When FICO first introduced the credit score in the 1980s, it had good intentions: To level the playing field for consumers and make decisions easier for lenders.
Nearly 30 years later, we still use the exact same model. And while it’s never been perfect, its flaws have become much more apparent in recent years as consumers’ financial habits have started to evolve.
Currently, we use a traditional credit score to gauge creditworthiness for untraditional consumers, and this situation has created serious limitations. Fortunately, a solution is well within reach, and it comes in the form of a new, alternative credit score.
Unpacking the Value of Alternative Credit Scoring
In order to meet the evolving needs of consumers, it’s time to introduce a new type of credit score — one that looks at data beyond traditional financial institutions in order to understand the creditworthiness of the growing number of consumers who choose to manage their finances in new ways.
While there’s no single prevailing model for alternative credit scoring, many have already been introduced with great success. These models typically rely on a combination of the following activities as a way to gauge consumers’ propensity to pay bills:
- Traditional loan repayment behavior
- Non-loan payment data (e.g. utility or rent payments)
- Cash flow information
- Home, job and lifestyle stability information
- Education and employment data
- Online behaviors
- Personal and professional connections
Some of the most common data points used to understand these activities include:
- Checking and savings account transactions to understand cash flow based on income, spending habits and account balances
- Utility bill, rent, cable and/or mobile phone payments to understand intent to make payments and typical payment patterns (early, on-time, late)
- Mobile phone location to verify home and work addresses as a way to understand stability
- Social media activity to assess home, job and lifestyle stability, education and occupational attainment, online behaviors and personal and professional connections
While the latter two data points (mobile phone location and social media activity) are considered less reliable than bank account and bill payment data, some alternative credit scoring models have used them with success.
Ultimately, with the right data in place, these alternative models can prove just as trustworthy as the traditional FICO credit score and provide several benefits for consumers and lenders alike.
Trust in Alternative Credit Scoring Models
The trustworthiness of alternative credit scoring is extremely important, as lenders must be able to rely on these models to limit their risk. Fortunately, there are several data points that have proven their worth.
According to a recent study on the predictive value of alternative credit scores by the Center for Financial Services Innovation, utility bills and rent payments are among the most reliable data points used in alternative credit scoring models. The fact that these data points are easy to collect only makes them all the more appealing.
The study also reports that many consumers who would be unable to obtain a loan using traditional credit scoring models actually represent prime or near-prime credit risk for lenders, making alternative models that can generate scores for most adults an ideal solution to safely broaden access to credit.
Of course studies are one thing. How all of this works in practice is quite another. So far, though, the results have been positive. Consider the case of TransUnion, which now uses an alternative credit scoring model that it calls CreditVision Link. The firm has over three billion non-traditional data points for more than 260 US adults including property, tax, and deed records; and checking, debit, or payday lending information. TransUnion has used these alternative data points to accurately score more than 90% of applicants who would have been unscorable under the traditional model.
Benefits of Alternative Credit Scoring Models
Once lenders establish trust in alternative credit scoring models, both lenders and consumers can begin to reap the benefits.
For lenders, the benefits of alternative credit scoring typically include:
- Enhanced predictions due to access to more timely and holistic information on consumers’ spending habits and payment behavior
- Lower costs and increased efficiency due to the use of less expensive data sources and faster data collection methods
- Reduced discrimination due to the use of automated data collection, which removes the need for manual and discretionary decision making
For consumers, benefits of alternative credit scoring typically include:
- Increased access to credit due to the use of data points beyond traditional financial behavior that fail to capture information on the millions of unbanked and underbanked consumers
- More accurate portrayal of creditworthiness due to the use of more timely information, which can make it easier for consumers to build credit
- Better service due to a more efficient and less discretionary processes
When all is said and done, FactorTrust, the alternative credit bureau, reports that underbanked US adults represent $105 billion in untapped opportunity for lenders while VantageScore Solutions finds that alternative credit scoring could help approximately 7.6 million consumers who are currently unscorable reach a credit score of 620 or higher.
Why It’s Time for a Change
Why exactly do we need to introduce a new model for credit scoring? There are many factors driving the need for change, but they are largely led by Millennials who are unlike any generation before them. There’s no shortage of articles that try to pick out defining characteristics of the Millennial generation, good and bad — they’re digital, they’re narcissistic, they support brands with a cause.
And whether or not these broad strokes actually define Millennials, one thing that is certain is that this generation approaches many different everyday challenges in their own unique way. Perhaps the best example of this is how they manage their finances.
A New Financial Mindset
Not too long ago, everyone “banked.” We opened checking and savings accounts and we used credit cards — it was just the norm. Those who didn’t follow this pattern typically did so due to dire financial circumstances.
Today, however, we live in a different world. We live in a world shaped by a great recession in which many people were failed by the very banks that they trusted to keep their finances safe. This experience hit particularly hard for Millennials, who came of age in the throes of the recession.
As a result, many Americans (led by Millennials, but not confined to this generation) have started to re-think how they handle their finances.
Growing Financial Options
In addition to world events shaping a new financial mindset, so too has the rise of technology.
Today, consumers have far more options than they once did for how to store and spend money. For instance, many online options now exist that help consumers manage their money and retain access to it digitally, all without any involvement from traditional financial institutions. One of the best examples of these options is Amazon Cash, which enables consumers without credit or debit cards to load cash directly to their Amazon accounts via kiosks at retailers like CVS.
A Change in Banking Status Norms
As a result of a new financial mindset and the growing number of non-traditional financial options, a change in banking status norms has set in.
According to the FDIC, 27% of US households are unbanked or underbanked. Those terms are defined as follows:
- Unbanked: No one in the household has a checking or savings account.
- Underbanked: The household has an account at an insured institution, but also goes outside of the banking system to alternative financial providers for services and products like money orders, check cashing, international remittances, payday loans, refund anticipation loans, rent-to-own services, pawn shop loans, and auto title loans.
A large portion of consumers who fall into this group cited non-financial reasons for retaining an unbanked or underbanked status including a lack of trust in banks, privacy concerns, and high or unpredictable bank account fees.
Although the growing number of financial options may make it easy for these unbanked and underbanked households to get by without engaging traditional financial institutions, this status poses a major problem when it comes to credit.
From obtaining a loan with which to buy a house or underwriting for insurance to gauging responsibility when applying for a new job, credit scores are used for a variety of purposes. As a result, credit counts for a lot when it comes to mobility in the US economy.
However, because of how credit scores are traditionally calculated, those who are unbanked and underbanked are typically credit invisible (meaning they have no file with any of the major credit bureaus) or credit unscorable (meaning they have a file with at least one of the major credit bureaus but the information is either too little or too stale to generate a reliable score). Today, 45 million US adults are credit invisible or credit unscorable.
Essentially, this means that the growing group of unbanked and underbanked consumers is severely limited when it comes to activities like buying a house.
It’s Time to Embrace Alternative Credit Scoring Models
Under the status quo, the vast majority of lenders use the traditional FICO credit scoring model. However, this model prohibits 45 million US adults from obtaining credit due to their banking choices rather than the risk they pose to lenders, and seriously limits upward social and economic mobility as a result. Perhaps the most concerning part of this problem is that the overwhelming majority of these credit invisible and credit unscorable consumers are actually good candidates to receive credit.
At a time when more and more consumers are choosing to go outside the traditional financial system, whether it’s because of a lack of trust in banks, the growing number of alternative financial options, or anything else, it’s clear that we need a new type of credit score.
Fortunately, the solution is well within reach. Many firms have already created alternative credit scoring models based on data points like checking and saving account data and utility bill, rent, and mobile phone payment history, and these models have proven their trustworthiness time and again.
Best of all, alternative credit scoring models provide benefits for lenders and consumers alike by enhancing creditworthiness predictions, making the credit application process more efficient and less expensive, and expanding access to credit in a risk-averse way.
Written by Sanjoy Malik, CEO, Urjanet