The Ins and Outs of Credit Scoring

It is talked about in many contexts. It is a term tossed about without clear definition. It engenders fear and caution among lenders. It raises compliance concerns. Consumers seem genetically predisposed to distrust it. What is it? Credit scoring.

Credit scoring is feared because it is not properly understood. It is something mysterious that happens in a black box. When the users of scoring or those who are scored don't understand the principles, the result is distrust.

For creditors using scores, the primary challenge is to use the scores correctly and consistently. To use the score correctly, the user must understand the nature of the score, what it examines, and just what it does and does not tell you. Using scores consistently is important to make safe and sound decisions and to make fair decisions.

How It Works
Credit scoring is a statistical tool that analyses past behavior. As such, it does not predict the behavior of the consumer being scored. Credit scoring does not have predictive capabilities. Instead, we use credit scoring to make predictions or assumptions about an applicant based on how the statistical tool of credit scoring compares that applicant to previous customers.

Credit scoring actually works by conducting a statistical analysis of past behaviors. It identifies the behaviors that customers have demonstrated in common that have the strongest correlations with good or bad credit performance. It then analyzes the characteristics of the applicant and compares these to the analysis of previous customers.

The number produced by the credit scoring system tells the creditor where the applicant ranks when compared to previous customers. The creditor then uses this number to decide whether to extend credit. In short, the credit score is a form of risk analysis and the creditor uses the score to decide how much risk to take.

Types of Scores
Credit scores come in many varieties. Part of the challenge in using scores is to understand the type and nature of the score being used. Credit scores can be based on any type of credit-related data and developed for a variety of uses.

The most common and best known use of credit scores is in making credit decisions. Customers with higher scores are offered credit, customers with low scores are denied, and the creditor may make risk-based decisions on customers with scores in the grey area.

In the context of making credit decisions, there are several types of scores, all of which we refer to as credit scoring. However, in using the score the creditor should understand the differences between these types of decision-making scores.

One type of score, the "classic," is based on the credit performance data of previous customers. It evaluates a broad base of information which usually includes credit history, applicant attributes, and the nature and type of credit. This score includes more than the applicant's credit history. Many systems include information such as the type of employment, time on the job, length of residence and whether the applicant owns or rents the residence. Some also consider the applicant's age, following the rules of Regulation B.

Another type of score, now probably more common than the classic, is the credit history score. These are scores developed by the credit bureaus using only credit bureau information. They are limited to the information that bureaus collect and maintain. Even without information such as the applicant's occupation or time on the job, the credit bureau scores are powerful.

Underwriting scores are yet another variation of a credit score for decision-making. Underwriting scores have been developed primarily by the secondary mortgage market. These systems consider applicant qualifications such as the credit history, but also consider property and loan attributes. Some of the factors that underwriting systems consider have nothing to do with the applicant and instead take into account aspects of the mortgage and property to secure the loan.

Credit scores can also be designed and used to review the status of an account and the customer's performance. Performance scoring is used to make decisions about account maintenance and servicing. For example, if the score shows that the customer has handled an open-end line of credit responsibly, the performance score would support increasing the amount of the line available to the customer. Poor performance might result in reducing the amount available or even canceling the card. Any such action would be adverse under Regulation B and trigger an adverse action notice.

Some creditors use bankruptcy scoring to consider the likelihood that a given applicant or account holder will declare bankruptcy. Credit activity of consumers in financial difficulty differs from the credit activity of solvent consumers. Both may have high credit scores, having paid on time, but they may look very different when certain factors are examined by the bankruptcy score.

Regulations
With all these credit scoring systems available, creditors must sort out certain regulatory requirements. The regulations affecting the use of credit scoring include Regulation B, new requirements from the FACT Act, modifications to the FCRA, and safety and soundness considerations.

Credit scoring garnered attention in the early days of ECOA. In the mid-1970s, credit scoring was a relatively young science. The challenge for the drafters of Regulation B was how to fashion a rule that ensured fair, nondiscriminatory treatment of applicants while supporting sound credit decisions. The solution was the very carefully crafted definition of credit scoring contained in Regulation B.

Regulation B's definition exists not for the purpose of defining all credit scoring but for the specific purpose of governing how the applicant's age may be considered in a scoring system. It also provides support for general discrimination analysis within the context of the effects test and related concepts.

The specific rules relating to credit scoring appear in two places in Regulation B: rules on the consideration of age, and rules requiring adverse action notifications and the reasons for adverse action.

Consideration of age in credit scoring is only permitted under two conditions. First, the consideration of age 62 and above must be treated at least as favorably as the other most favorable age category. Second, the reasons for denial must come from the credit scoring system if the scoring system played a role in the denial. The credit scoring rules in Regulation B do not reach beyond these two. However any credit scoring system must be designed to prevent discrimination.

The FACT Act brings in new rules relating to credit scoring, fueled largely by consumer frustration at being reduced to a number. The new rule requires users of credit scoring systems based solely on credit history information for making mortgage loan decisions to tell the customer that they are using the scoring system and that the consumer has a right to their score. Reasons for the score, as with reasons for adverse action in Regulation B, must also be provided. As a practical matter, this notice requirement simply advises the consumer that a credit score is being used.

The FACT Act's definition of credit score is significantly different from the definition in Regulation B. While the Regulation B definition includes any type of credit scoring system, including performance scores, bankruptcy and underwriting scores, the FACT Act applies only to scores based on credit history. As a practical matter, this usually means the credit bureau score. Other scoring systems would only become subject to the FACT Act definition if the factors considered are limited to the consumer's credit history. Thus, an underwriting score which considers the loan to value ratio for the mortgage is excluded from the FACT Act's definition.

Using Credit Scores
Credit scores can be used in a wide variety of ways. Neither Regulation B nor the FACT Act limit how scores are used other than to prevent discrimination. Some creditors, particularly those handling a high volume of applications, might use the score as the only step of making a credit decision.

Other creditors will combine the credit score with additional review. In Regulation B terminology, this is a mixed system using both the score and a judgmental review. Still other creditors may only use the credit score as a guide.

Finally, the use of any scoring system should contribute to the safety and soundness of the lender's business. Scores should be used to make better loans. Regulators have begun to use credit bureau scores to differentiate between prime and sub-prime loans. Current regulatory guidance generally holds that scores less than 660 may be considered sub-prime. That number may change based on trends in lending and defaults. However, scoring of any type clearly plays a key role in the analysis of safety and soundness.

Notifications
The critical question for regulatory purposes is the role that the credit score played in making the decision. The use of the credit score in mortgage credit decisions triggers the FACT Act notice. When the credit score is used to deny or make a counter-offer, Regulation B requires that some or all of the reasons for adverse action come from the credit scoring system.

When the credit score is the only basis for the decision, the selection of reasons must come exclusively from the scoring system. The factors that the scoring system considers are the candidates for selection as reasons. Anything not considered by the system cannot be used.

Reason selection becomes more complex when the system is mixed or when the system is used merely as a guide. However, to the extent that the score contributes to a denial or counter-offer, the score and its factors are part of the reason for denial and the reasons given must include some taken from the scoring system.

When judgmental consideration follows the credit score, the judgmental review may take different directions based on the credit score. This effectively means that the score played a role in the decision. When the decision is a denial, the reasons given to the applicant must include factors from the credit score.

Even when the loan officer claims that the credit score is "simply a guide" or "interesting" but not part of the decision, the fact is that the score probably influenced the decision. Accordingly, both the FACT Act notice and Regulation B should be complied with.

Credit scoring is here to stay. It is a useful and accurate tool. Over time, it is likely to evolve into more sophisticated forms than we currently use. So, all lenders should be familiar with the basic rules.

ACTION STEPS

Talk with your lenders and branch managers to find out what types of credit scores are used, when and how.
Compare score use with requirements of the FACT Act and Regulation B. Look at both substantive rules and the notification requirements. Fix any problems.
Include credit score use in your next fair lending assessment. Be sure to analyze any overrides to the scores.
For decisions involving credit scores, review the reasons provided to the consumer to ensure that they include reasons from the credit score.
Review any credit scoring systems, including the factors considered, for possible disparate treatment.