Financial institutions have had no shortage of regulatory changes to manage in recent months. While the CARD Act and the Dodd-Frank Wall Street Reform and Consumer Protection Act have occupied the majority of the headlines, there are other regulatory changes the financial sector is trying to navigate.
The most recent compliance questions are related to risk-based pricing regulations under section 615(h) of the federal Fair Credit Reporting Act (FCRA).
The new FCRA regulations, effective January 1, 2011, will impact actions creditors need to take when using consumer reports to either extend offers of credit or conduct account reviews of existing portfolios.
The new rules state that a “risk-based pricing notice” must be provided by the creditor when a consumer report is used in connection with providing credit “on material terms that are materially less favorable than the most favorable material terms available to a substantial proportion of consumers.”
Clear as mud? The actions needed are not as complex as the law makes it sound and will be outlined here.
In addition, if a creditor conducts periodic account reviews of its consumer credit portfolios, and increases a consumer’s annual percentage rate because of a deteriorated credit report, the creditor must provide a risk-based pricing/account review notice to the consumer.
The new regulations also set forth a number of exceptions to the risk-based pricing notice requirement, including an exception where the creditor instead elects to provide credit score notices and disclosures to consumers in connection with credit applications.
Determining whether a consumer received less favorable material terms may be decided on a case-by-case basis. In this scenario, lenders will need to compare the material terms offered to the consumer to those made to other consumers for the same type of credit product.
In most cases, “material terms” refers to the annual percentage rate (APR), excluding teaser/introductory and penalty rates. For credit with no APR (such as charge cards), “material terms” is defined as “the financial term that varies based on information in a consumer credit report and that has the most significant impact on consumers.” Examples include an annual fee or a deposit requirement.
There are two alternative methods that can be used to determine which consumers should receive a risk-based pricing notice. The first is the “credit score proxy” method. Creditors using this method may determine a cutoff score where 40% of its consumers have higher credit scores and 60% have lower credit scores. A risk-based pricing notice would then be given to any consumer with a credit score in the lower 60 percentile.
These cutoff scores must be recalculated every two years using a sampling of the lenders consumer base. Provisions are provided, for those creditors that do not have an adequate sample, that allow the use of market research or relevant third-party sources for similar products to assist in complying with the recalculation requirement.
The second alternative allows creditors to use a tiered pricing method. Under this method, notices are dependent upon how many pricing tiers are available. When there are four or fewer pricing tiers, all consumers outside of the top tier get a notice.
In the situation of five or more tiers, those consumers not in the top two tiers and any other tier that, combined with the top two tiers, comprise no less than 30% but no more than 40% of the total number of tiers, must receive a notice.
Additionally, if a consumer applies for a credit card with a multiple-rate offer and is granted credit at an APR higher than the lowest rate available under that offer, notice is required. The same is true for account reviews. If a creditor increases the APR for a customer based on information obtained through a consumer report, notice is required.
There are several exceptions to the risk-based pricing notice requirements:
• When a consumer applies for and is granted explicit terms, as long as the material terms were specified before they applied;
• When an adverse action notice is provided instead;
• Prescreen solicitations where there is a firm offer of credit;
• When the consumer receives a credit score disclosure statement;
• In circumstances where a credit score is not available, a special notice may be provided.
The alternative credit score disclosure is of particular interest in the above exceptions. This may become quite popular as an alternative to the risk-based pricing notice.
In this exception (with variations for secured and unsecured credit), the creditor would provide the consumer with the consumer’s specific credit score, as well as the distribution of credit scores among consumers who are scored under the same scoring model as the consumer, showing where the consumer fits in based on his or her score.
A bar chart would be used for this disclosure. An alternative to the bar chart would be a clear and readily understandable statement informing the consumer how his or her credit score compares to other consumers. The credit score disclosure alternative to the risk-based pricing notice would be given to all applicants, not just consumers who fall outside of the best pricing grid.
As a creditor, when and how do you need to provide notice? Risk-based pricing notices must be provided after the terms of credit have been set, but before the consumer becomes contractually obligated to the credit transaction.
The rules set forth the detail for complying with closed-end credit (secured and unsecured), open-end credit (secured and unsecured), account reviews, indirect auto lending, student loans and instant credit, among others. The rules also attach template forms that if used, represent a “safe harbor” for compliance purposes.
Generally, for multiple party transactions one notice may be sent if all parties live at the same address. However, if an alternative to a credit score is used separate notices must be sent to each consumer involved. Recipients of a risk-based pricing notice are eligible to receive a complimentary credit report from the consumer reporting agency or agencies identified in the notice.
In short, to comply with the new regulations creditors must be ready to compile all of the appropriate data, such as credit score and the corresponding distribution information, and populate the required disclosure forms as necessary to send to their mailing company. They will also need to determine their portfolio score cut-offs for sending risk-based pricing notices.
Paul Thielemann is SVP of sales and marketing for Zoot Enterprises in Bozeman, Mont. His e-mail is firstname.lastname@example.org.