Understanding Risk-based Pricing Rules

Risk-based pricing occurs when the price and terms of credit offered to a particular consumer are based on the risk of nonpayment by that consumer. Many industries issue credit based on risk: the credit card industry, the mortgage industry, and last, but certainly not least, those in the automobile industry. Therefore, all credit card agencies, mortgage brokers and companies, and automobile and power sports dealerships are directly affected.

FTC, FRB Issue Ruling

According to the new ruling, finalized by the Federal Trade Commission and Federal Reserve Board, effective January 1, 2011, creditors in the financial services industries are required to supply what is called a Risk-Based Pricing Notice (RBPN) to credit applicants whenever the creditor uses a credit report or score to extend credit that results in loans or credit containing higher interest rates or other terms contrary to what other consumers with optimum credit worthiness would have received.

The ruling of issuing an RBPN came about as a result of a gap created by the Adverse Action Notice, which was only issued to applicants upon the denial of credit. As the law stands, consumers who receive credit or have been approved for a loan with higher APRs or other less-than-optimal terms are given no such notification that their higher loan rates or terms are most likely a result of something on their credit report.

The RBPN is designed, among other things, to improve the accuracy of consumer reports by alerting consumers to the existence of negative information on their credit reports so that, if they so choose, they can attempt to correct any inaccurate information.

Actions for Dealers

The new risk-based pricing rule recommends using one of three methods to determine which consumers should receive the notice:

1. Direct comparison method
2. Credit score proxy method
3. Tiered pricing method

Under the direct comparison method, an applicant's terms (APR) are compared against other applicants' terms (APRs). An RBPN would be delivered if the current applicant’s terms are "materially less favorable" than the terms offered to a "substantial portion" of your other applicants.

Unfortunately, it may not be operationally feasible for a dealership to do this and the FTC and FRB recognized this. So, because of the difficulty of applying the direct comparison method, two other alternative (or short-cut) methods as mentioned previously were suggested: the credit score proxy method and the tiered pricing method.

The credit score proxy method requires that the dealership provide an RBPN to every applicant who falls below a pre-determined “cut-off.” And, the tiered pricing method requires that a dealership, which categorizes applicants according to tiers, should provide a notice to everyone who does not fall within the top one or two tiers that comprise no less than 30 percent and no more than 40 percent of the total number of tiers.

Unfortunately, none of these methods offers a simple, user-friendly way to identify who is to receive the notice and who is not. To make things even more complicated, according to Robert Harkins, president of HH&O Consulting Group, "It can be a costly endeavor for a dealership to comply depending on the method chosen."

Exception to the Rule

Lucky for those of us placed with the responsibility of adhering to yet another government ruling, the FTC and FRB, having been strongly influenced by officials with NADA, offer an alternative (or exemption) to the RBPN. The exemption notice allows creditors the option of providing consumers who apply for credit with a "Credit Score Disclosure Exemption Notice" in lieu of the RBPN.

Among other required information, the Credit Score Disclosure Notice includes the consumer's credit score, source of the credit score, a range of scores with information on how lenders use their scores and a written or graphic description of the consumer's position compared to other applicants. The ruling states that as long as dealers provide a Credit Score Disclosure Exemption Notice to every applicant, they are exempt from having to provide the RBPN.

In light of what may seem daunting, the goal here is to help make consumers more aware of their credit standing, especially if the cost of borrowing money is going to cost them more in the long run.

David Robertson, executive director of AFIP, summarized the goal of the ruling: "Whether a dealer uses one of the suggested methods of determining which clients receive a Risk-Based Pricing Notice, or utilizes the Exception Rule by providing a Credit Score Disclosure Notice to their customers, either method moves credit score awareness to the forefront versus the Adverse Action Notice that occurs after the credit is denied."