Credit scoring services have long used similar criteria. While banks and lenders have relied on traditional credit scores to assess the risk of a loan, these older methods exclude a major portion of the market.
Borrowers with a weak or nonexistent credit history may still have the financial means to make monthly payments, yet are often overlooked due to the standards set by traditional credit scoring models.
Alternative credit scoring allows lenders the opportunity to reach new audiences by utilizing different criteria to determine a borrower’s reliability. As you will see, an alternative credit scoring method can be beneficial for lenders and potential borrowers alike.
The difference between traditional and alternative credit scoring
Traditional and alternative credit scoring models aim to achieve the same purpose; the difference is the criteria they use to determine a borrower’s score. Credit Infocenter explained that a traditional credit score is usually determined strictly by a borrower’s lines of credit. Credit scoring agencies will want a mix of information to determine a credit score, including:
- Payment history – has a borrower ever missed a payment or defaulted on a loan?
- Current debts – can a borrower handle another payment?
- Credit utilization ratio – does a borrower have a diverse borrowing portfolio?
- Number of open accounts – how has the borrower handled making multiple payments?
- Length of credit history – older accounts show a better payment history
Credit bureaus may also use information from public records to gain a larger picture of a borrower’s financial history. They will then determine a score typically between 300 and 850 – higher being better. Commercial banks can set their own minimum credit scores for lending, but according to Experian, anything above 700 is typically considered very good
By these standards, the Consumer Financial Protection Bureau found that only 54% of adults in the U.S. have Superprime or Prime credit scores. This leaves a significant portion with a less than ideal credit score, and 22% have thin credit — or no credit at all.
Alternative credit scoring gives borrowers without a strong past of credit a chance to receive a loan by basing their score on different criteria. For example, to determine a borrower’s alternative credit score a lender could evaluate data such as:
- Rent, utility, cable and/or cell phones payments – does a borrower pay them on time and in full?
- Checking account data – does a borrower have sound financial backing?
- Shopping history – does a borrower make unnecessary/frivolous purchases without the financial means to back them up?
- Property records – has a borrower invested in their own property?
In addition to these factors, some alternative credit scoring models will also take a deeper look into a borrower’s education, occupation and even social media presence. With all of this information, lenders have a comprehensive profile of a potential borrower and can determine their risk level based on more information than just a traditional credit score.
Pros and cons of alternative credit scoring models
The biggest advantage to alternative credit scoring is that more borrowers can qualify for loans.
For young individuals with no credit history or adults with thin or stale traditional credit scores, in particular, this could help them qualify for loans with better terms. At the same time, lenders can expand their client base and distribute more loans with a better understanding of the credit risk involved on a borrower-by-borrower basis.
With this information, borrowers can also be proactive in improving their alternative credit score as they would for a traditional one. Wisewage explained that consumers can be more vigilant of these factors in their everyday lives and make better financial decisions that would help them in the long run. An alternative credit score can, in some cases, be a better reflection of a borrower’s creditworthiness in the moment as opposed to one financial error shown on their credit report.
Of course, alternative credit scoring doesn’t come without its disadvantages. One of the biggest drawbacks to this method is concern over privacy. As helpful as some of the information is to lenders, not every borrower wants to share details about their shopping habits and occupation history when applying for a loan. There is a fine line between finding information helpful to a borrower’s portfolio and invading their privacy.
Additionally, not all lenders will accept an alternative credit score as part of an application. Lenders and credit unions should determine if alternative credit scoring is beneficial to their business and clients before changing their current methods.
Who generates alternative credit scoring models?
Forbes reported that some of the largest credit bureaus have started participating in alternative credit scoring methods. These traditional giants are bringing in companies specializing in alternative data for assistance.
Each organization can request different alternative data and utilize it alongside traditional records for a comprehensive borrower assessment. What’s more, there’s evidence the public would embrace the method.
PR Newswire reported that 71% of American adults would be willing to share more personal data with a lender if it resulted in a fairer credit score. Privacy concerns stem from lenders finding borrower’s information without their consent, but clearly many adults are more than happy to provide alternative data themselves if it’s in their best interest.
As more lenders begin adopting alternative models and credit bureaus continue to be transparent with what information they form their decisions on, it’s likely that more borrowers will share their information voluntarily.
A dedicated risk management and credit scoring system can help financial institutions and private lenders make sense of big data by taking the raw information and turning it into a plan of action. When data is organized and streamlined, lenders can make better, more informed decisions that benefit themselves and the borrower in the long run.