Secret History of the Credit Card
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credit scores - what you should know about your own by Malgorzata Wozniacka and Snigdha Sen

Malgorzata Wozniacka is a Polish-born reporter and currently a student at the Graduate School of Journalism at the University of California, Berkeley. Her work has appeared in Gazeta Wroclawska, The Hartford Courant, The European Review, Transitions Online, and the San Francisco Chronicle.

Snigdha Sen is a student at the Graduate School of Journalism, University of California, Berkeley. Her articles have appeared in Bloomberg News, East Bay Business Times, The Daily Californian and the Associated Press. She has also worked as a journalist in India's English dailies, including The Times of India and Business Standard.

Millions of Americans who once worried about test scores in their school days are now discovering a new score is following them around as adults -- the credit score.

It's estimated by credit industry experts that roughly 75 percent of the U.S. population that is eligible for credit (i.e. 18 years or older), have a credit rating score at any given time that indicates the individual's credit worthiness to take out a loan, a mortgage, etc.

The credit score system has been around for 45 years and is credited with making lending less discriminatory and credit more widely available. But while the meticulous collecting and sharing of consumers' credit histories has dramatically improved the efficiency of U.S. credit markets, critics say the credit bureau's information -- affecting everything from who insures you to who hires you -- may contain substantive errors and is increasingly being used and shared among companies without consumers' knowledge.

The vast majority of Americans don't know their credit score -- or even how to find out what it is. A July 2003 survey commissioned by the Consumer Federation of America found that only 2 percent of Americans said they knew their credit score. And only 3 percent could, unprompted, name the three main credit bureaus.

Here's a primer on what consumers should know.

» The Credit Reporting System

Americans' financial habits are monitored by one or more of the three national credit reporting agencies (CRAs): Equifax, Experian, and TransUnion. Every month, financial institutions or creditors send the CRAs credit files which include consumers' account numbers, their types of credit (e.g. mortgages, credit card loans, automobile loans), their outstanding balances, collection actions taken against them, and their bill-payment histories.

More than 4.5 billion pieces of data are entered each month into credit records, which in turn become part of the more than 1 billion consumer credit reports issued annually in the United States.

These credit records also include information supplied by the consumer (primarily from filling out credit application forms), as well as public records such as bankruptcies, court judgments, overdue child support, foreclosures and liens. By law, credit bureaus can list negative information for seven years. Many national and international creditors, such as banks and department stores, are registered with all three CRAs. Lenders supply the CRAs with information about their customers and in turn have access to credit records.

» Your Own Credit Score

The most important item in a consumer's financial resumé today is his or her credit score. The one most widely used is the "FICO" (Fair Isaac Corporation) score, the standard measure for credit risk. This score was developed in 1989 as a joint project by Equifax and the Minneapolis-based Fair Isaac Corporation, which provides financial services to the world's 10 largest banks, as well as companies in more than 60 countries.

The scoring system awards points for each factor that can help predict the likelihood of a person repaying debts on time. The total number of points -- the credit score -- predicts how creditworthy a person is. The FICO score, a three-digit number between 300 and 850, is a snapshot of a person's financial standing at a particular point in time. The higher a credit score, the more likely a person is to be approved for loans and receive favorable interest rates.

[FICO scores are calculated from a lot of different credit data in your credit report. The percentages in the chart reflect how important each of the categories is in determining your score. These percentages are based on the importance of the five categories for the general population. For particular groups - for example, people who have not been using credit long - the importance of these categories may be somewhat different.]

The best credit rates are given to people with scores above 770, but a score of 700 -- out of a possible 850 -- is considered good, according to Fair Isaac. The median score is about 725. Generic interest rate calculations on the myfico.com Web site show that when the score dips below the mid-600s, those consumers generally qualify only for "subprime" lending and the interest rate starts to climb significantly.

Fair Isaac Corporation does not maintain a database of FICO scores, as many assume. Instead, when a lender requests a credit rating, the score is generated by one of the national credit bureaus from which the lender has requested the report. Fair Isaac provides the credit bureaus with software containing an algorithm -- a mathematical formula derived from random samples of consumers' credit information -- and that is what is used to calculate the score.

Currently, you can obtain for a fee, your FICO score at myfico.com.

However, starting December 1, 2004 consumers living in the western U.S. will have the right to order a free copy of their credit report under the Fair and Accurate Credit Transactions Act (FACTA) and the Fair Credit Reporting Act (FCRA). FACTA, which was enacted on December 4, 2003, amends the FCRA and requires, among other things, that the three nationwide consumer reporting agencies (CRAs) - Equifax, Experian, and Trans Union - provide to consumers, upon request, a free copy of their credit report once every 12 months.

All U.S. consumers will become eligible for free reports on the following schedule: WESTERN STATES: Alaska, Arizona, California, Colorado, Hawaii, Idaho, Montana, Nevada, New Mexico, Oregon, Utah, Washington, and Wyoming) will become eligible on December 1, 2004; MIDWESTERN STATES: (Illinois, Indiana, Iowa, Kansas, Michigan, Minnesota, Missouri, Nebraska, North Dakota, Ohio, South Dakota, and Wisconsin) will become eligible on March 1, 2005; SOUTHERN STATES: Alabama, Arkansas, Florida, Georgia, Kentucky, Louisiana, Mississippi, Oklahoma, South Carolina, Tennessee, and Texas ) will become eligible on June 1, 2005; and EASTERN STATES: (Connecticut, Delaware, District of Columbia, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, New York, North Carolina, Pennsylvania, Rhode Island, Vermont, Virginia, and West Virginia) and Puerto Rico, and all U.S. territories will become eligible on September 1, 2005.

After December 1, 2004 visit www.annualcreditreport.com to request your free credit report or request the report by phone or mail:

Toll-free number: 877-322-8228 Mailing address: Annual Credit Report Request Service, P.O. Box 105281, Atlanta, GA 30348-5281 Requests by phone or mail will be processed within 15 days of receipt.

And read the Federal Trade Commission's final ruling on the issue of providing U.S. citizens with free access to their credit reports at: http://www.ftc.gov/os/2004/06/040624factafreeannualfrn.pdf

Related Links

General Consumer Information

See the Consumer Data Industry Association's informative Summary of Procedures for Disputing the Accuracy of a Credit Report a chart outlining the dispute resolution process.

To remove your name for either two years or permanently from unsolicited offers for credit and insurance from the lists compiled by Equifax, Experian and Trans Union, call toll free: 888-5OPT-OUT [888-567-8688]

» A Little History…

Credit reporting was born more than 100 ago, when small retail merchants banded together to trade financial information about their customers. The merchant associations then turned into small credit bureaus, which later consolidated into larger ones with the advent of computerization.

By the 1960s, controversy surfaced over the CRAs, according to Chris Hoofnagle of the Electronic Privacy Information Center, a public interest research center. Hoofnagle says the credit reports were being used to deny services and opportunities, and individuals had no right to see what was in their files. In addition, CRAs back then reported only negative financial information as well as "lifestyle" information culled from newspapers and other sources -- information such as sexual orientation, drinking habits, and cleanliness.

The controversy led to a congressional inquiry, and in 1971, Congress passed the Fair Credit Reporting Act (FCRA), which established a framework for fair information practices to protect privacy and promote accuracy in credit reporting. Consumers gained the right to view, dispute and correct their records, and CRAs began to supplement the often-bleak reports with information on consumers' positive financial history.

Professor Michael Staten, director of the Credit Research Center at Georgetown University, views the FCRA and the amendments to it over the years as one of the most important and functional laws in the United States. "It's fair to say that protections for consumers were tightened, and at the same time businesses have proper access to information that will benefit consumers," he says. "You can't talk about the FCRA without talking about tradeoffs. Privacy is at its core, so there's always a tension. But this law has been one of the greatest successes. It's becoming the envy of the world."

However, it wasn't until 2001 that consumers gained direct access to their credit scores. Earlier that year, Consumer Reports had documented the problem of credit scores being off limits to consumers in an article entitled "New Assault on Your Credit Rating." The article, combined with growing pressures from lending institutions wanting to disclose scores to consumers, finally opened credit score information to individuals. An updated version of the FCRA, signed into law by President George W. Bush in December 2003, requires CRAs to provide consumers a copy of their credit score at a "fair and reasonable" fee. Consumers can obtain their FICO credit score, for a fee, at myfico.com.

» The Sharing of Credit Scores and the Ramifications

Obtaining one's credit report and credit score and correcting any mistakes is becoming more important because of score sharing. A growing number of companies having nothing to do with the business of offering credit (such as insurance companies, cellular phone companies, landlords, and affiliates of financial services firms) are now scrutinizing the data on credit reports and using this information to decide whether to do business with a consumer and how much to charge.

For example, in September 2004, The Wall Street Journal reported that when TXU Energy in Texas raised its rates for natural gas service, customers with the lowest credit scores had their rates raised higher than the others. According to the article, new rates were based on numeric rankings of credit-worthiness that take into account a customer's history of paying electricity, telephone and cable bills. The paper said TXU defended the use of credit information, which it gets from Experian, as an accurate predictor of future payment performance.

Employers once used credit reports to screen potential new hires without their knowing. However, today the FCRA requires that employers seek consumers' permission to pull a report, and to inform the applicant if he is denied employment based on the report. Many states also have laws restricting the use of credit scoring. For example, New York's law stipulates insurers can't deny coverage based on low scores.

Despite improvements introduced by the FCRA, many credit reports (and hence credit scores) still contain errors. According to a June 2004 study by the consumer advocacy group U.S. Public Interest Research Group (U.S. PIRG), as many as 79 percent of credit reports have errors -- 25 percent of which are serious enough to potentially result in a credit denial. More than half of the reports had information that was either outdated or belonged to someone else.

Ed Mierzwinski, the consumer program director of U.S. PIRG, says credit card companies often inaccurately portray their customers to credit reporting agencies in an effort to dampen credit scores and ward off competition. If companies make consumers look like they're a bad risk, says Mierzwinski, then other companies won't try to recruit them.

Mierzwinski cites a June 2003 report by the Federal Reserve, which suggests that credit card companies may be hurting their customers -- and lowering the customers' credit scores -- by withholding certain information from the major credit bureaus. The research, based on the study of a random sample of 301,000 individuals' credit files, found that nearly half -- 46 percent -- of the consumers had files where the credit limit had been withheld at least once by a creditor.

Withholding a consumer's credit limit is a major problem, says Mierzwinski, because the limit is used to calculate the "utilization" of existing credit -- a major factor in producing a credit score. To measure utilization, scoring systems look at the ratio of a person's balance to their credit limit. If a person has a $1,000 balance and a $10,000 credit limit, their ratio is very low (10 percent) and their credit score increases. If the balance is high -- meaning a person is nearly maxed out -- then the ratio goes up and the credit score decreases.

However, lenders often don't include their customers' credit limits in their reports to score-generating companies. These score-generating companies, such as Fair Isaac, substitute a consumer's highest balance in place of the missing credit limit, inflating the utilization ratio and lowering the credit score.

Another problem, Mierzwinski says, is using credit scores to determine insurance risk. Insurance laws require that insurance rates be based on causation, or "actuarial evidence." This means a statistical relationship between two factors must be proven. For example, the fact that a person who has a lot of speeding tickets will have more accidents has been statistically proven, but no statistical relationship has been found between credit scoring and insurance risk. "If I miss a payment on my credit card, or am the victim of identity theft, does it mean I'm a worse driver than you?" Mierzwinski asks. "Consumer advocates do not believe there is any relationship between the two."

» Monitoring Your Credit Record

As credit reporting grows in importance, a cottage industry in credit-score deciphering is mushrooming. Consumers can now sign up, for a fee, to have their personal credit files monitored by companies and notified via e-mail when their score changes.

Since all creditors do not use the three major credit bureaus (CRAs) equally, monitoring one bureau does not mean monitoring the other two. Mistakes may appear on any of the three reports. Although this is a problem, Georgetown University's Michael Staten says having competing CRAs makes the credit reporting process healthier.

The obsession to improve credit scores has also resulted in several credit-repair schemes popping up on the Internet, including offers to create new identities for people with bad credit. In 1997, Congress passed the Credit Repair Organizations Act to clamp down on the false advertising and business practices that some credit repair organizations were engaged in.

» Insider Scores and Affiliate Sharing

Although consumers can now monitor their credit ratings with the national credit bureaus, a new practice may be undermining the privacy and access rights Americans gained with the FCRA. Some credit card companies, like Citigroup, now develop and use their own internal credit scores. In its testimony before the U.S. Senate Banking Committee in June 2003 in defense of affiliate sharing, Citigroup said it uses information collected from its affiliates to create internal scores that help determine eligibility for credit, supplementing credit reports and FICO scores.

The company said that sharing credit information and transaction histories with affiliates largely reduced errors and "the burden" on customers to provide documentation to their bank's affiliates. But critics like Evan Hendricks, editor and publisher of Privacy Times, a biweekly newsletter in Washington, say an error in one account would be shared by all affiliates -- and could go unfixed, since the records are secret.

"The fact of the matter is, we don't know exactly what such companies are doing. This is a very murky area," Hendricks says. He says the Citigroup testimony was the first time that the sharing of "insider scores" with affiliates was acknowledged by the industry. Hendricks calls it an aggressive use of personal information that does not comport with fair information practices. "If people don't have access [to their information], that's going to breed inaccuracies."

Others, like Ed Mierzwinski of U.S. PIRG, say internal sharing of credit information can lead to the development of what he calls "black box databases."

"Sharing information with affiliates is simply not fair, because consumers have no access, knowledge of, or control over the use of their information," Mierzwinski says. "Consumers should have the right to look at their file and to dispute the file. These large banks are using consumer information to create unregulated databases. It could be used to redline people -- and they wouldn't even know about it."

» Why A Credit Score Is A Good Thing

Despite the drawbacks, critics agree that credit scoring has dramatically improved the efficiency of credit markets. "What credit reporting does, and does especially well in the U.S., is that it improves risk assessment," says Michael Staten of Georgetown Univeristy. "It gives the lender a better picture of whether the loan will be repaid, based entirely on how the consumer has handled loans in the past. You could say that it takes out a lot of the factors that you would consider discriminatory."

One major advantage of credit scores, says Professor Staten, is that they allow investors who buy securities to get a more accurate assessment of the underlying risk in these loans.

Securitization is the process of bundling large pools of consumer loans (e.g. mortgages, credit card loans or automobile loans) and selling them as securities to investors. Investors who purchase the securities buy a share of the stream of revenue that flows as loans are repaid. This allows the lender to get the loans "off their books" and shift some of the risk to outside investors.

How does that help consumers seeking credit? These investments make available huge quantities of additional funds to the lender that can then be made available in consumer credit markets. This lowers the price of loans or the interest rates to the consumer and makes credit more widely available, Staten says.

Credit bureau data has also brought consumers more equitable treatment, and has introduced more credit products to millions of households that would have been turned down as too risky just a generation ago, according to a 2002 study conducted by Staten and John M. Barren, a professor of economics at Purdue University. The U.S. credit reporting system has also made consumers more mobile by reducing the cost of severing established financial relationships and seeking better opportunities elsewhere, the study says.

Staten's study argues that historically, when the release of personal credit histories is restricted, it hinders credit availability, raises prices, and hinders economic development. However, consumer advocates warn that until the industry is further regulated, Americans have to keep an unswerving watch of their credit scores -- or pay the price for negligence.

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posted nov. 23, 2004

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