New Credit Rules Decoded
By Randy Henrick

Barring any postponements, the Federal Trade Commission’s new Risk-Based Pricing Rules will be in effect come Jan. 1, 2011. The rules require creditors — including dealers — to provide notices to consumers who receive credit terms less favorable than those granted to other consumers. The notices will explain that they received those less favorable terms because of derogatory information in their credit reports. The information in question will often include — but not be limited to — a low credit score.

It’s a complicated rule that was designed to aid consumers in making credit decisions. The good news is that it applies only to consumer credit, not business credit, and there are a number of ways dealers can comply.

The new notices are intended to complement adverse action notices, which dealers are already accustomed to issuing when they can’t attain financing for a customer. The difference with the risk-based pricing notices is that they must be handed to consumers before the transaction is consummated; that is, before the customer signs the retail installment sales contract (RISC). And if there are joint customers, each must receive a notice.

Now, the notices are only required for consumers applying for credit. The trigger point for the rule is when a credit report is used to “grant, extend, or otherwise provide credit to that consumer on material terms that are materially less favorable than the most favorable terms available to a substantial proportion of consumers from or through that person.” For indirect auto finance, auto dealers must provide customers with the notice or implement the exception notice process discussed below. Risk-based pricing notices (RBPN) given verbally are recommended.

Identifying Notice Recipients

The first task is to identify who should get a notice. The “material terms” element of the rule means the annual percentage rate or, in the case of credit that doesn’t have an APR, “the financial term that varies based on information in a consumer report and that has the most significant financial impact on consumers, such as a deposit.” Presumably, that statement could be interpreted to mean that leasing is included, but leasing is never mentioned by name in the rule. Additionally, dealers are not required to provide a notice if the customer applied for specific credit terms (e.g., customer applies for a promotional APR) and the dealer arranges for credit with exactly those terms.

Ideally, dealers will determine on a case-by-case basis whether a consumer has received materially less favorable terms by comparing his or her terms to those granted to other consumers in similar transactions — disregarding underwriting criteria that does not depend on credit report information. Where you draw the line with this direct comparison approach is anyone’s guess.

One thing to note about the rule, customers who receive notices are entitled to a free credit report, a concept introduced by the Fair and Accurate Credit Transaction Act of 2003. Additionally, regulators have provided model notices dealers can adapt for their stores. For customers who don’t have credit scores, a separate notice is required.

Now, the rule does provide dealers with two alternatives for identifying which customers should receive notices. Here’s a review of both methods:

1. Credit Score Proxy Alternative: This method works by conducting a representative sampling of your completed deals from the last two years, and, according to the rule, this must be done separately for new- and used-vehicle credit. The goal of this exercise is to determine a cutoff credit score which, according to the rule, is the point at which approximately 40 percent of customers have higher credit scores and approximately 60 percent have lower credit scores. If a dealer determines that a score of 650 is the cutoff point, then a risk-based pricing notice must be given to every new customer whose credit score is lower than the cutoff score.

Special rules apply if a dealer uses more than one credit score in setting the material terms of credit. Additionally, the rules require that the cutoff score be recalculated every two years if a two-year representative sample is used, or once a year if two years’ worth of deal information is unavailable.

2. The Credit Tier Method: Using this alternative, customers are tiered based on their credit scores. And every customer whose credit score falls outside of the top tier must get a risk-based pricing notice unless the dealer has five or more tiers. If there are five or more tiers, notices are required for customers who fall outside the top two tiers. Since most dealers don’t tier their customers, this alternative may not be viable.

The Dealer Exception

There is an exception that doesn’t require dealers to hand out notices to any customers, but it does require that a written credit score disclosure notice be given to every customer financed — regardless of his/her score. Consumers who receive this notice are not entitled to a free credit report.

The exception notice tells the consumer his/her credit score, the source of the credit score, and the date the score was created. It also must contain information about the percentage of U.S. consumers who have lower and higher credit scores than the customer. Like the risk-based pricing notice, this notice must be handed to the customer before the transaction is consummated. For customers without credit scores, a separate notice is required.

It’s important to note that there is a cost to this exception, as a dealer must purchase a credit score and a notice form from a credit bureau showing the national distribution of scores.

If you are able to analyze a two-year sampling of deals to determine a cutoff credit score, the credit score proxy alternative may be your best choice. That way, only certain customers will have to get notices. Whatever procedure you use, keep a copy of the notice you give to a customer in the deal jacket to document your compliance with the rule.

Randy Henrick is associate general counsel and lead compliance counsel for DealerTrack Inc. He is also chairman of the New York State Bar Association’s Consumer Financial Services Committee. E-mail him at randy.henrick@bobit.com. Nothing in this article is intended to be legal advice and should not be taken as such. All legal questions should be addressed to competent counsel.