Should borrowers be penalised for shopping around?
At the end of last year, the Treasury Select Committee ordered an investigation into credit searches, amid evidence that borrowers are unfairly penalised by lenders when shopping around for credit cards and loans.
In a report, the Committee concluded that while shopping around for credit is vital to maintain competition and ensure consumers get the best deal, some borrowers could be left at risk as a result.
This is because most lenders now carry out credit searches as part of their ‘risk-based pricing’ strategies, with loan and credit card rates based on an individual’s likelihood of defaulting. Only two-thirds of applicants must be given the typical APR advertised.
But credit searches currently appear to leave consumers in a no-win situation. On one hand, the increasing use of risk-based pricing means many borrowers shopping around for credit won’t receive the typical APR advertised. However, if they continue to search for credit elsewhere they risk damaging their credit rating – which could make it harder, or more expensive, for them to borrow down the line.
This is because when a lender searches your credit record, it leaves a ‘hard footprint’ that can be seen by other lenders. Although being rejected for a loan won’t be recorded on your file, numerous footprints within a short space of time can adversely affect your credit rating.
However, banks and other lenders argue credit searches are vital in order to prevent fraud and to stop borrowers overstretching themselves financially.
We asked Eric Leenders, from the British Bankers’ Association, and Toby Van Der Meer, from moneysupermarket.com, whether credit searches are a necessary way of protecting lenders from fraudulent applicants - or are unfair on borrowers.
Eric Leenders, executive director of retail at the British Bankers’ Association, says:
Perhaps the key lesson of the credit crunch is the importance of trying to have a complete understanding of risk before embarking on any kind of commercial relationship. Hand-in-hand with this is the obligation on all of us to identify and stamp out fraud wherever we can.
For both these reasons, it’s vital that banks (and financial firms) are able to access as much relevant information as possible, before deciding whether to provide credit. Banks use credit searches as indicators of both the propensity to repay any money borrowed and potential fraud – and they have proved to be predictable on both counts.
There will be many other factors in the banking relationship that may be considered, particularly if you have a long-standing relationship with the lender. Banks may well look at the number and frequency of credit searches – but it’s unlikely this alone would cause them to decline an application for credit.
In recent years, lenders have adjusted their credit-scoring models to reflect the fact that customers are actively shopping around to find the best deals.
So, whereas in the past, two or three searches within a short period of time could have adversely affected your credit score, lenders recognise now that this may actually reflect responsible behaviour.
As time passes, the weighting attached to these credit searches will diminish and fall away. Other risk factors will be more significant, such as how you have met other financial commitments, or if you have any County Court judgments against you.
However, perhaps most importantly, there are actions you can take to improve your own credit rating, such as reviewing it regularly, keeping up-to-date with existing commitments, ensuring your record is accurate (with your current and past addresses, and credit history, for example) and finding out from lenders that have refused you credit why they have done so.
Toby Van Der Meer, managing director of money at Moneysupermarket.com, says:
When you buy a product in a supermarket, you expect to pay the price that’s advertised.
However, imagine your surprise if you got to the checkout, only to be told that you cannot have that product and must go and shop again, only this time, the price you are likely to pay is much higher as a result of your previous attempts.
Sounds unfair? Well this is exactly what’s happening to consumers who are shopping around for consumer credit products such as credit cards and personal loans.
When a customer shops for a credit product, an application form has to be completed and a full credit search carried out. Only when this is complete will a customer be informed as to whether or not their application has been accepted and what rate and credit limit they have been approved for.
With many card and loan providers advertising ‘typical rates’, the rate advertised is not necessarily the rate you will get. In most cases, only 66% of customers will get the advertised rate, leaving the remaining 34% at the mercy of the banks.
Many of these customers will be forced to look elsewhere, and this is where the inherent problem lies. Whenever a consumer shops around for a product, a credit search is recorded on their credit files.
The more searches they make the more detail or ‘footprints’ are created on their credit file. Banks may then view this as a negative factor, which will in turn undermine the consumer’s ability to obtain further credit.
Consumers should be allowed to shop around for products, know what credit they will receive and at what price, before they make their buying decision. The solution to this problem is already being widely used in the UK banking system.
Consumers can currently shop around for a mortgage without their search being recorded on their credit files. There is no reason why this approach cannot be adopted for credit cards and personal loans.
Your credit score is a three-digit number (ranging from a low of 300 to a high of 850) calculated from the information in your credit report. Your credit score enables lenders to determine how much of a credit risk you are. Basically, a low credit score indicates you present a higher risk of defaulting on your debt obligations than someone with a high score. If you have a low credit score, any products you successfully apply for will carry a higher rate of interest commensurate with this risk.
Used by the holder to buy goods and services, credit cards also have a monthly or annual spending limit, which may be raised or lowered depending on the creditworthiness of the cardholder. But unlike charge cards, borrowers aren’t forced to pay the balance off in full every month and, as long as they make a stated minimum payment, can carry a balance from one month to the next, generating compound interest. As the issuing company is effectively giving you a short-term loan, most credit cards have variable and relatively high interest rates. Allowing the interest to compound for too long may result in dire financial straits.
This is used to compare interest rates for borrowing. It is the total (or “gross”) interest you’ll pay over the life of a loan, including charges and fees. For credit cards where interest is charged at more frequent intervals, the APR includes a “compounding” effect (paying interest on interest). So for a credit card charging 2% interest a month (equating to 24% a year), the APR would actually be 26.82%.