For quite some time now, banks, credit unions, and other institutions have struggled with making lending decisions that are based solely on the premise of a credit score in solidarity.
This has been due largely to the fact that many individuals (an estimated 45 million Americans by the Consumer Financial Protection Bureau) don't have enough credit history for the three major credit bureaus to create a credit score for them.
Now, many in the financial industry are suggesting that it would be prescient for lenders to use alternative forms of data to evaluate whether or not a borrower is creditworthy. In this article, we will look at some forms of alternative data that could serve as feasible options for evaluating an individual borrower's creditworthiness.
What Does a Credit Score Evaluate?
First, though, let's talk about what a traditional credit score seeks to determine.
A credit score evaluates the likelihood that a borrower will repay any debts that they undertake. The factors that make up a credit score are as following:
1. Payment history (35%): Has a borrower missed any debt payments?
2. Credit Utility (30%): How much of your available credit are you using?
3. Credit History (15%): How long have you had access to credit?
4. Hard Inquiries/New Credit (10%): How often do you apply for new credit?
5. Credit Types (10%): Do you have a good mix of credit types?
Why FICO May Not Be Best.
As you may already be able to see, many of these credit factors are entirely unimportant for calculating an individual's actual "repay-ability" score, and some of the factors that ARE important can be recreated using alternative means.
For example, I could have access to $50,000 in credit and be using none of it, and that would make my credit score look incredible based on the "credit utility" portion of my credit score. However, that doesn't mean that I would be able to repay $50,000 if I decided to use it. Far from it!
This is because my ability to repay debt is founded in my debt-to-income ratio, which is a measure of how much debt I am taking on relative to the free cash flow available at my disposal.
Furthermore, credit score factors like payment history and length of credit history can be calculated using other means. Let's look at these forms of alternative data now.
Alternative Data That Works
Some forms of alternative data that could be used to evaluate creditworthiness include:
Income Information: As we mentioned above, how much a person makes will play a huge role in determining their ability to repay any money borrowed.
Cell Phone Payment History:
This is one of the most common recurring expenses for any American person, and it is also not reported on a credit report.
Apartment Rent Payments:
Similarly, this would serve as a good measure of a person's ability to make full, on-time payments over time.
Reasons Why Alternative Data May Not Work
There are several reasons why alternative data evaluation may not work the way that we would think it would for discovering an individual's credit worthiness. These include:
Unregulated Information: Because a group like the Fair Isaac Corporation (FICO) will not be regulating this data, it is possible that it will be more prone to being inaccurate or incomplete.
Time Component: Since alternative data forms aren't standardized yet, it would take a lender more time to make a lending decision based on these forms of data.
Discrimination Risk: Finally, since this data would require more transparency in an individual's circumstance, it may lead to various forms of discrimination that the current analysis factors are not prone to.
Personally, I believe that we will see more inclusion of alternative data factors into making credit decisions within the next five years. At the very least, we should expect to see more inclusion of the debt-to-income ratio because this is a truly necessary factor for determining how likely a person is to repay their debts.