Starting Feb. 22, credit card issuers will do financial checkups on potential customers and anyone getting increased credit limits.
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Credit card companies will be peering more deeply into card applicants’ financial affairs starting next month.
|Credit card reform arrives: complete coverage|
Starting Feb. 22, when major provisions of the Credit CARD Act of 2009 take effect, anytime you apply for a new credit card or your credit limit is increased on an existing account, card issuers must consider whether you can actually repay the card loan. In many cases, that will mean a behind-the-scenes financial checkup on a credit card applicant’s income or assets.
But you’re unlikely to be asked to hand over paycheck stubs or other financial documents to issuers. Instead, you’ll be judged by new statistical tools — called income estimation models — rolled out recently by the major credit reporting bureaus and approved by the Federal Reserve for use in assessing ability to pay. The tools will estimate a consumer’s income based on card application information, credit bureau data and information from employment and IRS tax databases.
Major retail stores had complained to the Fed that its ability-to-pay rules, as initially proposed, could kill instant in-store credit offers pitched to shoppers at the cash register. The proposed rules had required card issuers to collect financial information from applicants, but final credit card reform law guidelines issued Jan. 12 by the Fed allows issuers to use statistical income estimation models developed by the credit reporting bureaus.
As a result, “there is a partial sigh of relief” from retailers, says Mallory Duncan, senior vice president of the National Retail Federation. “Using that kind of estimator will cost more money, but it’s preferable to asking people for income information at point of sale.”
“The new rule is you are required to collect it, but in lieu of that you can use an estimation model,” Duncan says. He said stores will likely use the behind-the-scenes income estimation tools and avoid asking shoppers for paycheck stubs or salary information — a process that would have been rife with logistical hurdles.
He adds: “They’re probably not going to give those estimates out for free. That will probably drive up the cost of those decisions at point of sale.”
With only about five weeks until the rule takes effect, retailers will be scrambling to put the new income screening procedures in place. “They have a very limited time in which to pull this together,” Duncan notes.
Retailers had asked the Fed to consider waiving the ability-to-pay rule for accounts with relatively small credit limits. Regulators rejected that suggestion, however, noting that even low credit limit accounts “could still have a significant impact on a particular consumer, depending on the consumer’s financial state. For example, subprime credit card accounts with relatively ‘small’ credit lines may still be difficult for certain consumers to afford. Suggesting that these card issuers may simply avoid consideration of a consumer’s income or assets may be especially harmful for consumers in this market segment.”
There is a partial sigh of relief.
|— Mallory Duncan|
National Retail Federation
Consumer groups had asked the Fed to consider placing more stringent income requirements on people under 21, such as requiring them to have lower debt-to-income ratios or only considering income from wages they earn. Regulators, however, declined to make it harder for young adults to show ability to pay, saying the rules established for all borrowers were sufficient for young people and avoided “unnecessarily impinging on their ability to obtain credit and build a credit history.”
More financial scrutiny
Why the additional scrutiny for credit card applicants? The credit card reform law includes a provision requiring credit card issuers to take additional steps to prevent customers from getting in over their heads in credit card debt. The goal: preventing someone with no income or assets from getting a plastic license to spend that could lead to bankruptcy.
Under the final ability-to-pay rules, card issuers must create policies and procedures for reviewing ability to pay credit card debts that consider at least one of the following: the ratio of the consumer’s debt obligations to income; the ratio of debt obligations to assets; or the income the consumer will have after paying debt obligations. The debt-to-income ratio is a common financial measure used to determine financial stability of an individual or company. It is the amount of debt owed as a percentage of the amount of income available to repay it. The lower the ratio, the better.
Regulators said card issuers may consider, among other things:
- Salary, wages, bonus pay, tips and commissions from full- or part-time, seasonal, military or irregular jobs and self-employment.
- Interest, dividends, retirement benefits, public assistance, alimony checks, child support and other kinds of maintenance payments.
- Savings accounts or investments.
- Credit reports and credit scores.
No verification required
The Fed said card issuers will not be required to verify income amounts reported by consumers — a provision sought by consumer groups as an additional safeguard against people overstating their incomes to get higher credit limits.
“For an ability-to-pay provision to have real bite, issuers need to require some sort of verification as they do for other sorts of loans,” says Lauren Bowne, a staff attorney at San Francisco-based Consumers Union, the nonprofit owner of Consumer Reports magazine. “They could have added a bit of teeth to it.”
Both consumer groups and bankers noted that the income estimation models are new — Experian launched its service in November and Equifax started offering its products in December. Many have questions about how the models will work and their accuracy in predicting income levels. If they base their estimates on credit bureau and employment data, how would they handle people who have limited credit histories and who recently changed jobs, received raises or lost their incomes? Would the income models be able to accurately estimate incomes for these situations?
The credit bureaus acknowledge that the models are not perfect.
“Income estimation models are built to handle the majority of individuals, and there will always be some special cases where income estimates are less accurate,” says Brannan Johnston, Experian’s vice president of income and deposits. Experian’s tool, called Income Insight, uses the credit bureau’s payment database and verified income databases.
“Only changes reflected on a consumer’s credit report will affect the estimate,” Johnston says. The fact that someone has been laid off typically shows up in the credit report as missed payments and higher debt utilization ratios. Similarly, a person getting a new job often has improved credit profiles.
“As long as a person’s credit report changes, the estimate provided by Income Insight will change as well,” Johnston adds.
How income estimation models work
How will credit card applications be handled? Most credit card applications currently ask for household income information. It is self reported by the consumer and usually not verified, meaning the bank doesn’t ask you to provide copies of paycheck stubs, investment account statements or income tax returns as it would if you were applying for a mortgage loan.
When applicants enter their annual incomes, that information — along with their present and former addresses, birthdays and Social Security numbers — will be forwarded to a credit bureau. Within minutes, the bureau’s database of payment histories can generate a credit score that rates the applicant’s creditworthiness. In the same amount of time, the bureau’s new income estimation model can generate an estimated income to the nearest $1,000.
Johnston from Experian says no lenders are allowed to reject credit card applicants based solely on the income estimation tool.
If the model spits out an income amount that is dramatically different from what the consumer has reported, it triggers an alert. The creditor will ask the consumer to submit additional information. That may include copies of recent paycheck stubs, tax forms or other financial paperwork.
“More than 85 percent of the consumers where we estimated income of less than $35,000 actually had incomes of less than $50,000,” Johnston says of the model. “It will rarely be dead on. No borrower will be turned down for credit based on that.”
Similarly, if a consumer has a “thin file,” meaning he or she doesn’t have a significant credit history or work history, that will signal the need for additional verification by the card issuer.
Nessa Feddis, senior counsel for the American Bankers Association trade group, says some banks may still grant credit cards to those thin file applicants. “They may start people out with a very low credit limits,” she says. “And then, with experience, see how they do and then adjust appropriately.”
Income doesn’t tell the whole story
Banks and retailers argued that knowing how much a cardholder earns does not help lenders determine whether they will repay their credit card bills. Past payment history — as shown in credit reports and in credit scores — is a better indicator of ability to pay. Feddis, from the bankers association, makes a distinction between ability to pay and willingness to pay debts. Cardholders can have large incomes showing ability to repay, but not be willing to pay their credit card debts before they pay other financial obligations.
You can’t predict with 100 percent accuracy who is going to repay their loans, otherwise you would only give loans to people who don’t need credit.
|— Nessa Feddis|
American Bankers Association
“Credit scores show more willingness to repay,” Feddis says. “If you’re willing to repay, generally you’re going to be able to pay.”
“It’s not always obvious who is going to repay a loan,” Feddis says, adding “You can’t predict with 100 percent accuracy who is going to repay their loans, otherwise you would only give loans to people who don’t need credit.”
The economy also plays a role in who can and can’t pay their credit card bills. “Nobody knows who is going to lose their jobs,” Feddis says. “It was only when unemployment started to get into the double digits that you saw people not paying on their credit cards. The credit card companies, prior to the unemployment rate increases, were doing fairly well.”
Adds Bowne from the consumer group: “It will be interesting to see what changes are coming: Are there going to be more hoops to jump through just to apply for a credit card?”
See related:Credit card reform law: complete coverage, Fed: Want a credit card? Prove you can pay the bill, Instant in-store credit offers in jeopardy, A guide to the Credit CARD Act of 2009, Credit CARD Act interest rate protections kick in, Fed knocks the ‘floor’ out of variable interest rate credit cards