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National Community Reinvestment Coalition

All of us have credit scores, but most of us don't know what they mean. If we knew what they meant, would we be more likely to get approved for a low-cost loan? The answer is "probably," but the disclosures of credit scores have to be meaningful if they are to be helpful to the borrower.

Credit scores are numbers ranging from 300 to 800 that are supposed to reflect the risk that we, as borrowers, pose to banks. The higher the score, the less risky we are and the less likely we will be late on loan payments or default on the loan altogether. Credit scores are calculated on the basis of a credit history that is collected and stored in three major credit reporting agencies or private sector credit bureaus. The record of paying on time or paying late, the amount of debt compared with the amount of available credit on credit cards, and the length of time using credit are major factors that contribute to the score.

If a borrower has a score above 660, he most likely will qualify for a prime rate loan at interest rates advertised in newspapers. If a borrower has a score significantly below 660, he is likely to receive a subprime loan at interest rates ranging from two to four percentage points above widely advertised rates. The rationale behind the higher rate on sub-

prime loans is that the bank is compensated for accepting the higher risk of delinquency and default associated with lending to a consumer with blemished credit.

Credit scores have been used for decades for consumer and credit card lending. In the mid-1990s, credit scores became a widely used tool in mortgage lending as well. It is not the only criterion banks and mortgage companies use, but it is an important criterion, ranking up there with loan-to-value ratios and total debt-to-income ratios. Proponents of credit scoring assert that its use has increased lending to minority and low- and moderate-income borrowers because it is an objective assessment of a borrower's creditworthiness: Subjectivity is removed from the loan process, and the chances of discrimination are decreased. It is further claimed that credit scoring makes the loan process much more efficient and saves resources that can be devoted to carefully analyzing marginal cases.

The National Community Reinvestment Coalition (NCRC) does not believe that credit scoring has revolutionized access to credit and neither has the advent of subprime lending, for that matter. Instead, the strengthening of the Community Reinvestment Act (CRA) and the stepped up enforcement of fair-lending laws have been the major forces behind the explosion of credit for minority and low- and moderate-income borrowers during the 1990s. Lenders made only 18 percent of their home mortgage loans to low- and moderate-income borrowers in 1990. The low- and moderate-income loan share surged eight percentage points to 26 percent by 1995, but by 1999 it had climbed only three more percentage points, to 29 percent.

Let's review the major events coinciding with the big jump in lending during the first part of the 1990s and the major events during the lending slowdown in the second half. Congress mandated the public dissemination of CRA ratings in 1990 and the improvement of Home Mortgage Disclosure Act (HMDA) data to include the race, income and gender of the borrower. In 1995, after a highly visible and lengthy review process during previous years, federal banking agencies strengthened CRA regulations to emphasize lending performance as opposed to process on CRA examinations. During the same time period, the Justice Department settled several fair-lending lawsuits with major lending institutions. After 1995, the mortgage industry widely adopted credit scoring, and subprime lending took off. Home mortgage lending increased in the first part of the decade as policy-makers strengthened and applied CRA and fair-lending laws. Lending slowed down in the second half of the decade; during this period, credit scoring and subprime lending were on the rise. Economic conditions played less of a role in the different trends in lending because we were blessed with a tremendous economic recovery during the entire 1990s.

The reason credit scoring was not responsible for the explosion of home mortgage lending to low- and moderate-income borrowers is that credit scoring is not designed to serve those who have the least experience with the financial industry. Credit scoring depends on an established credit history, so that econometric equations can judge the odds of a borrower paying late or defaulting. Officials at one large bank NCRC interviewed for this article stated that they do not use credit scores in their approval decisions regarding special affordable loan programs. They indicated that the people among the low- and moderate-income population who are targeted by special affordable loan programs have low credit scores because they do not have much of a credit history. Instead, the bank uses nontraditional credit history, such as evaluating the timeliness of rent and utility payments. It is likely that CRA encouraged this bank to establish the special affordable loan programs. For this large bank, and probably for many other banks, CRA has more to do with increasing lending to low- and moderate-income borrowers than credit scoring.

Why disclosure would help

While credit scoring has not had a noticeable impact on increasing credit to traditionally underserved borrowers, meaningful disclosures of credit scores would nevertheless help increase access to affordable credit. The optimal time for disclosure is before a customer applies for a loan. If a customer obtains a credit score and the major factors for that score before reaching the loan application stage, he would have a good idea of his cred-itworthiness. The customer would be in a better position to know if he was getting a good deal on the loan or whether to bargain with the lender.

The caveat is that a consumer must have a clear understanding of what the credit score is and what factors affected his score. The disclosure of the number itself has little meaning. If the credit score is low, for example, the consumer needs to know which factors in his credit history had the most impact on lowering the score. He could then decide whether to delay applying for the loan and how best to clean up his credit. For this reason, HomeFree-USA, a counseling agency in Washington, D.C., and a member organization of NCRC, always includes credit score counseling in its home-buyer preparation courses. Similarly, NCRC educates consumers about their credit scores in its financial literacy curriculum.

Although credit scores are imperfect estimators of creditworthiness, disclosure of credit scores can help reduce the incidence of discrimination in prices, particularly in the area of subprime lending. Fannie Mae's chief executive officer has been quoted as saying that 50 percent of subprime borrowers could have qualified for lower rates. Freddie Mac issued a statement on its web page a few years ago saying that up to 30 percent of subprime borrowers could have qualified for lower-priced credit. A paper commissioned by the Research Institute for Housing America concluded that after controlling for credit risk, minorities were more likely to receive subprime loans.

An unanswered question is how many borrowers who were inappropriately placed into the subprime loan category could have avoided this if they had simply known about their credit scores. Also, how many of them could have obtained lower interest rate loans, even if the loans remained subprime? For example, if an educated borrower knew that his score was 620, which is generally considered A— credit, and was quoted an interest rate four percentage points higher than the widely advertised rate, he would know that he was being overcharged. While other underwriting factors, such as loan-to-value and debt-to-income ratios, also contribute to the pricing decision, meaningful credit score disclosures alert borrowers when quotes are or at least seem far higher than they should be.

As California was passing a law requiring credit bureaus to disclose credit scores, Fair, Isaac and Co. Inc., one of the major firms producing scores, took a constructive step and made credit scores available for a small fee through its web site, The company also has a description on its web page of the major factors influencing the score and the weight of each factor.

How banks should disclose and use credit scores

The new California law also requires banks to disclose credit scores to consumers applying for loans. California is the only state to require this disclosure. Several bills working their way through Congress would also require credit bureaus and banks to disclose credit scores.

For the consumer, it is advantageous to be armed with credit score information and to take action to improve the score, if needed, before applying to a bank. However, if a consumer does not have a credit score prior

to application, disclosure by the lending institution is still valuable. In a loan approval decision, for example, disclosure of the credit score will help the borrower understand why his loan had a certain interest rate. If the interest rate is in the subprime range, the borrower may want to take steps to improve his credit before closing on the loan. In the cases of loan denial, a lender is required under the Equal Credit Opportunity Act to send a borrower an "adverse action notice." If the reason for the rejection involved one of the factors in a credit score, that factor must be discussed in the adverse notice.

Lending institutions can run afoul of fair-lending laws quickly if they are not careful about using credit scores when helping borrowers apply for loans. For example, in 1999, the Department of Justice settled a fair-lending lawsuit with Deposit Guaranty National Bank over Deposit Guaranty's alleged arbitrary and discriminatory use (or disregard) of credit scores. The lawsuit came about after an examination by the Office of the Comptroller of the Currency concluded that Deposit Guaranty disregarded credit scores when approving loans for whites but rejected blacks with similar credit scores. As a result, the black rejection rate was three times the declination rate for whites.

It is important and valuable for a bank to institute a review process for declined applicants, especially those on the margins of approval. Such a review process may help banks make more loans to minority and low-and moderate-income applicants with little traditional credit history. A judgmental review process must establish consistent criteria by which to overrule credit scores. Such criteria can include consideration of nontraditional credit, including rental and utility payment histories.

Disclosure with a twist

The NCRC believes that information in the HMDA data about credit scores could be instrumental in resuming steady increases in access to credit for minority and low- and moderate-income borrowers. Several months ago, the Federal Reserve Board asked for public comment on its proposal to include the annual percentage rate (APR) in HMDA data.

In response to the Federal Reserve's proposal, NCRC pointed out that the APR, along with credit score information, could vastly improve our knowledge of how credit scores impact pricing and approval decisions. Because many kinds of credit scores exist, it would be difficult to interpret what actual numerical scores mean if they were added to HMDA data. At the very least, the loan-by-loan data could indicate if a credit-scoring system was used and the type of credit-scoring system, such as a bureau or custom score. Policy-makers would then have important insights as to whether most loans to minority and low- and moderate-income borrowers are credit-scored and whether banks using credit-scoring systems are more or less successful in approving loans to traditionally underserved borrowers. Community groups and counseling agencies could then use this additional information in HMDA data in their advice to borrowers about which banks are most likely to use credit-scoring systems in a fair manner to provide loans at reasonable rates.

Conclusion of Mr. Silver

In announcing a Bush administration proposal to provide the public with data on the quality of nursing homes and Medicare health plans, Thomas Scully, a senior official at the Department of Health and Human Services, stated: "Collecting data and publishing it changes behavior faster than anything else." The motivational force of data disclosure under CRA and HMDA has helped activists and the public at large work with banks to increase lending to minority and working-class borrowers. Meaningful disclosures of credit scores to consumers and incorporating credit score information in HMDA data would be two more valuable tools for building wealth in traditionally underserved communities.

This concludes the fourth installment in our series. The Federal Reserve System's Mortgage Credit Partnership Credit Scoring Committee thanks the respondents for their participation. The topic of the fifth installment is the use of counteroffers, overrides and second reviews of credit-scored applications. Although each of these activities plays a vital role in the mortgage process, there is potential for disparate treatment of borrowers. The fifth installment addresses where disparate treatment may occur and helps identify solutions.

The views expressed in this series are not necessarily official opinions of the Federal Reserve System or of the Federal Reserve Bank of St. Louis.

1 Disparate treatment is defined as a situation in which a lender treats a credit applicant differently on the basis of race or any other prohibited factor. It is considered by courts to be intentional because no credible, nondiscriminatory reason explains the difference in treatment.

2 Disparate impact is defined as a situation in which a lender applies a policy or practice equally to credit applicants but the policy or practice has a disproportionate adverse impact on applicants from a group protected against discrimination.

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