Academic journal article The Journal of Consumer Affairs

Credit Scoring and Its Effects on the Availability and Affordability of Credit

Academic journal article The Journal of Consumer Affairs

Credit Scoring and Its Effects on the Availability and Affordability of Credit

Article excerpt

The Fair and Accurate Credit Transaction Act of 2003 (the FACT Act) directed several federal agencies to conduct studies related to the credit reporting industry. A primary concern was the accuracy and fairness of the credit reporting and scoring systems. In this article, Federal Reserve System Board economists report on a study in which they examined various issues related to credit scoring, including how credit scoring has affected the availability and affordability of credit. In a responding commentary, Calvin Bradford notes flaws and deficiencies in the Federal Reserve System study.

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In recent decades, consumer credit markets in the United States have become increasingly national in scope and credit has been extended to a broader spectrum of consumers. The development and use of credit scores has greatly facilitated these trends. Credit scoring is a statistical technology that quantifies the credit risk posed by a prospective or current borrower. Credit scores seek to rank order individuals by their credit risk so that those with poorer scores are expected to perform worse on their credit obligations than those with better scores.

Credit scoring is widely used to evaluate applications for credit, identify prospective borrowers and manage existing credit accounts. It is also used to facilitate decision making in other areas, including insurance, housing, and employment. The large savings in cost and time that have accompanied the use of credit scoring are believed to have increased access to credit, promoted competition and improved market efficiency.

In response to Section 215 of the Fair and Accurate Credit Transaction Act of 2003 (the FACT Act), (1) the Federal Reserve prepared a study on how credit scoring has affected the availability and affordability of credit, the relationship between credit scores and loan performance and how these relationships vary for the population groups protected under the Equal Credit Opportunity Act (ECOA). The study also addressed the extent to which the consideration of certain factors included in credit scoring models might have a negative or differential effect on populations protected under the ECOA and the extent to which alternative factors could be used in credit scoring to achieve comparable results with a less negative effect on protected populations. This article presents a summary of the study.

BACKGROUND OF THE STUDY

Largely because of a lack of data linking credit scores to race, ethnicity and other pertinent demographic information about individuals, little research has been conducted on the potential effects of credit scoring on minorities or other demographic groups. With the exception of dates of birth, the credit records maintained by consumer-reporting agencies, which serve as the basis for most credit scoring models, do not include any personal demographic information. (2) Moreover, federal law generally prohibits the collection of such data on applications for nonmortgage credit. Even in the context of mortgage credit, for which some creditors are required to collect information on race, ethnicity and sex, little information is publicly available about how these personal demographics relate to credit scores.

The Board's study was prepared using two types of information. The first type was gathered from public comments submitted for the study and from a review of previous research, studies and surveys. The second type was collected from the unique research conducted by the staff of the Federal Reserve Board specifically for this study.

Regarding the second approach, the Board's staff created a database that, for the first time, combined information about personal demographics collected by the Social Security Administration (SSA) with a large, nationally representative sample of individuals' credit records. The sample comprised the full credit records of more than 300,000 anonymous individuals drawn in June 2003 and updated in December 2004 by TransUnion LLC (TransUnion), one of the three national credit reporting agencies. …

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