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There also may be cost overruns; a contracted project may take longer than originally agreed or require more materials, and the company will have to absorb that hit. But the main pitfalls of cost-based pricing are that it ignores value, and gives no consideration to the customer.
January 1, 2011, is the mandatory compliance deadline for the risk-based pricing notice requirements under implementing regulations jointly written by the Board of Governors of the Federal Reserve System (Board) and the Federal Trade Commission (FTC) (the agencies).1 The rules require creditors to provide a notice to consumers when, based in whole or in part on information in a consumer report, a creditor grants credit to the consumer on material terms that are materially less favorable than the most favorable terms available from the creditor to a substantial proportion of other consumers. The rules contain model notice forms and provide several methods for compliance. This article provides an overview of the risk-based pricing rules.
Section 311 of the Fair and Accurate Credit Transactions Act of 2003 (FACT Act)2 amended the Fair Credit Reporting Act (FCRA) to add the risk-based pricing notice requirement in 615(h)(15 U.S.C. 1681m(h)), and directed the Board and the FTC to issue implementing regulations. The Board codified its implementing regulations in subpart H of Regulation V, 12 C.F.R. 222.70-75.3 Risk-based pricing refers to a creditor's practice of setting the price or other credit terms based on a consumer's risk of nonpayment. Creditors generally offer consumers with poor credit histories less favorable credit terms than consumers with strong credit histories to compensate for the higher risk of default.
Creditors currently are required by 615(a) of the FCRA (15 U.S.C. 1681m(a)) to provide adverse action notices when they deny a consumer's credit application, based in whole or in part on information in a consumer report. However, when a creditor does not reject an applicant with impaired credit, but instead offers credit on less favorable terms, the creditor generally is not required to provide an adverse action notice. The risk-based pricing notice requirements are designed to address such circumstances not covered by 615(a), where a consumer receives less favorable credit terms based on his or her consumer report, rather than being denied credit.4
The final rule clarifies that the risk-based pricing notice requirements apply only to consumer credit, i.e., credit primarily for personal, household, or family purposes.5 Business credit is excluded. This is consistent with the purpose of the notices to alert consumers that their consumer reports may contain negative information and allow them to check the reports for accuracy.6 To facilitate this review, consumers receiving a risk-based pricing notice are entitled to a free consumer report for 60 days after receipt of the notice in addition to the free annual reports to which they are entitled under the FACT Act.
The risk-based pricing rules generally require a creditor to determine whether a consumer receives materially less favorable material terms for a specific type of credit product11 and to provide a risk-based pricing notice to a consumer when this occurs. The agencies state that it would not be operationally feasible in many cases for creditors to compare terms offered to each consumer with the credit terms offered to other consumers to determine if the material terms are materially less favorable. As a result, the agencies provide tests that serve as proxies for comparing the terms offered to different consumers to determine which consumers must receive a risk-based pricing notice, although creditors retain the option to determine which consumers must receive a risk-based pricing notice on a case-by-case basis.
A creditor that sets the material terms of credit granted, extended, or otherwise provided to a consumer, based in whole or in part on a credit score, may use the credit score proxy method. This method uses a cutoff score at which approximately 40 percent of the consumers to whom the creditor grants, extends, or provides credit have higher scores and approximately 60 percent have lower scores. Any consumer whose credit score is lower than the cutoff score must be given a risk-based pricing notice. When a creditor has granted the most favorable credit terms to more than 40 percent of consumers, it has the option to set the cutoff score at an alternative point based on its historical data.
Creditors using the credit score proxy method when no credit score is available must assume that the consumer receives credit on terms materially less favorable than the most favorable credit terms offered to a substantial proportion of consumers. The creditor must provide a risk-based pricing notice to the consumer.
The tiered pricing method is available to creditors that set the material terms of credit by assigning each consumer to a discrete number of pricing tiers for a specific type of credit product. Creditors that use four or fewer tiers must provide notices to all consumers who do not qualify for the top tier. For example, if a credit card issuer has three pricing tiers (10 percent, 14 percent, and 18 percent) for the purchase APR, the issuer must provide a risk-based pricing notice to each consumer who did not qualify for the 10 percent purchase APR. When the creditor uses five or more pricing tiers, it must provide notices to any consumer who does not qualify for the top two tiers and any other tier that, together with the top two tiers, comprise no less than the top 30 percent but no more than the top 40 percent of the total number of tiers. For example, if a creditor has nine pricing tiers, the top three tiers comprise no less than the top 30 percent but no more than the top 40 percent of the tiers. Therefore, a creditor using this method would provide a risk-based pricing notice to each consumer who is placed in the bottom six tiers.12
Section 222.72(c) addresses how credit card issuers can comply with the risk-based pricing rule. Issuers have the option of using any of the methods described above. If the issuer uses the credit score proxy or tiered pricing method, it must determine which consumers receive a notice through an analysis of the issuer's entire portfolio, rather than on an offer-by-offer basis. Alternatively, in connection with an application program, such as a direct-mail offer or a take-one application, or in response to a solicitation under 226.5a of Regulation Z, if the creditor offers multiple purchase APRs, the creditor may satisfy its obligations by sending risk-based pricing notices to any consumer who does not receive the lowest APR under that particular offer. When using this special method for credit cards, the issuer determines which consumers must receive a notice on an offer-by-offer basis with no requirement to compare different offers. Issuers are not required to provide notices when the consumer applies for a credit card and the issuer provides a single APR (excluding teaser or penalty rates) or when the issuer provides the consumer the lowest APR under the specific offer, even if there are lower rates available under different credit card programs issued by the card issuer.
The content of the notices is prescribed in 222.73(a) (1) and (a)(2). Generally, the notice conveys what type of information is contained in a consumer report and that the terms of credit offered to the consumer are based on such information and may be less favorable than those for other borrowers with better credit histories. The notice encourages the consumer to verify the accuracy of the information in his or her report and notes the consumer's right to dispute inaccurate information. The notice must also inform the consumer of his or her right to receive a free credit report, provide information about how to obtain the report, disclose the identity of the consumer reporting agency or agencies that issued the report, and the fact that the consumer has 60 days after receipt of the notice to request a credit report.
Timing requirements for the risk-based pricing notice vary based on the type of credit extended. For closed-end credit, notices must be given before consummation of the transaction but not earlier than when the decision to approve the application is communicated to the consumer. For open-end credit, notices must be provided before the first transaction is made under the plan. When periodic account reviews are performed, the notice must be given at the time the decision to increase the APR is communicated to the consumer. If no notice is provided prior to the effective date of the change in the APR, the risk-based pricing notice must be given no later than five days after the effective date of the change.
The rules for providing the notice vary when credit is extended in conjunction with the purchase of an automobile from an auto dealer. First, when an auto dealer is the original creditor, pursuant to 222.75(b)(1), the auto dealer must provide the risk-based pricing (or alternative) notice, even if the dealer immediately assigns the credit agreement to a third party that serves as the source of funding for the credit. Conversely, when a creditor grants credit for the purpose of financing the purchase of an automobile from an unaffiliated auto dealer, the risk-based pricing notice can be provided either by the creditor or the dealer pursuant to the timing requirements discussed previously. If the notice is provided by the dealer, the creditor must maintain reasonable policies and procedures to verify that the auto dealer provides the notice within applicable time periods. Furthermore, if the consumer receives a notice containing a credit score (under the exception notice provisions of 222.74(e) or (f), discussed below) obtained by the dealer (or other party) and that score differs from the score obtained by the creditor, the creditor's obligations under the regulation are considered satisfied. 153554b96e