Have you ever wondered how the interest rate you got on a loan or credit card compares to what other borrowers were given? Historically, risk-based pricing has been a black box where consumers apply for credit and hope for the best, but never know if they're getting it, and if not, why not. That is beginning to change, however. As of January 1st such decisions will no longer be as mysterious. A new rule has taken effect that requires lenders to notify consumers if they didn't receive the best loan credit available, and borrows will also begin to find out part of the reason why. This new regulation should help to provide much more transparency to consumers on credit decisions.
Mark Greene, CEO of credit score firm FICO, appeared on CNBC's Squawk Box today to explain the new rule (full video clip below):
Risk-based pricing is a new set of legislation enacted by the Fed and the FTC a few months ago. It says that as of the 1st of this year, anytime a bank makes a lending decision about a consumer that's either adverse, they deny the credit or they grant credit at less than most favorable terms, they have to explain why. They have to show the data that they use. Typically, that's a FICO credit score -- a number between 300 and 850. And they have to explain what it was about the score that they didn't like that led them to have this adverse action for the consumer.
To be exact, the new rule does not explicitly force lenders to provide an explanation for why they were given less-than-ideal loan terms -- yet. At this time, a lender has two options: it can either tell a borrower that it received a rate that wasn't the lowest, or it can do so and provide their credit score, which would include some information about what score would have been necessary to attain the best terms. But in July, a provision of the Dodd-Frank financial regulation bill will eliminate that first option, forcing lenders to provide the credit score and some explanation of the rationale that led to that score.
But you might see lenders prefer to choose this second option from this point forward. FICO spokesman Craig Watts explains that this is likely for two reasons. First, since they're going to be required to do so in July anyway, they probably won't want to revise their procedures twice, so will comply with the new standard early instead. Second, from a customer service point-of-view, providing some explanation for providing less-than-ideal credit terms is much better than just telling someone they didn't get the best terms and leaving them wondering why.
FICO has also created a website called scoreinfo.org that provides information for consumers explaining what to expect from this new rule. It also provides information on how to interpret credit scores and provides tips on how to improve them.
In the past, lenders have already been already required to provide some reason for why they denied you credit altogether. So there are two really novel aspects to this new rule. First, by July lenders must provide reasons why you are denied anything less than their best credit terms. As you can imagine, this impacts the vast majority of consumers, as only the most prime among borrowers are provided the lowest interest rates on loans and credit cards. Second, by July this new disclosure will provide credit scores if you're denied credit as well, which generally remained a mystery to most consumers.
This empowers consumers because it provides them with some information about how lenders interpret their credit histories. They will now better understand the sorts of factors that lenders care about so they can better influence their future credit outcomes. For example, if less-than-ideal credit terms are given because a borrower's credit score was low due to too much outstanding revolving credit, then he will now know that he must pay down his credit cards to get better terms in the future.
Since credit scores mean so much these days within the credit decision process, knowing one's score and what effects it is also incredibly helpful. Currently, FICO provides a free credit score opportunity through its myfico.com credit score site if you sign up for their monthly Score Watch service, which you must subsequently cancel if you don't want to pay for the service after obtaining your credit score. This can only be obtained once every two years, however, according to the company.
Knowing more about credit consequences should help borrowers to improve their future loan terms. And as consumers' credit worthiness improves, competition among lenders will also increase to try to attract those newly prime borrowers. As a result, this additional disclosure could lead to cheaper credit on average, since it should reduce the risk that lenders face as consumers improve their debt practices.