Consumer Compliance Outlook: Fourth Quarter 2010

An Overview of the Risk-Based Pricing Implementing Regulations

By Rebecca Reagan, Supervisory Examiner, Federal Reserve Bank of Richmond

January 1, 2011, is the mandatory compliance deadline for the risk-based pricing notice requirements under implementing regulations jointly written by the Board of Governors of the Federal Reserve System (Board) and the Federal Trade Commission (FTC) (the agencies).¹ The rules require creditors to provide a notice to consumers when, based in whole or in part on information in a consumer report, a creditor grants credit to the consumer on material terms that are materially less favorable than the most favorable terms available from the creditor to a substantial proportion of other consumers. The rules contain model notice forms and provide several methods for compliance. This article provides an overview of the risk-based pricing rules.

SCOPE OF RULES

Section 311 of the Fair and Accurate Credit Transactions Act of 2003 (FACT Act)² amended the Fair Credit Reporting Act (FCRA) to add the risk-based pricing notice requirement in §615(h)(15 U.S.C. §1681m(h)), and directed the Board and the FTC to issue implementing regulations. The Board codified its implementing regulations in subpart H of Regulation V, 12 C.F.R. §§222.70-75.³ Risk-based pricing refers to a creditor's practice of setting the price or other credit terms based on a consumer's risk of nonpayment. Creditors generally offer consumers with poor credit histories less favorable credit terms than consumers with strong credit histories to compensate for the higher risk of default.

Creditors currently are required by §615(a) of the FCRA (15 U.S.C. §1681m(a)) to provide adverse action notices when they deny a consumer's credit application, based in whole or in part on information in a consumer report. However, when a creditor does not reject an applicant with impaired credit, but instead offers credit on less favorable terms, the creditor generally is not required to provide an adverse action notice. The risk-based pricing notice requirements are designed to address such circumstances not covered by §615(a), where a consumer receives less favorable credit terms based on his or her consumer report, rather than being denied credit.⁴

The final rule clarifies that the risk-based pricing notice requirements apply only to consumer credit, i.e., credit primarily for personal, household, or family purposes.⁵ Business credit is excluded. This is consistent with the purpose of the notices to alert consumers that their consumer reports may contain negative information and allow them to check the reports for accuracy.⁶ To facilitate this review, consumers receiving a risk-based pricing notice are entitled to a free consumer report for 60 days after receipt of the notice in addition to the free annual reports to which they are entitled under the FACT Act.

GENERAL REQUIREMENTS

When a creditor engages in risk-based pricing and uses consumer reports for this purpose, the requirement to provide a risk-based pricing notice to a consumer depends on what “material terms” are extended to the consumer and how those terms compare to the material terms extended to other consumers. Under the final rule, “material terms” generally is defined as the annual percentage rate (APR) for credit products that have an APR.⁷ For credit products without an APR, material terms means the financial term that the creditor varies based on the consumer report and that has the most significant financial impact on consumers, such as an annual membership fee.⁸

The agencies state in the final rule that focusing on the APR is appropriate because most consumer credit products have an APR, and it has historically been a significant factor in the pricing of credit.⁹ The APR used to determine the applicability of the rule varies, depending on the type of credit product:

For open-end plans, the APR is the rate required to be disclosed under §226.6(a)(1)(ii) or §226.6(b) (2)(i), excluding any temporary initial rate that is lower than the rate that will apply after the temporary rate expires, any penalty rate, and any fixed APR option for a home equity line of credit.
For credit cards (other than a credit card used to access a home equity line of credit or a charge card), the APR is the rate for purchases described under §226.6(b)(2)(i). If the credit card has no purchase APR, the material term is defined as the APR that varies based on information in a consumer report and that has the most significant impact on the consumer.
For closed-end credit, the APR is the rate required to be disclosed under §226.17(c) and §226.18(e).¹⁰

The risk-based pricing rules generally require a creditor to determine whether a consumer receives materially less favorable material terms for a specific type of credit product¹¹ and to provide a risk-based pricing notice to a consumer when this occurs. The agencies state that it would not be operationally feasible in many cases for creditors to compare terms offered to each consumer with the credit terms offered to other consumers to determine if the material terms are materially less favorable. As a result, the agencies provide tests that serve as proxies for comparing the terms offered to different consumers to determine which consumers must receive a risk-based pricing notice, although creditors retain the option to determine which consumers must receive a risk-based pricing notice on a case-by-case basis.

Credit Score Proxy Method

A creditor that sets the material terms of credit granted, extended, or otherwise provided to a consumer, based in whole or in part on a credit score, may use the credit score proxy method. This method uses a cutoff score at which approximately 40 percent of the consumers to whom the creditor grants, extends, or provides credit have higher scores and approximately 60 percent have lower scores. Any consumer whose credit score is lower than the cutoff score must be given a risk-based pricing notice. When a creditor has granted the most favorable credit terms to more than 40 percent of consumers, it has the option to set the cutoff score at an alternative point based on its historical data.

Creditors can use a representative sample for each specific type of credit product to determine the cutoff score. For creditors who are new to the market, secondary source information derived from appropriate market research or third-party sources for a specific type of credit product, such as market research or data from companies that develop credit scores, can be used. If a creditor acquires a credit portfolio as a result of a merger or acquisition, it may rely on information from the entity it acquired, with which it merged, or from which it acquired the portfolio.

Creditors that use the credit score proxy method must recalculate their cutoff score(s) no less than every two years. If market research, third-party data, or information from an entity it acquired, with which it merged, or from which it acquired the portfolio was used, the creditor must calculate a cutoff score using its own consumers within one year. Creditors with insufficient origination activity to calculate a score may continue to use secondary sources for an additional time frame not to exceed two years.

When a creditor uses multiple credit scores in setting the material terms of credit, the method used to determine the cutoff score must be the same method used to evaluate multiple scores for credit decisions. For example, a creditor may select the low, median, high, most recent, or average credit score of each consumer. If the creditor does not use a consistent method, a cutoff score should be calculated using reasonable means. The agencies deem as “reasonable means” either using a method that is regularly used or calculating the average credit score of each consumer.

Creditors using the credit score proxy method when no credit score is available must assume that the consumer receives credit on terms materially less favorable than the most favorable credit terms offered to a substantial proportion of consumers. The creditor must provide a risk-based pricing notice to the consumer.

Tiered Pricing Method

The tiered pricing method is available to creditors that set the material terms of credit by assigning each consumer to a discrete number of pricing tiers for a specific type of credit product. Creditors that use four or fewer tiers must provide notices to all consumers who do not qualify for the top tier. For example, if a credit card issuer has three pricing tiers (10 percent, 14 percent, and 18 percent) for the purchase APR, the issuer must provide a risk-based pricing notice to each consumer who did not qualify for the 10 percent purchase APR. When the creditor uses five or more pricing tiers, it must provide notices to any consumer who does not qualify for the top two tiers and any other tier that, together with the top two tiers, comprise no less than the top 30 percent but no more than the top 40 percent of the total number of tiers. For example, if a creditor has nine pricing tiers, the top three tiers comprise no less than the top 30 percent but no more than the top 40 percent of the tiers. Therefore, a creditor using this method would provide a risk-based pricing notice to each consumer who is placed in the bottom six tiers.¹²

Application to Credit Card Issuers

Section 222.72(c) addresses how credit card issuers can comply with the risk-based pricing rule. Issuers have the option of using any of the methods described above. If the issuer uses the credit score proxy or tiered pricing method, it must determine which consumers receive a notice through an analysis of the issuer's entire portfolio, rather than on an offer-by-offer basis. Alternatively, in connection with an application program, such as a direct-mail offer or a take-one application, or in response to a solicitation under §226.5a of Regulation Z, if the creditor offers multiple purchase APRs, the creditor may satisfy its obligations by sending risk-based pricing notices to any consumer who does not receive the lowest APR under that particular offer. When using this special method for credit cards, the issuer determines which consumers must receive a notice on an offer-by-offer basis with no requirement to compare different offers. Issuers are not required to provide notices when the consumer applies for a credit card and the issuer provides a single APR (excluding teaser or penalty rates) or when the issuer provides the consumer the lowest APR under the specific offer, even if there are lower rates available under different credit card programs issued by the card issuer.

Account Review

Under §222.72(d), a creditor is required to provide risk-based pricing notices if it performs an account review using information in a consumer report and a consumer's APR is increased as a result. Section 222.72(d) (2) contains an example to clarify: “A credit card issuer periodically obtains consumer reports for the purpose of reviewing the terms of credit it has extended to consumers in connection with credit cards. As a result of this review, the credit card issuer increases the purchase APR applicable to a consumer's credit card based in whole or in part on information in a consumer report. The credit card issuer is subject to the requirements of paragraph (a) of this section and must provide a risk-based pricing notice to the consumer.”

CONTENT AND TIMING

Section 222.73 establishes the requirements for the content, form, and timing of the risk-based pricing notices.

Content

The content of the notices is prescribed in §222.73(a) (1) and (a)(2). Generally, the notice conveys what type of information is contained in a consumer report and that the terms of credit offered to the consumer are based on such information and may be less favorable than those for other borrowers with better credit histories. The notice encourages the consumer to verify the accuracy of the information in his or her report and notes the consumer's right to dispute inaccurate information. The notice must also inform the consumer of his or her right to receive a free credit report, provide information about how to obtain the report, disclose the identity of the consumer reporting agency or agencies that issued the report, and the fact that the consumer has 60 days after receipt of the notice to request a credit report.

To facilitate compliance with the content provisions, model disclosure forms H-1 and H-2 are provided. Model form H-1 may be used (as applicable) when a creditor extends credit to a consumer on materially less favorable terms, while model form H-2 may be used when an APR is increased as a result of an account review. Creditors' appropriate use of the model forms provides a safe harbor.¹³

Timing

Timing requirements for the risk-based pricing notice vary based on the type of credit extended. For closed-end credit, notices must be given before consummation of the transaction but not earlier than when the decision to approve the application is communicated to the consumer. For open-end credit, notices must be provided before the first transaction is made under the plan. When periodic account reviews are performed, the notice must be given at the time the decision to increase the APR is communicated to the consumer. If no notice is provided prior to the effective date of the change in the APR, the risk-based pricing notice must be given no later than five days after the effective date of the change.

The rules for providing the notice vary when credit is extended in conjunction with the purchase of an automobile from an auto dealer. First, when an auto dealer is the original creditor, pursuant to §222.75(b)(1), the auto dealer must provide the risk-based pricing (or alternative) notice, even if the dealer immediately assigns the credit agreement to a third party that serves as the source of funding for the credit. Conversely, when a creditor grants credit for the purpose of financing the purchase of an automobile from an unaffiliated auto dealer, the risk-based pricing notice can be provided either by the creditor or the dealer pursuant to the timing requirements discussed previously. If the notice is provided by the dealer, the creditor must maintain reasonable policies and procedures to verify that the auto dealer provides the notice within applicable time periods. Furthermore, if the consumer receives a notice containing a credit score (under the exception notice provisions of §222.74(e) or (f), discussed below) obtained by the dealer (or other party) and that score differs from the score obtained by the creditor, the creditor's obligations under the regulation are considered satisfied.

Under open-end plans, if credit is granted contemporaneously with a purchase of goods or services, the risk-based pricing notice may be provided at the earlier of the time of the first mailing by the creditor to the consumer after credit is granted or within 30 days after the decision to approve credit. For example, a consumer may apply for and be approved for a credit card when making a purchase at a department store. If a notice is required to be given to the consumer, the creditor may provide the notice in a mailing containing the account agreement or the credit card or within 30 days after the decision to approve credit, whichever is earlier.

EXCEPTIONS

Section 222.74 contains six exceptions to the risk-based pricing notice requirements. No notice is required when:

A consumer applies for specific material terms (for example, a 10 percent APR) and is granted those terms, unless those terms were specified by the person using a consumer report after the consumer applied for or requested credit and after the person obtained the consumer report.
A creditor uses consumer reports to prepare a prescreened credit solicitation under the “firm offer of credit” provision of §604(c)(2) of the FCRA (15 U.S.C. §1681b(c)(2)).¹⁴ However, if a consumer receives a solicitation, applies for credit, and a risk-based pricing notice is triggered under §222.72, the creditor must provide the notice.¹⁵
A creditor provides an adverse action notice to the consumer under §615(a) of the FCRA (15 U.S.C. §1681m(a)).

More important, the agencies provide a set of exceptions that apply if a creditor provides to all consumers who request credit a credit score disclosure notice in lieu of a risk-based pricing notice. The exception notices are:

For loans secured by residential real property, creditors must disclose the consumer's credit score and certain additional information required by §222.74(d)(1)(ii) clearly and conspicuously and in writing. Appendix H contains model form H-3, which creditors can use to comply. This notice contains all of the information required to be disclosed pursuant to section 609(g) of the FCRA (15 U.S.C. §1681g), and the agencies intend that model form H-3 also be compliant with the disclosure required under 609(g). This credit score exception notice must be provided before consummation of the transaction in the case of closed-end credit or before the first transaction is made under an open-end plan.

For credit not secured by one to four units of residential real property, creditors must provide a credit score notice similar to the credit score exception notice for residential real estate. Creditors must disclose the consumer's credit score and certain additional information required by §222.74(e)(1)(ii). Appendix H contains model form H-4, which creditors may use to comply.

These credit score exception notices explain that credit scores are affected by a consumer's credit history and can affect the availability and cost of credit. Both notices disclose the consumer's credit score and compare it with a distribution of credit scores among consumers in graphical form or through a clear and readily understandable statement informing the consumer how his or her credit score compares with the scores of other consumers. Since the credit score is provided with these exception notices, the consumer does not have the right to a free consumer report, other than a free annual report. A statement encouraging the consumer to verify the accuracy of the information contained in the consumer report and noting the consumer's right to dispute any inaccurate information in the report is required. The creditor must also disclose how the consumer can obtain a consumer report.

For either of the credit score exception notices described above, if the creditor obtains two or more credit scores for a consumer and uses one of those scores as the basis for setting the material terms, that score must be disclosed. If the creditor instead uses multiple scores to set the material terms (such as by averaging the scores), the creditor may disclose one of the scores obtained or may disclose more than one score. Regardless of which method the creditor uses, the information specified in §222.74(d)(1)(ii) or (e)(1)(ii), as applicable, must be provided for each credit score disclosed.

If a creditor regularly obtains credit scores from a consumer reporting agency and is unable to obtain a score for a particular consumer from that consumer reporting agency, an exception notice may be given stating that a credit score was unavailable, which may indicate a lack of credit history. Other disclosures in the notice describe what credit scores are, why they are important, and how to obtain a copy of the consumer's credit report. Model form H-5 affords a safe harbor.

MULTIPLE CONSUMERS

In the case of risk-based pricing notices for transactions involving two or more consumers who are granted, extended, or otherwise provided credit, a creditor must provide a notice to each consumer to satisfy the requirements of §222.72(a) or (c). If the consumers have the same address, a creditor may satisfy the requirements by providing a single notice addressed to both consumers. If the consumers do not have the same address, a creditor must provide a separate notice to each consumer.

Credit score exception notices have different requirements. When a transaction involves two or more consumers, the creditor providing such notices must provide a separate notice to each consumer to satisfy the exceptions in §§222.74(d), (e), or (f), regardless of whether the consumers have the same address. Each separate notice must contain only the credit score(s) of the consumer to whom the notice is provided and not the credit score(s) of the other consumer.

Section 222.75 also provides other rules of construction. Section 222.75(a) generally provides that a consumer is entitled to only one risk-based pricing notice per credit extension, unless the creditor must provide an account review notice(s) to the consumer. Section 222.75(b) provides that the original creditor has the obligation to provide a notice, even if it immediately assigns the credit agreement to a third party and is not the source of funding for the credit. A purchaser or assignee of a credit contract is not required to provide a notice.

CONCLUSION

The risk-based pricing and credit score exception notices provide consumers with an additional opportunity to review the accuracy of their credit reports or to receive their current credit score. The disclosure is further intended to educate consumers about the connection between the information in their credit reports and the cost of credit. Creditors need to evaluate which method(s) for compliance with the risk-based pricing rules works best for their credit products. Specific issues and questions should be raised with the consumer compliance contact at your Reserve Bank or with your primary regulator.

¹ The December 22, 2009, joint announcement and the Federal Register notice are available on the Board's website.
² Public Law 108-159, 117 Stat. 1952, which is available online.
³ The FTC placed its substantially similar regulations in 16 C.F.R. part 640.
⁴ The Senate Committee on Banking, Housing, and Urban Affairs cited concerns that the adverse action notification construct had been made obsolete in certain circumstances and found this problematic because the adverse action notice is the “primary tool the FCRA contains to ensure that mistakes in credit reports are discovered.” See S. Rep. No. 108-166, at 20 (Oct. 17, 2003) available online.
⁵ 12 C.F.R. §222.70(a)(1)(i)
⁶ 75 Fed. Reg. at 2724
⁷ §222.71(n)(1) and (2)
⁸ §222.71(n)(3)
⁹ 75 Fed. Reg. at 2728
¹⁰ §222.71(n)
¹¹ Section 222.72(b) defines “specific type of credit product” as one or more credit products with similar features that are designed for similar purposes. Examples of a specific type of credit product include student loans, unsecured credit cards, secured credit cards, new automobile loans, used automobile loans, fixed-rate mortgage loans, and variable-rate mortgage loans.
¹² §222.72(b)(2)
¹³ The model forms are available online.
¹⁴ §222.74(c)
¹⁵ 75 Fed. Reg. at 2739