Thursday, November 18, 2010

Good Credit Is No Longer Enough

A couple of months ago, I took a refinance application for a doctor and his wife.  They were refinancing their home valued at about a half a million dollars, which was well in line with his annual income of over one million dollars a year.   After I had the basic information, I went into my office to pull their credit reports.  The wife looked a little worried when she asked me about their scores.  I assured her that their scores, which were over 750, were excellent and they would have no trouble securing the interest rate they wanted.  Worry then turned to confusion, as the wife explained to me that she had just had her credit line decreased by Wells Fargo to just slightly more than she owed on the card.  When she called Wells Fargo to ask why they had taken this action, they had told her that her credit was not very good and that she was a poor risk.  Although she protested their decision, they were adamant that this couple, who have more than 20 years of good credit, no late payments on any accounts, and a seven figure income, with very little debt in proportion to that income, were not a good enough risk for Wells.

I was not able to explain to the couple what Wells Fargo's motivation might be for cutting their credit limit at the time, but an article in the today sheds some light on why banks are deciding, for no apparent reason, that some clients are more creditworthy than others.  For more than a decade, the importance of a good credit score has been drilled into us, with the result that many more Americans know their credit score and understand its impact on their lives.  But today banks are using new tools in addition to credit scores to determine whether borrowers are creditworthy. 

For example, the Fair Isaac Company--creators and owners of the FICO score system that governs our lives--has a new system marketed to banks to track depositor behavior.  They assign each bank client a score based on deposit and withdrawal activity.  Presumably, checks for non-sufficient funds and returned checks will count against the borrower's score.  The scoring system can alert the bank when there is a change to the borrower's financial activity--for instance, a direct deposit which stops may signal the loss of a job.  Using up the savings may also signal financial difficulties.  And that can be the bank's cue to cut off credit.

In addition to tracking bank information, credit bureaus are also using income estimates to determine  potential debt to income ratio.  Although credit reporting agencies do not have direct access to income documents or to IRS-filed tax returns, the Federal Reserve has cleared the way for lenders to use credit bureaus' income estimates to determine whether a particular borrower would be creditworthy for credit cards and credit lines.  Using existing credit lines and the type, balance, and age of the consumer's mortgage, the credit bureaus attempt to determine what the client's annual income is.  His stated income on a credit application can then be cross checked against the credit bureau's guesstimate to see whether the numbers line up.

The banks are also tracking the consumer's home's value.  The WSJ article tells of Ken Lin, who had a very good credit score but was denied for a credit card.  He was flagged as high risk because he lives in California where his property value had declined but his mortgage balance had remained steady, signaling that he was on an interest-only mortgage.  As property values continue to decline nationwide, more borrowers may find that they cannot receive credit because they have lost the equity in their homes even if they have paid all of their bills on time. 

The cash value of bank accounts and other "liquid assets" can be an important mitigating factor in determining credit worthiness, but previously credit reports did not disclose financial liquidity just as they did not disclose income.  Now, however, Experian offers a service which estimates financial liquidity for consumers so that the banks can use this information to determine credit worthiness.

All of this just means that for the consumer who is beginning to have some financial problems--loss of equity in a home, job loss, etc. the financial service provider can identify those persons and cut off their access to credit even if they have had a perfect pay history.  It is a little like the credit version of "Minority Report"; we can now determine whether a person is at risk to default and punish them before they have a chance to make their first late payment.

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