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THE ISSUE
Credit scoring is used to determine the credit worthiness of
consumers for mortgages and other debt. It is not subject to review
by the consumer to determine its accuracy or applicability to that
consumer, and it can be affected by the behavior of others, such as
creditors, employers, and landlords.
THE LEGISLATION
Consumers Union is a co-sponsor of SB 1607, authored by California
State Senator Liz Figueroa. The bill is also co-sponsored by the
California Association of Realtors. This bill will provide home
mortgage consumers access to their credit scores, explanation of
these scores, and information on how the score is used.
BACKGROUND
WHAT IS A CREDIT SCORE?
Consumers who seek a home mortgage, auto loan, or credit card are
assigned a credit score. A credit score measures the relative degree
of risk of delinquency or default that a borrower represents to a
creditor or lender. The score, also called a "risk score," is based
on information in the borrower's credit report and also on
information about how other borrowers with similar information have
repaid their bills. Credit scores are widely used by mortgage
lenders and other lenders in evaluating loan applications.
Creditors may use their own credit scoring model, different
scoring models for different types of credit, or a generic model
developed by a credit scoring company. Many different credit scoring
models are used; the most widely used models have been developed by
Fair Isaac Co., a credit scoring company in San Rafael, California.
A credit score is sometimes called a "FICO" score.
To develop a credit scoring model, the model builder selects a
random sample of loan customers and analyzes the sample statistically
to identify characteristics that relate to patterns of repayment.
Then, each of these characteristics is assigned a weight based on how
strong a predictor it is of the likelihood of repayment. The higher
the score, the lower the risk for the lender. Credit scores range
between 900 and 300. A borrower with a score of 660 or greater is
considered to be of less risk for the lender, while a score of 620 or
lower is a poor credit score.
Credit scoring may not rely on factors such as race, religion,
gender, income, address, employment, national origin, or marital
status. Some credit scoring systems may use age as a factor in
determining a credit score.
In 1995, Fannie Mae and Freddie Mac began to encourage the use of
credit scores for the mortgages they buy from lenders. Credit
scoring is now widely used on mortgage loan applicants.
How is a credit score determined?
Credit scores rely on the following five factors:
What are the problems with credit scores?
Consumers are not told their credit score. Lenders and credit
reporting agencies are not presently required by law to reveal a
credit score to the borrower. Some lenders do reveal the score to
borrowers.
Consumers are not given enough information to understand their
credit score if it is revealed. Lenders and credit reporting
agencies are not required by law to reveal the reasons for the credit
score, the reason codes employed, how the credit score was
determined, or what credit scoring model was used. Even if the
consumer learns his or her credit score, the scoring model is a
"black box," and the consumer lacks information about what factors
contributed to the consumer's score.
Consumers do not know what actions they take will harm or improve
their credit score. Without knowing the reasons for the score or how
the score is determined, consumers cannot know what activities
generate higher or lower scores. For example, a consumer who does
not use credit cards or uses them infrequently has a lower score due
to lack of a borrowing history.
Consumers do not know that routine activity can lower a credit
score. A credit score can be negatively affected by routine activity
such as shopping for auto insurance, searching for rental housing,
applying for a job and opening a bank account. Because these
activities result in inquiries into the borrower's credit report and
recent credit inquiries can produce a lower score, the consumer is
unknowingly engaging in non-debt related activity which lowers the
credit score.
Consumers do not know what steps to take to improve a credit
score. Consumers may erroneously believe that closing old credit
accounts and consolidating debt will improve their credit standing.
However these actions can result in lowered credit scores by
affecting borrowing history and by increasing debt to credit limit
ratios.
Credit scores are based on credit reports which often have errors.
Credit scores use information found in a consumer's credit report.
However, credit reports frequently contain errors. For example, in
March 1999, the U.S. Public Interest Research Group reported that 70%
of credit reports in their sample contained mistakes or errors of
some kind and 29% contained serious errors that could be used to deny
credit. Nineteen percent of the credit reports contained accounts
that could not be identified or did not belong to the consumer; and
26% contained credit accounts that were closed by the consumer but
listed as open: U.S. PIRG, Mistakes Do Happen, March 1999, http://www.pirg.org/consumer/credit/mistakes/index.htm.
Consumers must rely on creditor action to maintain a current
credit report. Some credit granters fail to report positive
consumer activity to the credit reporting agencies. This can result
in lower scores because good payment records are not being
considered.
Consumers must find and correct credit record mistakes made by
credit reporting agencies. Errors in a credit report must be
repaired by the consumer. However, without knowing the basis or
reasoning behind credit scoring, the consumer cannot know what credit
report errors must be repaired to maintain a high credit score. In
addition, communication with credit reporting agencies is difficult,
as found by U.S.PIRG in its report of March 1999.
A borrower should be provided with the credit score and an
explanation for it. A borrower is at an enormous disadvantage when a
mortgage loan application is denied on the basis of a factor which is
not revealed to the borrower or is revealed but not explained.
Credit scoring has not been proven to be without bias. Although
lenders maintain that credit scoring removes bias from the lending
process, Home Mortgage Disclosure Act data reveals that denial rates
for minorities remain much higher than for non-minority borrowers. A
contributing factor could be that low- and moderate-income borrowers
often only have access to credit that has a higher risk rating in
credit scoring models, such as finance company loans. Credit scoring
does remove personal judgment from the loan process, but it
substitutes statistical judgments that are made based on the behavior
of prior customers. If those prior customers are not demographically
representative of the current base of loan applicants, a credit
scoring model might underestimate the likelihood of repayment by
consumers whose demographics are not fully represented in the sample
of prior customers upon which the scoring model was based.
Examples of the effect of credit scoring on consumers
At a Federal Trade Commission conference held in July 1999 on
credit scoring, a mortgage broker from San Diego described credit
scoring and reporting problems she encountered in her work. She
noted that when reviewing credit reports with her clients, she would
regularly find errors such as information on individuals with similar
names and credit information that was inaccurate, unsubstantiated,
and fictional (she also reported that her own credit report regularly
provided information on her ex-husband's other wives, despite her
attempts to fix the error).
At the same conference, an audience member provided the following
example of credit scoring inequity: the speaker, a finance manager
for a car dealership, had a customer who was a physician, his wife
was a physician, they had a substantial income, had credit histories
dating back to 1983, and 77% credit line availability. These
customers had three late payments in the past 16 years, which gave
them a credit score of 585 and made them ineligible for bank
financing. In contrast, the speaker had another customer who was a
full-time student, was employed part-time, and had one credit
reference for a cellular phone service which he had owned for 10
months. The student received a credit score of 715, making him
immediately eligible for a low-interest auto loan.
Another audience member described the effect several credit
inquiries had on his credit score when he shopped for car phones to
run his business. Because he was comparison shopping, nine phone
companies inquired into his credit score to provide the rates he
would be charged for phone service. As a result, his credit score
went down and the interest rate on his credit card was increased from
18% to 25.9%. It took the consumer two years to remedy the problem.
For mortgage borrowers, a poor credit score can translate into
thousands of dollars in extra interest costs. For example, according
to statistics from the California Association of Realtors, the
December 1999 median priced home in California was $221,499.
Assuming a down payment of 20% and an annual percentage interest rate
of 7.65%, the initial mortgage amount would be $177,199, and monthly
mortgage payments would be $1,257. Just a quarter of a point
increase in the cost of this mortgage would raise the monthly
mortgage payment to $1287, representing an increase in interest cost
over thirty years of more than $10,000.
