Posted by Lucy Griffin in Lucy and Nancys Common Sense Compliance
Whether or not we feel like we had enough warning, the requirement to send out risk-based pricing notices is almost upon us. As a last-minute check, there are several issues to think through.
In case this is news to you-and if it is, your week between the holidays will not be a happy one-this requirement is one of the last pieces of the FACT Act to be implemented. Remember the FACT Act, passed in December 2003? (FACT, recall, stands for "Fair and Accurate Credit Transaction.")
Compliance is mandatory by Jan. 1.
Are you covered? How to figure it out
Job one is figuring out where your bank and its practices stand.
• First, what risk or information about risk actually triggers the notice?
In working with risk-based pricing notices, it is helpful to think about their purpose. The intent is to alert consumers to the fact that they are not obtaining the best pricing available because of their previous credit performance.
The notice trigger is therefore tied to when and how the creditor uses the credit report-and not to other possible triggers that could affect pricing. The fact that different types of credit products have different rates, such as open-end and closed-end home-secured mortgages or loans for new cars and for used cars, is not the trigger. The sole trigger is using information in the consumer's credit report.
• The second issue is whether or not your bank offers risk-based pricing.
The unhappy answer to this: Unless you always make loans of a given type or product at precisely the same rate and with precisely the same fees and requirements, you are probably using risk-based pricing.
The only exception to this would be if the rate or fee differences are based on information other than the consumer's credit report, such as the condition of property securing the loan.
Most systems of risk-based pricing are fairly definitive. When the lender bases the interest rate or APR on the applicant's credit score, the creditor is risk-based pricing. The credit score is designed to indicate the risk each consumer presents. Ergo, pricing based on this number is risk-based pricing.
Don't kid yourself-nor miss the exception
Many lenders claim they do not use risk-based pricing. They have one basic rate for everyone. But when asked for details, they will carefully explain that from time to time, they do approve credit to an applicant who does not quite meet the qualification criteria but who, for a reason that is good enough for the lender, is deemed worthy of credit. However, being cautious, the lender raises the rate or charges an extra point.
Any lender that tries to persuade an examiner that this isn't risk-based pricing is guaranteed to lose the argument. Because it is risk-based pricing-in its purest form. In this situation, the lender has decided that this customer presents more risk than the creditor usually is willing to take.
There is a possible exception to this conclusion.
The risk-based pricing notice is triggered by using information in a consumer report -including the credit bureau's credit score-to make the decision. If the information used to raise the rate or impose additional costs comes from somewhere other than a credit report, that does not trigger the notice. If the decision to increase the cost of the loan is based on the appraisal or condition of the security property, the decision would not trigger a risk-based pricing notice.
Many banks have taken the approach of offering only single-rate loan products. However, the bottom line is that most lender will at some point engage in risk-based pricing. All of your loan officers should be aware of this notice requirement-just in case.
Moving beyond "if," coming to "who"
Yet another issue is who should get the notice. Unfortunately for the universe of creditors, the law is not written in such a way as to permit creditors to provide all their consumers with a notice alerting them to the practice of risk-based pricing.
That would have been too easy-much, much too easy. Instead, the creditor must give the notice to those consumers who have been adversely affected by risk-based pricing because of their credit history.
The problem is how to identify, as the group to receive risk-based pricing notices, those consumers who have received credit offers on material terms that are materially less favorable than the most favorable proportion of consumers.
Congress left it to the regulators to figure out what this means. Converting this convoluted sentence into definitions and rules that could be understood and followed was no mean feat.
How the regulators set things up
Fortunately, the regulation writers took a common-sense approach and used APRs and a 60/40 split as their guideposts.
As a general rule, loans made by a compliant lender have APRs. And, as a general rule, lenders track the loans they approve and put on the books so they know how many consumers received favorable pricing. The regulation writers used these as anchors for the rule and for compliance.
There are two basic methods-one based on credit scores of applicants and the other based on an analysis of pricing results by the number of consumers.
1. Using credit scores may be the easiest method.
For each product for which the creditor uses credit scores, the creditor must find the score that is the point above which 40% of the approved applicants fall. The remaining 60% of approved applicants, whose scores fall below the identified score, should receive the credit score notice.
2. Without using credit scores, the creditor must find another way to divide the consumers into groups that approximate this 60/40 split.
If the risk-based pricing uses tranches, such as offering three or five different rates depending on credit qualifications, the tranches should be grouped.
When this is the case, assuming that the tranches all represent about the same number of consumers, the top one of three or two of five should be considered the most favorable and the customers in the other tranches should receive the notice.
The trick: Creditors must do this for each loan product that is subject to risk-based pricing. A lender that makes new-car loans and used-car loans must determine the 60/40 split for both loan products. The same would be true for fixed-rate and variable rate mortgages, or first and second liens.
As the list of products grows, the list of risk-based pricing calculations grows.
Start with a listing of all credit products. Then determine whether any risk-based pricing is applied to each of the products. For every product that is subject to risk-based pricing, you must determine which customers get the most favorable rates and which customers should receive the notice.
Life would be much simpler if you could simply give all applicants the risk-based pricing notice. The problem with this, however, is that it won't work.
The regulation provides model notices which, if used correctly, provide a safe harbor. The notices clearly tell the recipient that he or she did not receive the best credit rate.
Obviously, you should not be sending this to the customers who do receive an offer on the best terms available.
The easy way-sending notices to everyone-doesn't work because it misinforms some of your customers.
And there's another reason not to do this: good credit risk customers didn't get there by sitting back and letting things roll by. They worked at it.
So when a customer like that gets a notice that tells them they are less than the best, you can expect a phone call, or a letter, or a complaint to your regulator.
Who needs that?
About Lucy Griffin
"Lucy and Nancy's Common Sense Compliance" is blogged by both Lucy Griffin and Nancy Derr-Castiglione, both longtime ABA Banking Journal contributing editors on compliance.
- Lucy, a Certified Regulatory Compliance Manager, has over 30 years experience in compliance. She began as a regulator, including stints with the Federal Reserve Board, the Federal Trade Commission, and the Federal Home Loan Bank Board. For many years she managed the ABA Compliance Division. Since 1993 she has served as a compliance consultant as president of Compliance Resources, Inc., Reston, Va. She is also editor of Compliance Action newsletter and senior advisor with Paragon Compliance Group, a compliance training firm.
In addition to serving as a Contributing Editor of ABA Banking Journal, Lucy serves on the faculty of ABA's National Compliance Schools board. For more than a decade she developed and administered the case study at ABA's National Graduate School of Compliance Management. She can be reached at email@example.com
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