Credit Scores and Credit Reports - Evan Hendricks

Introduction:

Peering Into The 'Black Box'

Sunshine is the best disinfectant.

- Justice Louis Brandeis
Other People's Money & How the
Bankers Use It (1914)

Although many people might not be aware yet, a rather simple rule has emerged to dominate the American consumer economy: the worse your credit score, the more you pay for mortgages, loans, credit cards, and insurance. Conversely, the better your credit score, the more favorable terms you will get on interest rates and premiums.

Some are learning about this trend the hard way. Take the case of Alan Cowan. Although never late paying his credit card bills, he found an "important notice" tucked into his monthly First USA bill advising him in small print that his 9.99% interest rate was going up to 19.49%. No reason was given for the increase, but when Cowan called for an explanation he was told that in spite of his spotless record at First USA, he was delinquent and had high balances with other creditors. Like many creditors, First

¹ Caroline Mayer, Read 'em and Weep; Cardholders See Rates Rise Based on Other Debts, Washington Post, December 20, 2001, pg. E1

USA routinely conducts monthly "account reviews" of customers' credit reports to spot any new problems that could portend greater risk.

It's part of a relatively new reality call "risk-based" pricing. In the old days, creditors would either approve you or disapprove you for credit-thumbs up or thumbs down. Now they don't want to reject you. Instead, they want to grant you credit or insurance at the rate that compensates for the "risk" reflected in your credit history. Your credit report, and the credit score derived from it, makes this all possible.

Kevin Washington (not his real name) experienced this in a different way. He responded to a Capital One pre-approved offer for an introductory, zero-interest credit card. When he received the card, he noticed in the fine print that he would be charged a 12.99 interest rate for using the card. He discovered that in the initial offer's fine print, Capital One reserved the right to counter-offer with a less attractive card if it found something in his credit report that it didn't like. But Capital One never informed Washington that it pulled a bait-and-switch based upon his credit history.

Of course, it goes way beyond credit cards. Margaret Jones, a retired Floridian on a fixed income with a stellar driving record, was surprised to learn in April 2000 that Progressive had raised her auto insurance rate 20 percent. This didn't make sense to Jones, as she had not had an accident or moving violation since she first took out the policy. When she called to inquire, a Progressive operator "rudely" told her that it was all part of a general rate increase. Persistent digging by Jones revealed that Progressive had begun pulling customer credit reports to re-set premiums.²

² Cathryn Smith, et al. v Progressive Corporation: U.S. Dist. Ct. - Northern Dist. Of Florida (Gainesville) - Case No.: 1:00-CV-210-MMP; Plaintiffs lead attorney was Terry Smiljanich, of James, Hoyer, Newcomer and Smiljanich, of Tampa, Florida. Author was their expert.

In January 2003, Tony and Alethea Preston were preparing to buy a home in Clermont, Florida. They were advised they needed mortgage insurance, a common requirement for many people who prefer to pay less than a 20% down payment on their home purchase. Initially, the mortgage broker estimated the monthly premium would run between $100-$200. However, at the settlement table, they were shocked to learn that the monthly premium for mortgage insurance was $762.29. Neither the mortgage broker nor the settlement attorney could explain the whopping discrepancy between the rather low estimate and the exorbitant premium. No notice or reason was provided by the insurer, Mortgage Guaranty Insurance Corporation (MGIC) of Milwaukee. Of course, MGIC jacked the rate after it pulled the Prestons' credit reports.³

One Last Check

If the volume is high enough, major creditors can check an applicant's credit reports and scores for a few dollars. It should not be surprising then that their use is spreading.

In December 2004, the Miami Herald was the first to report that three major banks in Florida - Bank of America, SunTrust and Wachovia - were declining to open checking accounts for applicants with rock-bottom credit scores.⁴

A Bank of America customer service phone representative told the Herald that a 540 FICO score was the cut-off. Bank spokesman Steven Lubetkin denied that was the number but declined to say what it was.

³ Tony Preston and Alethea Preston, et al. v. Mortgage Guaranty Insurance Corp. of Milwaukee, et al.: U.S. Dist. Ct. - Middle Dist. Of Florida (Orlando) - Case No.: 5:03-CV-111-OC-10GJR; Plaintiffs represented by Smiljanich, op. cit. Like many of the FCRA cases cited in the book, the author was their expert.
⁴ Harriet Johnson Brackey, "Banks Check Potential Customers' Credit," Miami Herald, December 5, 2004

"It is a minimum threshold level that should make our checking account options available to the largest number of people without creating any kind of significant risk to the bank," he said.

Wachovia's Mary Beth Navarro said her bank's cut-off in 2002 was in the mid-500s. But in 2004, it had been lowered to 460, in part because Wachovia also used ChexSystems, a service that tracks bounced checks and customers' past banking relationships. Banks said they disclosed the credit score check in their deposit account agreements.

Nona Wilgus, a BankAtlantic vice president, said the Fort Lauderdale-based bank stopped checking credit scores several years ago "because they really didn't make any difference and they eliminated potentially very good customers." Washington Mutual, too, said it did not check credit scores before opening new accounts.

Banking regulators admitted that they were unaware of the practice, even though it had been going on for five years. In recent years, policymakers at the Federal Reserve, the Office of the Comptroller of the Currency and the FDIC regularly urged banks to open their doors to customers who haven't used banks before.

Jean Ann Fox, of the Consumer Federation of America warned of a "Catch 22."

"Banks turn away checking account customers because they don't have a good credit score. But then you can't build up a financial identity, because you can't get a bank account, because you don't have one."

Employers

Brenda Matthews learned the hard way that it was legal for employers to check credit reports before hiring job applicants. After Johnson & Johnson offered her a job in the patent office of its New Jersey headquarters, she gave her old employer notice. But two weeks later, Johnson & Johnson rescinded the offer because of her credit history.

Matthews, an African-American, filed a discrimination complaint with the Equal Employment Opportunity Commission. Her attorneys charged that the company's use of credit reports had a disparate impact on minorities.

"It compounds an already unfair situation. African-Americans have been subject to historic discrimination in the credit market. For that to be compounded in the job market is a real inequity," said Rachel Geman, her attorney.

Johnson & Johnson told CBS Market Watch in a statement it couldn't comment on the EEOC filing, but said that Matthews applied for the position of tax specialist in the company's global patent office, a job "involving the timely payment of fees."⁵

Federal law requires employers to secure job applicants' permission before accessing credit files. But many job applicants are not in a strong position to say "no" when prospective employer "ask" to see their credit reports. Moreover, the Fair Credit Reporting Act does not require that credit reports only be used if they are relevant to the job in question.

CBS Market Watch reported that 35 percent of employers used credit checks in pre-employment screening, up from 19 percent in 1996, according to a survey of 208 companies by the Society for Human Resource Management. Meanwhile, about 41 percent of retailers said they used credit checks in pre-employment screening, according to the 2003 National Retail Security Survey, conducted by the University of Florida. About 10 percent of retailers said they planned to increase their use of credit checks in the coming year, putting it among the top five screening methods that retailers intend to ramp up, the study found.

⁵ Andrea Coombes, "Are credit checks of job applicants discriminatory?" CBS Market Watch, November 17, 2004

The industries most interested in credit checks are defense, chemical, pharmaceutical and financial services, said Donald Girard, a spokesman with Experian, one of three credit-reporting agencies that sells reports to employers.

Experian creates specific employment reports that don't include credit scores, birth dates or data on spouses.

Utilities

TXU Energy, the largest Texas utility company, in September 2004 proposed basing electric rates for its least profitable customers on credit scores. But TXU put the plan on hold after it sparked a storm of protest from consumer groups and a complaint by the Texas Public Utility Counsel.

"Electricity is not like any other commodity," the group's complaint stated. "It cannot be stored when prices are favorable, it has no substitutable product and it is a necessity and an essential service. The use of credit scores as a proxy for income levels, race, national origin, marital status, or other prohibited factors places the most vulnerable population groups at risk for electricity service." Although the plan remained on hold in December 2004, TXU Chief Executive Officer John Wilder defended the plan.

"We had a segment of our customer group that was unprofitable," he told CBS Market Watch. "The remedy was a pricing strategy, and we tried to apply a commercial solution to the issue. I feel very confident we'll be able to move forward with some kind of solution that will help us solve the underlying problem."⁶

⁶ Lisa Sanders, "Growing Smaller: Wilder re-energizes Texas Utility By Scaling Back Business," CBS Market Watch, December 13, 2004

Winning Scores, Losing Scores

These are just a few of the many little known ways in which credit scores and credit reports can determine how much you pay for a variety of necessities, or whether you get a job.

But more and more Americans are waking to the fact that credit scores can have a dramatic and immediate impact. Although unusual, it is possible that one delinquent account could lower a credit score from 70 to 120 points, according to the Fair Isaac Corporation, a leading developer of credit scoring models.⁷

Fair Isaac's Web site showed, for example, that on a $150,000 30-year, fixed-rate mortgage, a consumer with a 720 score might pay a 5.71% interest rate with a monthly payment of $871, while a consumer with a 674 FICO score 7.52% would pay $1,051 per month. Someone with a 619 score would pay an 8.53% rate with a monthly payment of $1,157. The difference in payment between "top-of-the-line" and "sub-prime" is $286 per month, or $3,432 per year.⁸

A consumer with excellent credit (credit score of 720-850) would pay about 7.8% interest rate for a home equity loan, while a consumer with marginal credit (640- 659) would pay 9.2% and one with poor credit (500-559) would pay a 12.1% rate.⁹ The rate swings for a new car loan are even greater, with good credit risks paying a 5.2% paying 11.4% and poor risks paying 17.2%.

In general, one would expect credit scores and credit reports to play a key role in evaluating a consumer's credit worthiness. In fact, the federal law known as the Fair Credit Reporting Act (FCRA) specifies that credit reports can be used for "credit, insurance, and employment purposes."

⁷ Fair Isaac & Co. via The Hartford Courant, http://banking.senate.gov/03_07hrg/071003/chart01.pdf
⁸ www.myfico.com, visited December 23, 2004
⁹ The Hartford Courant, see Footnote 6; (2003 data)

The first problem, however, is that most Americans do not understand how the credit reporting system works, how their credit scores are calculated, the important ways in which credit reports and scores can effect their financial well-being, or what they can do about it.

A second problem is the potential for inaccuracy in the credit report data that are used to calculate credit scores. Over the past 13 years, abundant evidence has emerged to indicate that inaccuracy has been and continues to be a significant problem for the nation's credit reporting system. As we will see, damages to consumers stemming from credit report inaccuracy can range from the economic to the emotional.

A third problem is that identity theft, considered the nation's fastest-growing crime, poses a direct threat to the accuracy and integrity of data in the credit reporting system. Identity thieves typically steal an individual's identifiers, such as Social Security number, name, address, date-of-birth, and/or mother's maiden name, and then use them to obtain credit in that individual's name. When debts created by the identity thief go unpaid, creditors report the negative payment history to the credit report of the innocent victim.

Consequently, the innocent victim's credit report is polluted by highly negative information that is inaccurate because it does not reflect that victim's activities. Multiply this dynamic by millions of cases each year and you will see why identity theft raises serious concerns about ensuring accuracy in credit report data.

Like your own credit score, the credit scoring and credit reporting system is a "work in progress." It would be inaccurate to characterize the system as totally or always unfair. But it clearly cannot be depicted as totally or always fair either. And, as we will see, when the system breaks down, the impact on individuals can range from inconvenient annoyance to life-altering devastation.

Spreading Awareness

This book is written to address these and a host of other issues concerning credit reporting in America. The book is designed to help readers gain a greater understanding of the credit reporting and scoring system, and how it impacts them.

It would seem that greater awareness is needed. According to a July 2003 survey by the Consumer Federation of America, "Only 25 percent of Americans-and less than 20 percent of those with incomes below $35,000-said they knew what their credit score was. But only three percent of Americans could, unprompted, name the three main credit bureaus — Experian, Equifax, and Trans Union — that provide both lenders and consumers with information from credit reports. Forty-three percent of Americans-only 35 percent of those with incomes below $35,000-said they had obtained a copy of their credit report from the three credit bureaus in the past two years."¹⁰

As the disclaimer states, this book does not give legal advice. Legal advice can only be given case-by-case by a lawyer, which this author is not.

This also is not a "credit repair" book. This author repeats the advice of consumer protection officials: be very, very leery of outfits that call themselves "credit repair" clinics. Contrary to its literal meaning, the common use of "credit repair" connotes improving one's credit score through the removal of negative-but-accurate data. There is no guaranteed method for removing accurate information from a credit report, whether it is positive or negative. But promising that you can do so and charging money in advance is a violation of federal law, according to the FTC.

¹⁰ CFA Opinion Survey, July 2003, conducted by Opinion Research Corp.; www.consumerfed.org/072803creditscores.html

This Book Covers...

The book is divided into chapters that cover the "basics" of credit scores and credit reports, and ones that cover "advanced" aspects of the systems, which create them. Chapter 1 explains the basics of credit scores-beginning with Fair Isaac's explanation as to how they are calculated. Chapter 2 is more advanced, delving into little known-and sometimes surprising-details about credit scoring that should further increase your understanding. Chapter 3 goes even further by exploring the world of "resellers" and "re-scoring," a little known but valuable service for improving the credit scores of mortgage applicants, but which appears threatened by hostile economic forces.

We return to "basics" in Chapter 4, describing how you can obtain your credit report and the circumstances that currently entitle you to a free report. This chapter notes that eventually, all Americans will be entitled to one free credit report per year under the 2003 Amendments to the FCRA, known as the Fair and Accurate Credit Transactions Act (FACTA). The requirement took effect in December 2004, and was gradually being phased in under rules set by the Federal Trade Commission.

The first two sections of the country that were entitled to free reports were the West and Midwest. Opening day for the South is June 1, 2005; the East gets theirs on September 1, 2005.

Similarly, Chapter 5 explains the basics of reading and understanding your credit report, and Chapter 6 describes the fundamentals of disputing inaccuracy. Chapter 7 offers a basic overview of identity theft, often described as America's fastest growing crime, and its impact on credit report accuracy. These "how-to" sections serve as a starting point for those who are ready to oversee their own credit histories.

Beyond 'How-To'

To fully appreciate the basics, one needs to understand the larger system. To that end, Chapters 8 and 9 examine how the three major credit reporting agencies (CRAs) compile credit data on 205 million Americans, and how they and credit grantors conduct, or sometimes don't conduct, reinvestigations upon receiving consumer disputes.

To help explain why credit reporting continually draws the attention of Congress, state legislators and enforcement officials, Chapter 10 traces the evolution of the industry, of the "mixed files" problem and other inaccuracy issues, and of identity theft.

Chapters 11 and 12 address the controversial subjects of credit repair and debt collection. Chapters 13-15 explore the use of credit reports and scores by automobile, homeowners and mortgage insurers.

Chapter 16 focuses on the heated debate over whether credit scoring is tied to racial discrimination. Chapter 17 looks at some of the special challenges faced by certain groups, including Hispanics, students and the divorced.

One activity that affects most adult Americans, but is little understood, is the marketing of pre-approved credit card offers-the topic of Chapter 18. Chapter 19 covers the thorny issue of unauthorized access to credit reports, a problem that can arise in a number of settings, including car dealerships, for a number of reasons, including identity theft.

Chapter 20 explores the kinds of damages typically suffered by victims of inaccurate credit reports or identity theft, and provides a preliminary methodology for identifying and measuring those damages.

Chapter 21 recounts the exciting legislative debate of 2003, which resulted in major amendments to increase the FCRA's consumer protections. Despite the improvements, no one in Congress or elsewhere felt that the problems of credit report inaccuracy or identity theft would go away anytime soon. Some advocates predicted the problems would get worse before they got better.

Chapter 22, the only entirely new chapter in this Second Edition, explores controversial policies of credit card companies that fail to report their card holders' credit limits to credit bureaus, a practice that can lower credit scores. It also examines credit card companies that practice "universal default," meaning they will raise card holders' interest rates if their credit scores drop too much - even if they've never had a late payment with that particular company.

Privacy

Credit scoring and credit reporting are inextricably linked to the fundamental privacy rights of consumers. As the U.S. Supreme Court has recognized, "To begin with, both the common law and the literal understandings of privacy encompass the individual's control of information concerning his or her person."¹¹

In the "Information Age," privacy is defined by, and measured according to, the principles of "Fair Information Practices" (FIPs). As we will see in Chapter 10, these principles are at the core of information privacy laws, both in the United States and abroad, including the FCRA. They seek to ensure that individuals maintain a reasonable level of control over their personal information by ensuring accuracy, fairness, collection and use limitation, purpose specification, security, and enforcement. These principles form the basis for an international consensus¹² as to how personal data should be protected by law and by organizational practice. Enacted in 1970, the FCRA was the United States' first information privacy statute.

¹¹ U.S. Dept. Of Justice v. Reporters Committee, 489 U.S. 749 (1989)
¹² "Principles of Fair Information Practices, Organization of Economic Cooperation and Development (OECD), 1980

The credit reporting system contains detailed and sensitive financial information concerning an estimated 205 million consumers in the United States. The system is de-signed to facilitate the free flow of information for the purposes of credit, employment, and insurance. It enables thousands upon thousands of organizations, large and small, to make important judgments about consumers based upon their personal information. There are many benefits for consumers and for the economy.

All too often, however, this takes place without the knowledge or consent of consumers. Problems arise for individuals' privacy, and for our economy and society, when judgments are made based upon inaccurate, incomplete, or irrelevant information. Privacy is damaged when personal information is used or disclosed for impermissible purposes. Moreover, privacy suffers when others gain unauthorized access to our credit reports.

The purpose of this book is to increase consumers' understanding of the system, and thereby increase their ability to exercise control over their personal information.

The more the system is subjected to public scrutiny, and the more consumers gain control over their data, the better the system works. The goal is privacy, which is sometimes explained as "informational self-determination."¹³ This goal is more readily reached by adhering to Brandeis' instruction that, "Sunshine is the best disinfectant."

This book answers many questions. But it will raise many more. Here are a few to keep in mind as you continue reading:

¹³ As noted by Dr. Spiros Simitis, Professor of Law, Johann Wolfgang Goethe-Universitat, Frankfurt, Germany, this right is recognized by the German Constitution and was affirmed by the German Supreme Court in a national case involving the Census. Also see the writings of Law Professors Paul M. Schwartz and Joel R. Reidenberg, including Data Privacy Law (Michie, 1996)

Should our society and our system of law continue to treat our personal data like a commodity?

Should we have a "property interest" in our data?

In the current "information age," is our personal information better viewed as a "resource," both public and private?

These questions ultimately go to the fundamental importance of credit reports and personal information in 21st Century America.

But first things first. Let's start with the basics.

Continue to Next Chapter

Credit Repair Specialists are Ready to Help!

Call Veracity and Begin Improving Your Credit Score Today!