice containing the specific reasons for a credit denial or other adverse action. The FCRA and ECOA notices, which are typically combined, provide an important tool in educating consumers about the impact on credit availability of negative information in their consumer reports.

Receiving notice of the specific reasons for adverse action coupled with notice that the adverse action was based in whole or in part on information in a consumer report (1) alerts consumers to specific problems or possible inaccuracies in their credit reports, and (2) informs consumers of their right to obtain a free copy of the report and to dispute inaccurate information.

With the increase in risk-based pricing, consumers who previously would have been denied credit (and would have received adverse action notices) now are offered credit at rates that reflect their risk as borrowers, thus expanding access to credit. When a consumer accepts a creditor's offer of credit, even on different terms from those that were requested, an adverse action notice is not required under Regulation B, and hence is not required under the FCRA. Therefore, when consumers apply for credit, adverse action notices are given to them less frequently than in the past.

Concern has been raised that because of risk-based pricing, adverse action notices may no longer be meeting at least part of the intended purpose under the FCRA - helping to ensure the accuracy of consumer reports. Inaccurate information in a consumer report may negatively impact access to credit at rates that reflect the consumer's creditworthiness, but there is no adverse action notice directing the consumer's attention to potential errors that may stand in the way of more favorable terms.

One suggested approach for addressing this concern is to revise the FCRA definition of adverse action to require that creditors provide an adverse action notice whenever credit is granted on material terms less favorable than those otherwise available. Providing adverse action notices to consumers that receive credit might provide some benefit to consumers, but at a cost to industry that likely would outweigh the potential benefit.

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