Image: House and money on scales © MOODBOARD, age fotostock

Lenders are using a new way to secretly evaluate you: income estimation models.

These tools, rolled out to comply with new government regulations, purport to predict your pay based on information in your credit reports. That information can include, among other things, the size of your mortgage and the credit limits on your cards.

Right there, I see a problem for frugal folks who live below their means. If you opted for a smaller mortgage or requested lower credit limits on your cards, it could look like you're poorer than you are.

The tools' creators acknowledge that might be a problem, but they insist the estimators do a good job of predicting income for most credit applicants.

Of course, you may never know one way or another, because lenders don't have to reveal if they're using an estimator or what it says about your income.

"Somehow the consumer has been cut out of the process," said Linda Sherry, the director of national priorities for Consumer Action, an education and advocacy organization. "I'm concerned that people aren't going to access this information and correct it (if it's wrong)."

Image: Liz Weston

Liz Weston

Here's how we got here:

  • The credit card reform law that went into full effect last year requires lenders to consider borrowers' ability to pay additional debt before approving a card application or increasing a line of credit.
  • In interpreting the law, the Federal Reserve told lenders they must consider the applicant's income or assets and other debts.
  • The tool most often used by lenders to evaluate creditworthiness -- the credit score -- doesn't include any information about income or debt-to-income ratios.

Now, lenders can get information about your income in several ways:

  • They can ask you. There's nothing prohibiting lenders from simply accepting what you say is your income, although retailers offering instant credit at checkout worry that people might be shy about revealing this number with a queue of other shoppers behind them. Also, lenders -- whose risk aversion is much higher than it was three years ago -- might still want what one credit bureau executive calls a "sanity check" to see if the number you reveal is in line with what you do or the other details of your finances. They could ask you for a pay stub, of course, but that would require you to have one handy and for the lender to be able to process it somehow, which would be unwieldy for online or instant-credit applications.
  • They can ask the Internal Revenue Service. They need your permission to do this, but if you agree, Form 4506-T (.pdf file) is filled out and sent to the tax agency. Within about 24 hours, the IRS spits back a transcript of your most recent federal income tax return. The turnaround time and the $57 fee make this a nonstarter for most credit card lenders, who want to make decisions quickly and cheaply (although mortgage lenders now routinely require this form).
  • They can ask a database. Equifax, for example, owns the TALX database of more than 150 million employment records, which list employer-confirmed salaries for specific people. (These databases are also used by human-resources departments to, among other things, check the salaries potential hires report on their applications.) The problem is that the databases might not have current information about you, particularly if you've changed jobs recently, you work for a small company or you're self-employed.
  • They can use an income estimation model. The Fed said lenders could use "statistically valid" methods for estimating income, and all three credit bureaus have introduced tools in recent months that they say will do the job.

What's an income estimation model?

Experian says it created its tool by matching individuals' credit reports to a big database of information about their wages and their interest and investment income. Now that the tool has been created, Experian says it can be deployed using just an applicant's credit report to predict his or her likely income.

Equifax and TransUnion have similar tools, and Equifax offers to provide lenders with payroll information from its database for an additional cost.