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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.

Not to be outdone, Fair Isaac, the creator of the leading credit-scoring formula, FICO, has also created an ability-to-pay tool: the Credit Capacity Index. It does not use income information, however. It simply slices and dices the information in your credit reports to predict your ability to take on additional debt, said Careen Foster, Fair Isaac's director for scores product management.

How will they use the information?

Credit card issuers can use income estimators in a number of ways. For example:

  • A department store might set certain criteria, such as an income above $50,000, to receive an instant-credit offer, using the tool to estimate whether the applicant's income is likely to be above that mark. If the estimate comes in low, the applicant might be asked to provide more documentation of income.
  • Credit card issuers might use income estimators to prescreen large groups of people to see whose incomes are likely to be within a target range -- say, $100,000 and up, to get a platinum card offer.
  • Card issuers might also use income estimators to set or adjust lines of credit once a credit application has been approved, although the tools' creators say they're not supposed to be used to deny credit or reduce existing credit lines. The reason for that is because the tools are not all that precise, frankly.

How close is close enough?

According to Experian, more than 85% of the incomes it estimates at about $35,000 are in reality somewhere under $50,000, and 15% are actually above $50,000. The tool's predictive abilities are about the same "at the low end and the high end" of the income scale, said Brannan Johnston, a former Experian vice president.

Equifax executives told me they didn't know how accurate their estimator is because their customers (lenders) aren't sharing their results other than to report that Equifax's estimator is "outperforming the competition."

If the TransUnion tool says someone's income is above $50,000, the estimate is right 75% of the time, TransUnion global chief scientist Chet Wiermanski said.

Foster said FICO compared its index with a "commercially available" income estimator and found its own tool was a better predictor of a borrower's ability to take on new debt.

Because the tools are more of a sledgehammer than a scalpel, the credit bureaus say their contracts with lenders forbid those lenders from using the income estimators for "adverse actions," such as denying credit.

That is why you may never know an income estimator has been used against you.

Another secret that shouldn't be secret

If a lender denies you credit, it's required under federal fair credit laws to tell you why and direct you to the credit agency that supplied the information the lender used to make its decision. That's so you can review and correct any inaccurate data.

But if a lender sets a credit limit too low based on an inaccurate estimate, no disclosures are required. You'll probably never know what led to the decision.

In my view, using a tool to evaluate applicants and not giving the applicant a chance to review and correct the information violates the spirit if not the letter of fair credit laws. And lenders already have far too many ways to evaluate you on the sly.

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If you agree, tell your lawmakers. This link will help you find your House representative, and you can find your senators here. Send them a link to this column, and a message something like the following:

"Credit card lenders are using a variety of secret methods, including income estimation tools, to decide who gets credit and how much. Fair credit laws need to be amended so that individuals can not only see the result of any scoring method or estimator used in a credit decision but also have an opportunity to correct any erroneous information. The days of people being kept in the dark about their credit must end."

Liz Weston is the Web's most-read personal-finance writer. She is the author of several books, most recently "The 10 Commandments of Money: Survive and Thrive in the New Economy" (find it on Bing). Weston's award-winning columns appear every Monday and Thursday, exclusively on MSN Money. Join the conversation and send in your financial questions on Liz Weston's Facebook fan page.