Partners, Volume 13, Number 2, 2003
Partners, Volume 13, Number 2, 2003
|Keeping Score With Your Credit|
In todays increasingly complex and competitive financial market, its essential for consumers to be aware of their credit scores. In addition to affecting the cost of borrowing money, credit scores are now consulted by auto and home insurance agencies, utility companies and potential employers in making business decisions.
Credit scoring has become a common tool for pricing loans over the last 15 years. As a composite representation of the risk associated with a particular borrower, an individuals credit score is in essence a predictor of future behavior based on past behavior. The more reliable ones payment history, the lower the risk of problems in future transactions.
Credit scores are not static. They fluctuate over time in response to changes in an individuals credit management. Negative transactions will result in a lower score; credit cleanup will generally lead to a higher score. Lower credit scores suggest greater risk, and thus lenders will charge higher interest rates, whereas higher scores indicate lower risk and attract more favorable interest rates.
Credit scores and lending decisions
The loan evaluation process varies with the lender and the type of loan. Because each lending institution evaluates credit scores and sets qualification ranges for loan applicants according to its own standards, several lenders presented with the same loan request could arrive at different decisions regarding approval and pricing.
Credit scores also determine whether a loan is considered prime or subprime credit. Those with impaired or limited credit histories or high debt relative to income typically qualify only for subprime credit. Some lenders offer both prime and subprime credit products, while others may not offer subprime credit, or offer it only through an affiliate.
Consumers should be aware of their credit score before shopping for a loan to guard against unscrupulous lenders who take advantage of those unfamiliar with the credit scoring process. Opportunistic lenders may misdirect borrowers into the highest priced loan despite a favorable credit score.
Credit scores are most often generated by Fair, Isaac and Company, Inc. Although the use of credit scores has been widely accepted and trusted by the financial industry, most lenders do not fully understand the calculation of individual credit scores. As a result different lenders address poor credit scores in different ways.
A number of credit reporting agencies work with applicants to correct credit history information and recalculate credit scores quickly. According to Alan Koch, Florida regional sales manager for CBA, his company can make corrections with the three major credit bureaus within three days. Although there is a fee for this service, Koch notes fees can be like an investment if corrections lead to a considerably lower interest rate.
However, CBA advises its customers that corrections on the credit report do not guarantee a better credit score. Koch relates the experience of one applicant who reduced his available credit by closing a few revolving accounts he no longer used. Unfortunately, one of them was his longest established credit reference, so closing the account actually lowered his credit score.
Credit scoring and insurance premiums
Insurance companies have also begun using credit scoring in pricing premiums. Insurance credit scoring predicts future insurance losses by comparing policyholder performance data with credit bureau data for the same individual. Independent tests conducted by insurance companies comparing policyholders credit scores against their claims histories indicate that credit scores are an accurate predictor of the probability of future claims. Since individuals with lower credit scores are statistically more likely to file claims, they are charged higher premiums or denied coverage.
Opponents of the practice of basing insurance pricing on credit scores argue that it results in discrimination. Auto insurance rates, for example, were previously based on an individuals driving record: two drivers with the same car and similar driving profiles would pay the same insurance rate. By contrast, insurance credit scoring results in higher premiums for drivers with lower credit scores even when all other factors are equal. Critics also contend that low-income individuals and senior citizens who have limited or impaired credit are more likely to be adversely affected by insurance credit scoring.
If an individual is denied coverage, the Fair Credit Reporting Act requires the insurance company to provide the consumer with an adverse action notice disclosing the specific attributes of the credit history, motor vehicle report and/or comprehensive loss underwriting report that led to denial of coverage.
Policyholders who have improved their credit scores can also request re-scoring when a policy is being renewed. Consumers should also be certain that insurance providers use the highest credit score when multiple drivers are included on the same policy.
Credit counseling services
Although most people dont address credit problems until they experience difficulty obtaining a loan or face possible bankruptcy, consumers should optimally check their personal credit reports on an annual basis. Not only does protecting ones financial profile facilitate access to competitive financial services, but it also helps to avert identity theft.
Consumer Credit Counseling Services (CCCS) provides several free services such as budget counseling, housing counseling and community outreach/workplace education. Beginning in July 2003, CCCS of Greater Atlanta will also offer debt management and repayment plans for a fee of 5.5 percent of the outstanding debt. CCCS is an affiliate of the National Foundation for Credit Counseling (NFCC) and has offices throughout the country. Branch operations may vary slightly, but they all consistently provide effective financial counseling to the full socioeconomic spectrum of the markets they serve.
Consumers should exercise care when choosing a debt management counselor. Many counselors mislead consumers into thinking initial payments are helping to reduce debt when they may in fact be counseling fees. Some debt management services are not staffed by accredited financial counselors and may actually be offered by home equity lenders eager to refinance the consumers debt without developing a plan to lower debt or improve credit management.
Consumers seeking quality credit counseling services should look for one of the more than 1,300 community based agencies that are members of the NFCC network. NFCC member offices nationwide can be reached by calling (800) 388-2227 or by accessing www.nfcc.org.
By Ana Cruz-Taura and Sibyl Howell, regional community development managers in the Atlanta Feds Miami and Atlanta Branch, respectively.