Credit scoring is legal, but lenders are required to follow some guidelines when using scoring. For instance, the Equal Credit Opportunity Act prevents lenders from discriminating against women and the elderly. It does not allow creditors to discriminate against consumers simply on the basis of race, color, religion, or national origin, or because their income comes from public assistance, part-time work, alimony, or child support.
By law, credit scoring must be based on a lender’s actual experience with consumers. For that reason, as well as economic reasons, scoring systems are usually reevaluated every three years or so. The Office of the Comptroller of the Currency, a government agency, also reviews scoring systems when they examine lenders. Lenders, employers and, insurance companies use a historical credit score scale or credit score range for pricing their products.
Creditors’ Crystal Balls
You may be a good customer now, but will you still be one a few years down the line? Creditors can use sophisticated “predictive” credit scoring systems to calculate how likely customers are to pay their bills on time in the future and even how profitable an account might be.
There are several types of predictive scores: behavior scoring, credit bureau scoring, bankruptcy scoring, and profitability scoring, for example. Here’s a brief description of each:
Behavior Scoring: Behavior scores use characteristics from the lender’s current customer files to determine which cardholders are likely to pay their bills on time. Behavior scoring systems look at factors such as how close to the limit you are on your accounts, how many times you have been late and for how much, how much you purchase each month, and how much of your credit line is used to obtain cash advances. In other words, it looks at your current behavior on your account, and compares that with other customers’ behavior to determine what kind of risk you are. Behavior scoring is commonplace; over half of all bankcard accounts are evaluated using behavior scoring.
How do lenders use behavior scores? One common way behavior scoring is used is to decide when to raise credit limits. Many lenders will automatically review accounts each year, or at some other interval, and decide whether or not to increase credit limits.
These scores are also used more frequently now for authorization purposes. Suppose, for example, you present your card to a merchant to pay for a charge. The merchant calls in for authorization for the charge, and the call is routed to your card issuer, who notices that the charge will put you over the limit. The card issuer can quickly run a behavior score on your account to decide whether to authorize the charge.
Credit Bureau Scoring is similar to behavior scoring but broader. (This is not to be confused with scores sold by credit bureaus. Although a credit bureau may sell a credit report score, it may also sell a bankruptcy score, or other types of scores.) While creditors use characteristics from their own customers’ accounts to develop behavior or application scoring systems, credit bureau scoring is based upon consumers’ records of payments on all the credit accounts listed on their credit reports.
Bankruptcy Scoring is usually provided by credit bureaus to lenders who want to know if new applicants or current customers are likely to wind up in bankruptcy court. Bankruptcy scores are based on a very large number of credit characteristics, including many factors found in credit reports. Not all of the factors that contribute to a bankruptcy score are directly related to whether you pay on time. Factors such as the type of job you hold and how long you’ve held it, how frequently you have moved in the recent past, how many accounts you have, and how close you are to your credit limits can all contribute to a bankruptcy score. In other words, just because you make your minimum payments on time doesn’t mean that you won’t be pegged as a candidate for bankruptcy.
Profitability Scoring is used by creditors to predict which accounts will generate the most revenue for the issuer. This type of scoring can be used by creditors to target the best customers for special offers or incentives. But it may also be used by creditors who want to weed out accounts that don’t make much money for them: those people who don’t charge often, or those who always pay their balances in full and don’t pay interest, for example.
Pros and Cons: The pros of credit scoring are that it can eliminate discrimination since the decision is made going by the numbers, instead of by what you look like or what neighborhood you live in. It also makes credit cheaper and easier to get since lenders can evaluate stacks of applications quickly by computer.
The problem with scoring is that some lenders use it to reduce consumers to a set of numbers. If, for instance, you always paid on time but then were in a serious accident that cost you thousands of dollars and set you back on your finances, your application would be treated just like that of anyone else who didn’t pay his or her bills on time. Or maybe you just moved here from Canada. You had credit cards and paid the bills on time there, but when the lender pulls your report here, it comes up blank and the computer turns you down for “no credit history.”
The other problem is that it’s hard to get any helpful guidelines from lenders about what makes for a good credit score. It’s true that it’s extremely complicated to explain how the systems really work—the math is mind-boggling. But it’s also frustrating for people to see college students getting cards with no income and no credit history yet have their applications turned down for cryptic reasons such as “level of utilization on revolving lines of credit.”
Insurance Bureau Scores
Most auto insurance companies, and an increasing number of homeowner’s insurance companies, use insurance bureau scores to help predict how likely a customer is to file claims. The information used to calculate an insurance score is the same type of information used in a credit score, and it comes from the credit report. However, the score is calculated separately from a credit score. Therefore, you can’t tell from your credit score how “good” an insurance risk you may be. (If you have a poor credit score, though, don’t expect a strong insurance score.)
Insurance scoring has been under scrutiny by a number of state regulators and has been criticized for unfairly making consumers who have great driving records, but poor credit histories, pay more for insurance. Insurance bureau scores are generally used for evaluating new applicants for insurance, as well as customers who are up for renewal. The insurance score is often used to help determine whether you will be eligible for discounts, but in some cases it may actually be used to deny coverage. Some states prohibit insurers from turning down consumers for insurance based solely on an insurance score, but most do not.
If you are turned down for insurance based on a score, by law you should be supplied with the name and address of the credit reporting agency that supplied your information so you can order a free copy of your credit report. As of this writing, however, there is no source that supplies insurance scores—either for free or for a fee. In several states, you can get the main factors in your credit report that contributed to your score, but this is not mandatory nationwide.
You can get more information about state laws regarding the use of insurance scores at insure.com or you can contact your state’s insurance commissioner (for information or to file a complaint) at http://www.naic.org.