Credit scores have opened financial markets of greater choice, but those choices, including those in the mortgage industry, are often too complex for consumers to understand. That lack of knowledge is leading to lower scores and greater financial stress.
The answer?
For starters, incorporate financial education in public schools at the elementary level and mandate financial education from financial institutions that use the scores to make or break applications for financial services.
Too often consumers aren't made aware of the workings of credit scores and credit reports until they are in financial trouble. Preventive education is much better medicine.
"Credit Scores, Reports, and Getting Ahead in America" a new report by public policy think tank, the Brookings Institution, offers sobering insights into the nation's credit scoring and reporting industry and suggests far-reaching change is over due.
The study says consumer credit reports and scores play a growing role in the ability of families to get ahead -- or not -- financially. Not only are they a deciding factor in approving or declining applications for credit, they also are a primary deciding factor influencing the cost of financial services, efforts to get jobs and to rent apartments.
A credit score, used by the vast majority of lenders to approve or deny a mortgage application (along with other services), is a statistical analysis of a consumers' creditworthiness generated, in part, from information on a credit report. A credit report tracks credit consumers' payment records on individual credit accounts, reveals how well or how poorly each account is being paid and records available and used credit levels, the number of creditors used, types of credit used and a host of related information.
Researched and written by Matt Fellowes, a senior research associate at Brookings' Metropolitan Policy Program, "Credit Scores, Reports, and Getting Ahead in America" is an analysis of a quarterly sample of 25 million anonymous consumer credit reports and scores for every U.S. county between 1999 and 2004.
Among the report's findings:
Lower credit scores signal higher risk to lenders who raise prices to compensate for the higher risk.
For example in 2004, a credit score of 760 to 850 landed a 5.3 percent interest rate on a 30-year $150,000 mortgage giving the borrower an annual financing cost of $9,984. For someone with a score of 500 to 590, costs on the loan soared to $14,856 because of the 9.3 percent interest rate mortgage necessary to fund the purchase, the report said.
That higher cost takes money off the table for other investments, said the report, indicating why scores are lower in the South is an unknown.
"That such large proportions of borrowers in this region stand out for having such weak credit scores begs further research in the future. Without that attention, large proportions of consumers in Southern counties will likely continue to have credit scores that limit access to credit products or only qualify them for very high-priced mortgages, auto loans, and all of the other credit-based products families rely on today," the report said.
The report also said those higher costs may spill over into the community by draining consumer spending away from retail, home ownership, home improvements, and education.
"For both families and leaders, it is therefore important to understand consumer credit scores, and the strategies needed to improve scores," according to the report.
"This trend points to a potentially ruinous fiscal cycle for consumers with low credit scores. While credit scores create an opportunity to underwrite high-risk consumers that opportunity comes with a price, such as higher-priced mortgage loans," the report said.
The Catch-22 continues as the higher prices make high risk consumers more likely to miss payments.
"This evidence does not suggest that a bias exists, or that there is a causal relationship between race and credit scores," the report said.
While there may not be racial bias in credit scoring and reporting, the disparity likely does reflect historical differences between races in the access to and availability of high quality education, well-paying jobs, and access to loans, among other factors, the report said.
Similarly, the proportion of all home owners behind on their mortgage payments jumped 115 percent, increasing from one out of every 100 mortgage borrowers to about one out of 50.
The report says while credit scores generate greater access to credit they also open the door to questionable business practices that lure consumers with more opportunities to get in over their heads.
"In the mortgage industry, for instance, some lenders sell negatively amortizing lines of credit to high-risk clients, most of which really should not buy this product. For high-risk clients who can only afford a loan by accumulating more debt on their principal balance, this may lock their credit score into a downward path," the report said.
With one out of every 50 homeowners facing an active mortgage delinquent on their mortgage payments in 2004, they may not necessarily lose their homes, but the effect on their credit score could increase their cost of living.
"This remarkable leap in mortgage delinquencies means that a growing number of American homeowners are finding the costs of home ownership too financially burdensome, throwing in jeopardy what for most families is their primary asset," the report said.
Among other solutions, the report recommends financial curriculum in public schools from kindergarten through grade 12; banks and insurance companies offering basic financial information about credit reports when they open a new account; utility and telecommunications companies informing customers about the role scores play in their access to services; Web-based financial education courses; free access to credit scores and more disclosures from credit bureaus about the accuracy of their information.
