New assault on your credit rating: subprime credit scoring
If you walked into a CitiFinancial office in Middletown, N.Y., in October, you could have taken out a home-equity loan with an annual interest rate of anywhere from 10.5 to 18 percent. You'd have to go through the trouble of applying for a loan to find out which rate you'd actually pay, and the rate would hinge on your credit score. Your credit score is a three-digit number generated by credit bureaus based on your debt profile and bill-paying history. CitiFinancial knows your credit score--but it doesn't have to tell you. Unfortunately, there's a lot more you likely wouldn't know.
You wouldn't know whether the interest rate is higher than you deserve to pay. You wouldn't know whether other lenders might have judged your creditworthiness differently; each interprets credit scores independently, and they, too, can keep that information from you. And you probably wouldn't know that CitiFinancial is owned by the same company that owns Citibank--and that you might pay thousands of dollars less for the same loan if you got it from Citibank.
Outrageous? You bet it is--for everyone who borrows money. If you don't know a key driver of your interest rate, you can't know whether you're getting a fair price.
This setup is even more harmful to consumers who have a few blemishes on their credit report. Don't assume you're not counted among those "bad apples. "Over the last few years, lenders have figured out that they can make major profits out of minor credit missteps by branding mostly diligent borrowers as "subprime" and jacking up their interest rate. Even consumers with "prime" credit scores have been subdivided into a range of rates.
This is only the latest twist in a long-running game of "Gotcha!" that lenders have been playing since the early 1990s. They relaxed the old standards of sound lending by luring consumers into debt waters well over their head, but they didn't relax the old strict standards of loan repayment. The result: Easy-money lenders point fingers at the subprime class they helped create, then punish those borrowers with significantly higher interest rates and fees. College students--and now even 16-year-olds--are a new target for subprime lenders.
Meanwhile, mainstream banks have adopted some of the practices normally associated with subprime lending for all their customers. Some big credit-card issuers have shortened billing cycles from 25 to 20 days, making it harder for customers to get their bills in on time, according to national surveys by Consumer Action, a San Francisco-based group. And card issuers are more closely monitoring bill-payment performance. Slip up, and you can get quickly hit with late fees and penalty interest rates. The interest rate on the Wells Fargo Platinum MasterCard can quadruple to 24 percent if payments are not kept current.
With the help of sophisticated credit-scoring models, lenders are rummaging deeper into consumer backgrounds, enabling them to reclassify some formerly prime customers as subprime. The benefit to the lender: increased profits.
All of this adds up to a profound change in lending that has gone largely unreported: Traditional banks are becoming more like subprime lenders. This report explains what consumers need to know to guard against this harsh new reality and the confusing world of credit scoring.
BOOM TIMES IN SUBPRIME
You may have heard about subprime lending from the voluminous bad press about predatory loan practices, which strip unsuspecting low-income customers of their homes, money, and property (see "Poverty Inc.," July 1998). But while officials have been cracking down on the worst abuses of subprime lending, other onerous practices have exploded into mainstream banking, allowing lenders to charge premium rates, exploit shaky credit histories, and suck borrowers into subprime for life.
"There is a perception that subprime borrowers are poor minorities, probably single women, but that is just a teeny tiny percentage of subprime," says Jeffrey Zeltzer, executive director of the National Home Equity Mortgage Association of subprime lenders. "The subprime borrower's annual income is only about $3,000 less than prime borrowers, on average. You're talking about school teachers, police officers, independent business people, lawyers in some cases, and doctors, and those with high income but equity-challenged by big loans."
Subprime debt comes in almost every form, including mortgages, refinance loans, credit cards, and new- and used-car loans. Total subprime lending increased tenfold, to $370 billion, between 1994 and 1999. Some big banks offer their own subprime loans. Others, such as KeyBank, Bank One, and Bank of America have seized a piece of the subprime action by buying up subprime finance companies. In September, Citi-group--a bellwether of the banking industry--announced plans to pay $31 billion to acquire Associates First Capital and merge its North American consumer finance operations with CitiFinancial to create the nation's largest subprime lender.
The explosive growth has been fueled by major Wall Street underwriting firms, which bundle subprime loans into securities that are then sold to investors. This replenishes the capital of subprime lenders so they have money to make more loans.
One key to this rough new world of lending is something simple: the withholding of information. "Your interest rate depends on your credit rating," says one loan officer from The Loan Zone, a subprime lender in the Midwest. How do you find out what your credit rating is? "You can't. That's blanked out on the credit report. I get it," the loan officer told a CONSUMER REPORTS reporter who was shopping anonymously for rates.
Because rates and the creditworthiness standards they're tied to differ from bank to bank, comparison shopping is more difficult.
Only California has a law, which takes effect in July, that will give consumers direct legal access to their credit score. In the rest of the country, credit bureaus and lenders have been prohibited from revealing credit scores to consumers, according to their contract with Fair, Isaac and Co. (FICO), a San Rafael, Calif., company whose risk-scoring models are most commonly used to generate scores.
All this may be changing. In November, FICO gave lenders the option of telling consumers their credit scores. Meanwhile, FICO and credit bureaus have been talking of releasing credit scores directly to consumers--for a fee. But they haven't said when this would occur. And unfortunately, many consumers don't know what credit scores are, how to interpret them, or even to ask for them.
COULD YOU BE SUBPRIME?
The "prime" in subprime lending refers to the quality of a borrower's credit score, which can range from about 375 (the worst) to 900. Labels differ from lender to lender, but consumers with the highest credit scores are generally categorized as "A," or prime. Subprime borrowers with progressively lower scores are typically branded A-minus, B, C, and D; even many subprime lenders won't lend to those with a lower rating. Generally, consumers with a prime rating have a credit score of at least 620 to 660; the exact threshold varies among lenders. Such borrowers would have no late mortgage payments on their credit reports and no more than one 30-day late payment on other consumer credit accounts.
Most mortgage borrowers have a prime FICO score, but 30 to 35 percent are considered subprime. Prime borrowers qualify for prime loans, which have the best interest rates and most favorable terms. Most subprime borrowers can also get a loan, but they have to pay more for the privilege through higher interest rates, higher fees, and less favorable terms.
The concept of risk-based pricing is only fair. Lenders should get paid more for the higher costs associated with making a subprime loan and the increased risk that the borrower won't repay it on time--or at all. But there's a big problem with this setup: Lenders and credit bureaus know much more about you and your creditworthiness than you do.
Secret information is power, and where lenders are concerned, that power gives them the upper hand in negotiating interest rates with consumers. "You may know you have good credit, but you may not know how good," says Keith Gumbinger, a vice president at HSH Associates, a Butler, N.J., firm that surveys loan rates around the nation. "It's not in the interest of lenders to tell you your score. If you know you're an 800, you can go borrow somewhere else."
Tiered rates are not just for subprime customers, either. Cleveland-based National City Bank had four tiers of interest rates in October--from 10.1 to 13 percent--for borrowers with credit scores above 679, or 29 points above the prime/subprime guidelines of the Federal National Mortgage Association and the Federal Home Loan Mortgage Corp. At First Union Bank, a financial specialist cited an A1 interest rate of 11.02 percent and an A4 rate of 11.32 percent.
People with less-than-perfect credit histories are at an even greater disadvantage when they're kept in the dark, because there are fewer lenders to choose from. Also, subprime secretiveness stifles the kind of competition that normally pushes prime rates as low as possible, and the greater difficulty and discomfort of borrowing hat-in-hand tempts these typically less savvy consumers into taking whatever rate they can get.
Lenders take advantage of blindfolded consumers in four major ways:
Exploiting confusion. Anywhere from 10 to 15 percent of consumers who obtained a mortgage with a high subprime rate actually had prime credit scores but didn't know it, according to the Federal Home Loan Mortgage Corp. Ida Mae Forrest, of Berkeley, Calif., thought she might have good credit. Still, she got a $95,602 refinancing mortgage from First Alliance Mortgage that cost her $16,204 in loan-origination fees, according to attorney Sheila Canavan. Forrest's FICO score: 734, well in prime territory.
Forrest, 76, died of a stroke last year, after she rescinded the mortgage with First Alliance and the lender began foreclosure proceedings. "This is an industry that ... targets populations they consider vulnerable," says Canavan, who is suing on behalf of Forrest's estate. "Everybody in America should keep their eyes open and watch their mom's and dad's money."
Charging high rates. Anywhere from 60 to 73 percent of people whose credit rating is subprime have generally good credit histories with only minor delinquencies in the previous year. "You don't have 'good' and 'bad' credit. There is perfect credit, then degrees downward from there," says Geoffrey Tootell, a vice president at the Federal Reserve Bank of Boston.
As you might expect, A-minus consumers are the cream that subprime lenders want most because their risk of default, while higher than prime borrowers, is significantly less than B, C, or D borrowers. A-minus borrowers generally pay only an extra half percentage point above what prime borrowers pay, says the National Home Equity Mortgage Association of subprime lenders.
But overall, subprime borrowers pay much higher interest rates than prime borrowers, according to research by Cathy Lesser Mansfield, an associate professor of law at Drake University in Des Moines, Iowa. While conventional prime mortgages had annual interest rates of 7 to 8 percent from 1995 through 1999, the median interest rate on subprime mortgages was between 10 and 12 percent over the same period, says Mansfield, who studied lender prospectuses containing data on more than a million subprime mortgages. Rates on some individual subprime mortgages were as high as 20 percent, she says. (The research did not examine the rates of A-minus borrowers compared with those of other subprime consumers.) A 3 to 4 point rate difference can cost $15,800 to $22,000 more in finance charges for a customer who borrows $50,000 over 15 years.
Keeping a lid on information. Prime loan rate quotes can be easily found in newspapers, on the Internet, over the phone, and plastered on the lenders' walls. But subprime lenders typically don't give a rate quote until after a consumer applies for a loan and the lender gets his or her credit score. Meanwhile, customers who have a prime credit rating and unknowingly walk into a subprime subsidiary of a mainstream bank usually won't be referred to the parent bank for better rates.
That can be an expensive mistake for a borrower. In October, for example, The Loan Zone, the subprime lending subsidiary of National City Bank, was charging prime customers 11 percent for a $40,000 10-year second mortgage, while parent National City Bank was charging only 10.1 percent for the same loan. The difference over the full term of the loan: about $2,400.
Why? National City wouldn't comment. But generally, subprime lenders have higher loan-servicing costs. Also, because they aren't banks and don't have access to low-cost checking and savings deposits, they must pay more to get the money they lend to their customers.
Engaging in questionable practices. Providian Financial Corp., a leading issuer of subprime credit cards, advertised a "no annual membership fee" card that supposedly saved customers up to $60 a year over similar cards. What Providian failed to adequately disclose was that the card required credit protection costing $156 a year, according to the San Francisco District Attorney's Office, which began investigating the lender in March 1999 after receiving consumer complaints.
The credit protection would suspend interest charges and waive late fees for up to 18 months, Providian claimed, if the cardholder were involuntarily unemployed or suffered other hardships. But Providian did not adequately disclose that the protection would cover the customer forward for only as many months as he or she had paid the fee--not 18 months. Moreover, Providian could deny coverage if the account was not current or even if the customer dared to use another lender's card.
Last June, in agreements with the San Francisco District Attorney and the Office of the Controller of the Currency, Providian agreed to stop such practices and to pay $300 million to consumers and $5.5 million in fines, without conceding any wrongdoing." The fine print is concise, clear, and easy to understand," Providian spokesman Alan Elias told our reporter. "But consumers must do their part and take the time to understand what they're agreeing to."
BEHIND YOUR CREDIT RATING
The recent boom in subprime lending has been driven by a rise in the number of Americans with imperfect credit, thanks to divorce, high out-of-pocket medical bills, bankruptcies, and aggressive lenders who kept pushing ever-more credit cards and ever-larger credit lines. "There are more people with bad credit these days," says George Yacik, a vice president at SMR Research, a market-research firm specializing in consumer-lending issues. "Roughly 20 percent or so of the U.S. population was subprime at the beginning of the 1990s. That figure had grown to something like 30 percent by the end of the decade."
Credit bureaus became more meticulous, too. Today, they collect information that wasn't typically reported before the 1990s--bill-paying data from phone companies, utilities, and even hospitals. That rigor turns up more people who have missed a payment somewhere, sometime, on some bill.
Finally, the introduction of automated FICO credit scores in 1989 made lightning-quick lending decisions possible and popular, and unleashed, ironically, just the sort of irresponsible instant credit that can hurt your FICO score.
Credit scoring brought some benefits, too, such as statistical objectivity that takes some of the bias out of the credit-granting decision. Some argue, however, that the system still discriminates against minorities and low-income consumers.
How is your credit score calculated? Risk models, created by FICO, produce Beacon scores for Equifax, Empirica scores for Trans Union, and the Experian/Fair Isaac Model for Experian.
The models tote up and analyze your various debts, then compare your credit history with the actual payment performance of millions of similar consumers in numerous categories, including people with a lot of credit experience, or "thick" files; people with thin files; people who recently opened new credit accounts; and people who have delinquencies on their record.
FICO has found that certain things predict how well people will pay their bills. The most important factors:
Previous payment behavior. Do you pay your bills on time or late? Obviously, on time is better, and late is progressively worse depending on how late, how frequently, and how recently. The most important bill to pay on time is your mortgage. Renters get no credit for diligent monthly payments.
Current level of indebtedness. What are your credit limits and how much have you used up? Maxxing out credit lines is bad. Getting credit only when it's needed is good.
In some cases, your score can be hurt if you accept a credit-limit increase offered by a credit-card issuer that's slow to report the new limit, warns Caryl Iseman, a director of the California Association of Realtors, who was instrumental in introducing the California Credit Score Disclosure Law. If the lender doesn't immediately report your new limit, your high balance can show up as exceeding your credit limit.
These first two factors drive 60 to 65 percent of the overall score. Three other factors make up the rest:
Length of time credit has been in use. New credit, statistically, is like another ball in the air for a juggler. Can you handle the added burden? The model presumes no, until you prove over time that you haven't taken on more than you should, by continuing to make payments on time. This is why opening a department-store credit-card account just to get the 10 percent shopper's discount on the day of application is a bad idea. That's impulsive, not responsible.
Pursuit of new credit. When you apply for credit, the prospective lender calls up your credit report, and the credit bureau notes the inquiry on your record. That makes lenders nervous. "Statistically speaking, someone seeking a lot of credit in a short time is inherently more risky than someone not seeking credit," says Tom Quinn, FICO's director of client support.
What about shopping around for the best loan? The model doesn't penalize you if you're hunting for an auto loan or a mortgage within a short time frame. But your score will get dinged if you shop around for the best credit-card or personal-loan deal by actually applying. When a credit-card company pulls your report to make you a "pre-approved" credit offer, the model ignores those inquiries.
Types of credit in use. Lenders like to see a mix of debt beyond credit cards. A mortgage and auto loan show that you can handle the money-management peculiarities of obtaining and maintaining each. Finance-company loans are a black mark. (One way to tell a finance company from a bank is that banks generally offer checking and savings accounts; finance companies don't.)
What about secured credit cards, which require you to deposit money in a savings account you can't touch as security for an equivalent-sized credit line? Most lenders don't identify secured cards as secured, so they look like regular unsecured credit and thus offer a good chance to build a positive payment record.
HOW TO PROTECT YOURSELF
No matter how good your credit history, all consumers need to be on guard today when borrowing.
Get your credit report. According to a 1999 study by the Public Interest Research Group, 70 percent of credit reports contain at least one mistake. Try to repair problems before you go for a loan. The big three credit bureaus are Equifax, Experian, and Trans-Union. They typically aren't allowed to report derogatory information more than seven years old, with the exception of a Chapter 7 bankruptcy, which stays on record for no more than ten years.
Demand your credit score from lenders. Consider avoiding those that won't reveal your score. Also, know that each credit bureau may arrive at a different credit score for the same consumer; lenders often use the middle score as your final credit score. Ask your lender for your score from each credit bureau, and question big discrepancies.
Never assume you're subprime. Consumers should always apply first for a prime loan at a major commercial or savings bank, and avoid finance companies. And they should consider a credit union if they have access to one; interest rates there tend to be lower, and they tend to give more personal attention to credit-report problems.
Get the details. Ask loan officers at the banks you're considering how the bank's credit tiers--A, A-minus, and the like--correspond with credit scores and interest rates. By examining these matrices on paper, you'll be able to find the best deals. For mortgages and home-equity loans, also ask about added fees and points, prepayment penalties, and balloon payment terms.
Most subprime customers are in the highest subprime category, A-minus, and rates should only be about half a point higher than the rate a prime borrower would pay. For consumers in the lowest creditworthiness tiers--C or D--rates should be no more than 4 points higher than what a prime customer would pay.
Avoid predatory lenders. Don't deal with pushy contractors, mortgage brokers, or others who try to lend more than is needed; require credit life insurance; have balloon payments due in less than ten years; charge excessively high rates and fees; or don't disclose anything you want to know.
Be ready to go prime. Consumers with a subprime loan should scrupulously pay on time so they can boost their credit rating back into prime territory, then replace the high-cost subprime loan with a lower-rate prime loan. They can make great strides toward prime over two to three years of responsible money management. Pay special attention to prepayment penalties. Without favorable prepayment terms, it may be too expensive to get out of a subprime loan.
RECOMMENDATIONS
Consumers can take some steps to protect themselves from lenders who might try to take advantage of them, but these steps are limited. Authorities must play a bigger role in reigning in anti-consumer lending practices, Consumers Union believes.
Officials are cracking down on predatory lenders. Some lenders' voluntary disclosure efforts are also a step in the right direction.
But an anti-consumer status quo will remain unless lenders are required to lift the veil of secrecy enshrouding much of the business. Congress should pass legislation that requires credit bureaus and lenders to disclose a consumer's credit score, explain deficiencies, and advise how to repair problems. Federal legislation should also require that lenders disclose their matrix of rates, credit scores, and credit tiers to anyone who requests this vital comparative-shopping information.
Some subprime lenders pull a nasty trick on their customers by not reporting their positive on-time payment record to credit bureaus. This prevents the borrower from building a good credit history. Unfortunately, it's difficult for borrowers to know before they take a loan if the lender doesn't report to credit bureaus, which is why regulations are also needed to require lenders to report.
The federal Community Reinvestment Act (CRA) requires lenders to make credit available in minority and low-income neighborhoods. Some lenders get credit for serving those borrowers through higher-priced subprime lending subsidiaries. Federal regulators should raise the standard for an "outstanding" or "satisfactory" CRA rating by requiring a more equitable distribution of prime loans in these communities.
Free and timely access to complete information about the price and terms of any deal is one of the most basic tools of consumerism. Lenders may think they have a choice in the matter, but they should not be exempt from these obligations.
Credit scoring
Peter Palmiotto, 27, wanted a mortgage for a townhouse in Newport Beach, Calif., and had to fight for months to get credit bureaus to accurately reflect that his auto loan and credit cards were paid off. "The people reporting all this information need to be more accountable," he says.
But that wasn't his only concern. Even with an accurate credit report, Palmiotto learned that the credit bureaus came up with widely varying numbers for his credit score. His lender picked the middle number, which pushed Palmiotto into a higher-risk category and caused him to pay about one percentage point more than he otherwise would have. The result: Palmiotto's $230,000 30-year mortgage will cost him $3,450 more the first two years of the loan. After that, he hopes to refinance.
Courting students
Tina Fanetti, 24, a graduate student at Iowa State University in Ames, Iowa, got her first credit card in her freshman year. Soon, 11 other issuers rushed to give the jobless student more than $12,000 in credit lines. She fell behind in her payments, got charged late fees, endured penalty rates of 21.9 percent, exhausted her savings, borrowed from one card to make payments on another, took out student loans to pay the credit cards, and saw her credit rating ruined before she entered adult life. Her advice to other students enticed by credit card come-ons: "Don't. The biggest mistake I ever made was getting credit cards. I never believed--until now--that the credit-card companies wouldn't think twice about skinning me alive."
Credit scores
You'd think the folks who invented credit scoring could explain the difference between the scores. But Fair, Isaac and Co. (FICO) tells visitors to its web site, "It's hard to say what's a good score to get--it varies from lender to lender." According to a recent federal report, "the typical 'A' credit or prime borrower ... has a FICO score that exceeds 650, has no late mortgage payments, and no more than one 30-day late payment on consumer credit." Here's roughly how American borrowers stack up.
RISK TIER CREDIT SCORE PERCENT OF
BORROWERS
A (prime) 660+ 70%
A- 620-659 18
B 580-619 9
C 550-579 2.7
D 520-549 0.3
Sources: HSH Associates for risk tiers and credit scores; SMR
Research and National Home Equity Mortgage Association for
percentages.
A tale of two lenders
You can often get a loan if you have less-than-perfect credit, but it will cost you. This example shows that interest rates for subprime borrowers were up to 5.65 percentage points higher for a $40,000, ten-year, fixed-rate home-equity loan than for those with excellent credit.
It pays to shop around. One lender may put you in a lower category than another--for example, if you were the borrower below with a 670 credit score. Cleveland-based National City Bank would consider you "B2" and charge 13.25 percent while The Loan Zone, the bank's subprime subsidiary, would call you "B" and charge 13.5 percent. A customer with a score below 619, however, would do better at The Loan Zone.
Note that at both institutions, even borrowers with scores generally considered prime, or above 650, pay more for not being perfect.
NATIONAL CITY BANK
CREDIT CREDIT INTEREST TOTAL FINANCE
TIER SCORE RATE CHARGES
A1 NA 10.1%* $23,698
A2 NA 10.6 25,038
A3 NA 11.6 27,761
B1 NA 13.0 31,670
B2 650-679 13.25 32,378
B3 620-649 14.25 35,251
B4 < 620 15.75 39,661
THE LOAN ZONE
CREDIT CREDIT INTEREST TOTAL FINANCE
TIER SCORE RATE CHARGES
AA 700+ 11.00% $26,120
A 680-699 12.75 30,963
B 650-679 13.5 33,091
C 620-649 14.25 35,251
D < 619 15.25 38,177
Rates quoted by loan officers for October 23, 2000.
* Rate includes discount for having a National City Bank account from
which direct payments are made on the loan.
Top subprime lenders
LENDER MANAGED RECEIVABLES
(billions as of 6/00)
Household $38.1
International
Associates 32.3
CitiFinancial 16.4
American General 11.6
Norwest 6.0
Source: Citigroup
Abstract:
Lenders are finding new ways to reduce credit ratings, creating more 'subprime' scores and charging borrowers higher rates. A review of credit reporting and score practices, and ways consumers can keep their ratings high, are provided.
