On Compliance: Risk-Based Lending

a magnifying glass focusing on the words credit score on a puzzle piece in a larger white puzzle
Oak Tree Business Systems Inc.

2 minutes

Credit unions must follow rules pertaining to non-discrimination and to credit score use disclosures.

Risk-based lending for credit unions can be tricky. After all, credit scores exist for a reason and assessing someone’s loan worthiness based on that score is common practice. Staying in compliance when doing risk-based lending requires following both the Equal Credit Opportunity Act and section 1029 of the Consumer Financial Protection Act of 2010, better known as the Dodd Frank Act.

Non-Discriminatory Lending

According to the ECOA, it is illegal to discriminate against any applicant based on race, religion, sex, national origin, marital status, age, or source of income. This means it is illegal for a credit union to use the aforementioned reasons as a basis for refusing a loan to any member, discouraging any member from applying for a loan, providing different credit terms for members with similar creditworthiness situations, or closing member accounts.

The best way to avoid an unfair lending charge is to understand what risk factors the examiners are looking for. According to the “effects test” or “disparate impact doctrine,” which assumes that demographic and statistical information can be used to demonstrate discriminatory practices, you must avoid any type of direct or intentional discrimination, including any practices that have the effect of discrimination. 

For example, as your credit union starts screening the credit of a member applying for a credit card, the member is evaluated on his or her ability to meet payment obligations. A credit scoring scheme sometimes is used, revealing the factors considered in decision-making. The complexity of credit scoring systems may increase the chances of unintentionally discriminating against members of racial minorities or women.

Now, having said that, it is completely legal to assess the creditworthiness of a member and use risk factors as a basis for finance terms. After all, this is why credit scores exist in the first place.

Credit Score Use Disclosure

Credit scores are not the only factor in risk-based lending. Other factors include employment status, outstanding debts and income. Obviously, a potential borrower with three bankruptcies would be deemed higher risk than a member with no bankruptcies and a credit score of 780.

According to section 1029 of Dodd Frank, your credit union would be required to submit a risk-based pricing notice to either member described in the paragraph above if it used the member’s credit score in determining the interest rate for the loan.

Maintaining Risk-Based Lending Compliance

So in essence, risk-based lending compliance is twofold. The first part has to do with making sure discrimination is a non-event. The second part has to do with whether or not a credit score (consumer report) was used to assess risk. If so, notice to the consumer is required. 

Richard Gallagher is CEO of CUES Supplier member Oak Tree Business Systems, Inc., Big Bear Lake, California, which has provided top-quality, fully compliant credit union forms and disclosure packages for more than 35 years.

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