In the past, when a loan applicant did not have sufficient or strong enough credit to borrow, his loan was denied. However, lenders and their Wall Street investment bankers saw the potential for profit in simply charging individuals with lower credit scores a higher interest rate to borrow. This adds a risk premium rate to the par rate of interest charged on mortgages made to prime homebuyers, an approach to lending known as risk-based pricing.

In 2003, Congress passed the Fair and Accurate Credit Transactions (FACT) Act, popularly recognized for giving consumers the right to a free credit report every year. The FACT Act also tasked the Federal Trade Commission (FTC) and the Federal Reserve Bank (the Fed) with the creation of a risk-based pricing notice.

The lender must give a loan applicant a risk-based pricing notice if:

  • the decision to extend a loan is based, wholly or in part, on the loan applicant’s credit report;
  • the interest rate or other terms of the loan offered are less favorable than terms that would be offered to a person with good credit; and
  • the loan is used primarily for personal, household or family purposes.  [12 Code of Federal Regulations 222.70]

If required, the lender must give the loan applicant the notice after a derogatory decision on a loan application has been communicated to the applicant, but prior to the loan closing. [12 CFR 222.73(c)(1)(i)]

The contents of this notice would include:

  • a statement that a credit report includes information about the loan applicant’s credit history, and the type of information contained in that history;
  • a statement that the terms offered have been set based on a review of the loan applicant’s credit report;
  • a statement that the interest rates and loan terms offered to the loan applicant are less favorable than he might have obtained had he possessed better credit;
  • a statement encouraging the loan applicant to verify the accuracy of the credit report;
  • a statement that the loan applicant has the right to dispute inaccurate information found in the report;
  • the identity of each credit reporting agency furnishing a credit report used in the loan decision;
  • a statement that federal law gives loan applicants the right to obtain a copy of their credit report from the credit reporting agency (or agencies) without charge for 60 days after receipt of the notice;
  • a statement informing the loan applicant how to obtain their credit report from the credit reporting agency (or agencies), and the contact information for the agency (or agencies); and
  • a statement directing consumers to the Federal Reserve Board and the FTC websites to obtain more information about consumer reports. [12 CFR 222.73(a)(1)]

With this notice, applicants with blemishes on their credit would have the ability to correct and/or rebuild their credit before becoming legally bound to a mortgage. [See first tuesday Form 217-1 and related commentary]

It took the FTC and the Fed six years to draft the notice and issue final regulations for lender implementation. During this delay the market had time to grow to a fever pitch, implode and fall into the Great Recession.  Behold the skillful economic planning on the part of the Fed and the FTC.

The final regulations do not go into effect until January 1, 2011, although some lenders will begin providing the notices in 2010.

first tuesday take: Hindsight and a healthy dose of cynicism would suggest that perhaps the FTC and the Fed did not want to be viewed as the “party poopers” while the party on Wall Street was still raging, and real estate brokers, builders and homebuyers were ecstatic . Of course, as was pointed out by a prior Fed chairman, the pulling of the punch bowl just as the party gets going is precisely the job of the Fed.  However, making such a game play during the height of the boom would have warded off some of the over-priced, high-risk mortgages which contributed to the real estate bust.

Had the notice been available, these financial gatekeepers (the Fed and the FTC) would have provided prospective borrowers with the ability to fix their credit scores and obtain more favorable mortgage terms, thus creating a more stable homeowner base.

The notice is certainly not a cure-all, but its noticeably lengthy implementation period of seven years does illustrate a fundamental failure in the financial and regulatory systems — the reluctance to ease an overactive market, or lean on a bubble to prevent its implosion.  Have they learned and will they lean as the next boom starts to form in the 2016-2018 period? That answer is still very much controlled by the lenders.  One day thoughtful real estate brokers may have a say in how the real estate market is managed, unless they let this crisis go to waste.  [For more information on the lean vs. clean policy of the federal government agencies, see the October 2009 first tuesday article Preventing the next real estate bubble]

See the upcoming Denial of Credit Due to Derogatory Credit Report (first tuesday Form 219) to be released next month which satisfies these notice requirements.

Re: Risk-based pricing notices could cut mortgage fees and interest rates from the Los Angeles Times and Fair Credit Reporting Risk-Based Pricing Regulations from the Fed and the FTC