Consumer credit scores were the topic of discussion today at the House Financial Services Committee. In a hearing with a variety of different witnesses, the group considered how the scores impact borrowers. Do they have a positive or negative effect overall?
How Credit Scores Help
I would go with positive, though the current system needs some reform. Sandra Braunstein, Director, Division of Consumer and Community Affairs for the Federal Reserve, explained why scores are good in her prepared testimony:
In recent decades, consumer credit markets have become national in scope, and credit has been made available to a broader spectrum of consumers. The development and use of credit scores has greatly facilitated these trends. Credit scores rank-order individuals by their credit risk; those with poorer scores are predicted to perform, on average, worse on their credit obligations than those with better scores.
The existence of a sophisticated consumer credit scoring system allows for a more robust credit market. Imagine the difficulty in assessing risk for lenders if they didn't have credit scores to work with. All would have to develop their own proprietary scores to compare one borrower to another. Big finance companies often do this anyway, but the landlord of a small walk-up in Brooklyn probably doesn't have the resources or know-how to do so. A credit score allows for a consistent rating of borrowers.
Without credit histories being kept by the credit rating agencies, then consumer credit would be even worse off. Then lenders would have to rely on the word of prospective borrowers about other debt they have outstanding and how good they are at paying their bills. Credit fraud would be a lot more common and losses would be much harder to avoid. Credit would be less available and more expensive, across-the-board.
How Credit Scores Work
Back in November, I wrote about FICO providing a little bit of direction regarding how credit scores are calculated. A representative from credit score guru FICO also testified (.pdf). Tom Quinn, Vice President of Scores explained the characteristics of what makes up a score:
- Payment History (35%)
- Amounts Owed (30%)
- Length of Credit History (15%)
- Pursuit of New Credit (10%)
- Mix of Credit (10%)
Quinn also says:
The score "rank orders" consumers by the likelihood that they will become seriously delinquent (90 days or more) on a credit obligation in the next 24 months. The higher the score, the lower the risk.
While that probably holds true in general, the rating methodology above doesn't really convince me that a score will always directly correspond to default probability. For example, imagine an heiress to some huge fortune who just graduated college and always acted responsibly. She never had a loan in her life, so would have a very low credit score, despite the fact that it was highly likely she would pay her bills. In fact, it's pretty likely that someone with a very high credit score will also have a considerable amount of debt, since a "mix of credit" and "length of credit history" matter. Yet, if such an individual had a high income, but no savings, and then sudden unemployment could easily cause default.
Of course, I doubt FICO would call their system perfect. I just hope most finance companies recognize that good risk management would incorporate credit score, but not rely on it.
So it's good that we have a system to track consumers' credit histories and provide ratings. But where might some reform be sought?
Paying for your Score
I also railed against the idea that consumers have to pay to obtain their own credit score back in November. FICO charges $15.95 for access to your score. Another witness at the hearing, Evan Hendricks, Editor/Publisher of the Privacy Times, suggested (.pdf) suggests:
Consumers should be entitled to one free credit score per year, and it specifically should be for a credit score that is used by a majority of lenders. (Not a so-called "educational" score.)
I agree. It seems like a reasonable "right" that consumers to have access to their own score for free.
Better Conflict Resolution
Another good change would be if consumers had more power to protest the claims of creditors. Hendricks explains a problem related to this that I ran into myself just after college involving a student AMEX card (Never again!):
The Big Three (credit bureaus) sometimes fail to satisfactorily resolve consumers' legitimate disputes because instead of truly reinvestigating disputes, they electronically notify the creditor of the dispute, and then permit the creditor to dictate the results via the creditor's e-response.
This means if you have a dispute with what a creditor says, then all you can do is note that dispute on your report, which often won't repair damage to your credit score even if your complaint is legitimate. Obviously, the creditor often won't admit they're wrong, unless the facts are overwhelming. Few people are willing to actually bring a big finance company or bank to court for credit history disputes, so that's a problem.
Both of these rights look like obvious places for Congress to pursue reform. I was disappointed to see the consumer credit rating industry completely overlooked in last spring's credit card regulation bill. Perhaps an amendment could be added to new financial reform proposals?