Consumer_Credit_and_Interest_Rates

Created by the Fair Isaac Corporation, the FICO scoring system was created to ensure that all consumers are given a fair interest rate based on that individual’s risk classification; however, there are many factors that the FICO scoring system fails to take into consideration. The current system provides an admirable starting point when viewing consumer’s credit history, but lenders should dig a little deeper to warrant a consumer’s interest rate. When it comes time to purchase on credit, consumers should not be assessed solely by their FICO credit score; instead, lenders should contemplate special circumstance (divorce, identity theft, the death or illness of a spouse, or no previous credit history) and debt to income ratios to determine risk categories. According to Fair Isaac Corporation (2001-2010), “90% of the largest banks use [a consumer’s] FICO credit score for a credit decisions” (Get your FICO score. Free, Para. 2). A credit score is a three digit number ranging from 300 to 800 and a higher number means a consumer’s credit score will be better. When a consumer’s credit score is good, that individual can obtain credit easier with a lower interest. However, what will a lender see in a consumers credit file' A credit score has five parts and each part is only a percentage of the total credit score. Payment history is the highest at 35%, how much a consumer owes is 30%, length of a consumer’s credit history is another 15%, new credit accounts for another 10%, and other factors make up the last 10% of a credit score. By law lenders do not have access to race, color, religion, national origin, sex, and marital status (Consumer Federation of America and FICO, n.d.). Experian, Transunion, and Equifax are the three credit reporting agencies that a lender will view reports from. The Fico scoring system is a suitable starting point when determining a consumer’s risk category, but lenders neglect to see the whole picture and this could cause a deserving consumer to have an unmerited interest rate. Every day millions of Americans find themselves in special circumstances that potentially harm his or her credit score. Divorce can devastate an individual’s credit score because of various reasons. When going through a divorce one party could intentionally neglect financial responsibilities with the intention of revenge or the two parties can become confused by who is responsible for each account. Perhaps the most damaging effect a divorce could have on an individual’s credit report would be if one party makes substantially less than the other. It could become very difficult for that individual to afford payments on accounts without the assistance of his or her ex-spouse causing their credit score to decrease until he or she gets back on their feet. However, a divorce is a controllable circumstance that good financial planning can help to avoid negative effects on an individual’s credit score, but there are circumstances beyond a consumer control. For example, without warning any consumer can become a victim of identity theft. When a consumer finds him or herself a victim of identity theft, it can damage that consumer’s credit score. Experts say that it uncertain how long it can take a consumer to restore his or her credit after becoming a victim. Proving that a consumer has been a victim of identity theft also can be challenging. Most of the time consumers discover they have become victims after the damage has been done; making filing the report difficult and providing evidence on how the theft occurred nearly impossible. The current systems requires that a consumer reviews his or her credit score every three months for the first year and then once a year after becoming a victim of identity theft. To remove inaccurate information because of identity theft the consumer must file a police report and an ID Theft report with the Federal Trade Commission, FTC, to have legal rights to remove inaccurate information from his or her credit report. Identity theft can happen to anyone and under current regulations it can further frustrate an already frustrated consumer causing him or her to give up on restoring a damaged credit score. In addition to outside influences, the death or illness of a spouse can leave a negative mark on a credit score. When faced with the death or illness of a spouse even the best consumer can become overwhelmed with medical bills, funeral costs, lost wages due to time off work, and emotional distress resulting in a lower credit score. Even if the consumer does carry medical and life insurance, this consumer will still have deductibles and other expenses. If a consumer has a spouse that suddenly becomes ill or dies then a consumer’s income will suffer from loss wages from both parties making it difficult to maintain a good credit score. In addition, when facing a circumstance such as illness and death even the greatest consumer could unintentionally neglect financial obligations due to emotional distress. Even if a consumer has saved six months of his or her income, the unexpected cost due to illness and death could still have a negative effect on a credit score. Under the current FICO scoring system it is possible for a consumer to increase his or her credit score by demonstrating strong money management skills; however, this can take years of hard work to restore the damages of one hard year. Previous credit history has the biggest impact on a credit score, and for some individuals who have not had enough time to establish credit could find it difficult to obtain credit. Not only does credit history make up a big part of a credit score, credit length making it very hard for young adults to obtain credit. Most college students have just turned the legal age to start establishing credit and need to obtain credit to continue his or her education. Government programs, such as Sally Mae, are available for students to obtain college loans at a lower interest rate than a traditional lender would give, but there are occurrences in which a college student would not qualify for these loans. When a student finds him or herself needing to obtain a loan from a private organization, he or she will have to repay the loan based on his or her credit score or even be required to have a cosigner to obtain a loan for educational purposes. Young adults have the hardest time trying to obtain credit, not only for educational purposes because they have no credit history and no credit length. When a young adult files for credit that individual is often given a high interest rate because there is no information available to base a credit risk. In addition to young adults, people who have chosen not to establish credit are often hit with high interest rates due to lack of a credit history. People who have chosen to save his or her hard-earned dollars to pay for expenses have displayed financial responsibility. However, people who have decided not to establish credit are often given high interest rates by lenders. Lenders should consider this when trying to determine a consumer’s risk category; if a consumer can manage his or her money effectively without establishing credit then that consumer should not be considered a high risk to the lender. Although, lenders assume that this type of consumer cannot repay the money borrowed because this consume has no record of his or her ability for repayment. Monthly expenses such as utilities, phone bills, and buy here pay here lenders only report to credit agencies if payment has not been made leaving this type of consumer’s good spending habits from being seen by lenders. As a result, the current FICO system has many gaps and there should be a better way to determine a consumer’s risk category. Since there are three credit reporting agencies lenders may view different information from each one. Consumers need to be aware that there is more than one agency and ensure that the information on each is accurate. It would be more effective if lenders would use only one credit reporting agency to stream line information and to ensure that no errors are made. Lenders should also focus more on debt to income ratios. If a consumer has a high debt level, then the probability of repayment for this consumer to repay is unlikely. Lenders should require consumers to provide yearly net income, living expenses, and other debts to prove if he or she can afford to repay debts. If the government made regulations that allowed a consumer’s debt not to exceed a percentage of his or her annually income, then it would be harder for consumers to become so far in debt that he or she cannot recover. Mortgage, auto, and students loans are debts that could exceed an annual income and these should be excluded because these can be necessary expenses. However, lenders should not let the monthly repayment on a home or auto loan to exceed a percentage of that consumer’s net income. The current FICO system does provide good details on consumer spending and repayment, but considering debt to income ratios and the ability for repayment should also weigh heavily on a consumer’s risk. Special circumstance can negatively affect even the best consumer and therefore, lenders should use debt to income ratio and the ability for repayment to more effectively determine a consumer’s interest rate. Lenders reserve the right to increase a consumer’s interest rate if they deem it appropriate, and when a consumer is dealing with a divorce, identity theft, or the illness or death of a spouse then that would be the last thing a consumer needs to agonize about. Lenders should take into account debt to income ratio of each consumer to determine the consumer’s risk category. If a consumer has a high to debt income ratio then a lender could consider that consumer to be a higher credit risk. A debt to income ratio should also be used in considering a consumer’s financially ability to repay a loan. If lenders focus more on debt to income ratios along with collective data from a consumer’s credit history than that system will have a better overview of a consumer’s risk classification. References C. (n.d.). About identity theft. Retrieved from http://www.ftc.gov/bcp/edu/microsites/idtheft/consumers/about-identity-theft.html Consumer Federation of America and FICO. (n.d.). Your credit scores. Retrieved from http://www.pueblo.gsa.gov/cic_text/money/creditscores/your.htm Fair Isaac Corporation. (2001-2010). My FICO. Retrieved from http://www.myfico.com Washington, Tisa Smart. "Save more with a higher score." Essence Oct. 200 104. General OneFile. Web. 26 Nov. 2010. http://find.galegroup.com.ezproxy.apollolibrary.com/gps/infomark.do'&contentSet=IAC-Documents&type=retrieve&tabID=T003&prodId=IPS&docId=A136709164&source=gale&srcprod=ITOF&userGroupName=uphoenix&version=1.0