One detail effectively missing from the mainstream economic debate is consumer credit scores and their use for everything from buying homes to getting a cell phone.
As credit scores presumably take greater hits during the deepening recession, using them to determine who can make purchases could have catastrophic affects on consumers and businesses, economists say.
Few things determine so much about a person and their cost for goods than a person’s credit. Over the years the use of credit scores has extended beyond solely the consumer lending realm to areas such as applying for a job. But with nearly 3.5 million Americans losing jobs since December 2007 — 598,000 in January alone — it is not a giant leap to predict many people will see their credit scores fall as they struggle to make monthly payments, or worse, default on certain debt, said Michael Bernstein, an economic historian and provost at Tulane University.
“By definition in a recession — and in this case a very serious recession — people fall back on paying their bills or default completely,” said Bernstein. “Either way their FICO (credit score) comes down.”
Fair Isaac Corp. provides the formula credit bureaus use to determine ratings known as FICO scores. It reports that the median FICO credit score examined during the first half of 2008 remained fairly stable nationally.
Equifax, one of the three major credit reporting bureaus, analyzed the national average of credit scores and found scores have declined slightly over the last eight months, said Demitra Wilson, a company spokeswoman.
U.S. consumer advocacy groups foresee a cataclysmic situation for consumers and potentially for businesses from using credit scores to determine a product’s cost. The insurance industry has historically been one of the primary sectors that use credit scores, in part, to determine the rates for automobile and homeowners’ policies. Typically, consumers with lower credit scores pay higher rates.
“In better economic times, the use of credit scoring (for insurance rates) has been unfair,” said Birny Birnbaum, executive director of the Center for Economic Justice, a nonprofit consumer watchdog organization. “Now, the situation will go from bad to truly catastrophic… as job loss in many states has doubled in the last couple of years. There’s virtually no business that doesn’t in some way use credit information.
“Not only is the information used, it is turned into some black-boxed scoring models and no one knows how they’re being used and what goes into them.”
Most studies have found the use of credit information has historically affected low-income people, minorities and immigrants, but as more people break under the weight of the collapsing economy, declining credit scores will mean higher rates consumers already can’t afford, Birnbaum said.
Insurance industry officials, who have long defended credit-based insurance scores, say their use of credit information is imperative because they help properly measure insurance risk.
“(Credit-based insurance) scores provide a numeric assessment of an individual’s insurance risk,” said Loretta Worters, spokeswoman for the Insurance Information Institute. “Insurance companies consider only those items from credit reports that are relevant to insurance loss potential. Unlike a lender, an insurance company is not assessing a customer’s income and debt; they are evaluating how customers manage their finances and credit granted to them.”
Worters said insurance companies vary on how they apply credit information to their own scoring model and in some cases don’t use them at all. Still, she recommends consumers not “bury their heads in the sand” when it comes to their credit scores and learn how to build and protect their credit history since the information is used when “applying for a job, renting an apartment, securing a loan and obtaining a cell phone in addition to purchasing home and auto insurance.”
“People have to review their budgets and borrow within their budget,” Worters said.
Credit scores should not be used to determine who is an insurance risk since they have no connection to someone’s propensity to file a claim, said Harvey Rosenfield, founder of Consumer Watchdog, a California public advocacy group.
“The situation is despicable and it’s going to hurt a lot of people,” Rosenfield said.
In light of taxpayers funding a bailout of the financial industry, it is ironic that U.S. citizens will be assigned credit scores based on their ability to pay down debt theoretically lent to them from their own pockets, he said.
“It presents a different perspective,” Rosenfield said. “And the entire debate right now is being controlled by the people who got us into this mess. A person’s credit history can be penalized, but Wall Street and the lenders are not penalized.”
Businesses may eventually feel the impact, too. Some retail services, such as cell phone providers, use credit scores to determine whether potential clients must put down deposits for new service.
Verizon Wireless, for example, uses credit history to determine if a deposit is necessary. Deposits ranging from $400 to $800 can be held for up to one year in an interest bearing account, said Gretchen LeJeune, a Verizon spokeswoman.
The pitfall lies in that someone may have the money for a monthly bill, but they may not have $400 to give to Verizon for a year, which could result in lost customers. Verizon’s finance department reviews credit applications and customer sign-up information “on an ongoing basis,” LeJeune said.
“The discussions around how we can best manage our business, including in the wake of an economic downturn, is part of an ongoing discussion in all departments: How do we run a successful business and address the varying needs of our customers?” she said.
So what can be done about the potential harmful effects of using credit scores? Nothing short of prohibiting their use is the short answer from advocacy groups.
“In a serious downturn, it could be argued that (credit) scores should be frozen …” the Tulane economist Bernstein said. “This is an extenuating circumstance that could make the situation worse and drive up costs even more.”
Sen. Mary Landrieu, D-New Orleans, has been fighting unfair fees that Fannie Mae and Freddie Mac charge at closing for home purchasers because of their credit scores, said the senator’s spokeswoman Stephanie Allen.
Insurance regulators have “done little to acknowledge the problem let alone address it,” Birnbaum said. “Congress clearly has the authority to limit use of consumer credit information. Individual states can address it.”
Some states have already prohibited the use of credit information determining certain types of insurance, including Maryland, Massachusetts and California. Two weeks ago the Indiana and Nebraska legislatures were debating bills limiting the use.
For now, Fair Isaac Corp. recently released its 2008 FICO formula, one that’s more “in sync with current consumers’ credit habits and lenders habits,” said spokesman Craig Watts.
Essentially the formula is supposed to “separate the good risks from the bad risks” for lenders by lowering the scores for debtors who are frequently late on payments.
Currently TransUnion is the only reporting bureau that offers FICO ’08. Watts said Equifax has indicated it will offer it in the next quarter and Experian has “not given a timeframe.”
It is up to lenders to seek out the newest FICO formula from the reporting bureaus, he said.