Digital lenders are rewriting the book when it comes to better credit decisions. They approve more loans, apply more accurate interest rates, and increase portfolio yield – without taking on additional risk. The marketplace is moving fast. We’re seeing alternative credit scoring go mainstream as 100+ financial services organizations test, or actively use these cutting-edge methodologies.
The old school application review process identified a sweet spot where credit quality was low enough to deliver interest income, yet high enough to control account delinquencies. These lenders relied on traditional credit bureau scores to support their approval decisions. It was a looks good on paper view of the world.
Disruptive new lenders use a more holistic approach. They start with credit management and then layer on behavioral indicators like cash management, and psychological indicators like risk aversion. It’s a wise move. According to FICO research, there are a whopping 3 billion unbanked adults worldwide who have no credit bureau score. Tap into 5% of that volume, and we’re talking about 150 million fresh loans.
Traditional lenders leave a lot of good loans on the table. It’s a double whammy. Many of these loans would have gone to younger borrowers who would have converted that first credit approval into a lucrative, long-term banking relationship.
Will FICO Become Obsolete?
FICO won’t disappear, but it will evolve. They recently announced the UltraFICO Score that looks at responsible cash management – in addition to responsible credit management – by reviewing checking account activity.
It’s a step in the right direction, but it still falls short of the robust credit scoring used by digital lenders. That’s because conventional credit bureaus continue to ignore major categories of pertinent predictive data.
They don’t look at freelance income unless the applicant can provide two years of tax history, which takes three years to accumulate and report. They don’t look at cash management, which can be tracked via savings and checking account activity. They ignore payment history for non-credit categories like apartment rent, cable connections, car payments, insurance, and mobile devices. Along with monthly utilities like gas, electric, water, and heating oil. Their heavy reliance on credit card activity short shrifts younger consumers with high disposable income who choose digital payment wallets over credit cards.
Alternative Scoring Methodologies
So what’s in the secret sauce? And is alternative scoring reserved for fintech-driven organizations with high powered data analytics? Let’s take a look.
Digital lenders start with a traditional credit bureau score to create a solid 2-dimensional foundation. Then they build a 3-D profile by layering on a variety of alternative indicators. It’s the difference between a black-and-white photo and a hologram.
These layers could include internal and/or external data. An in-house score is calculated from data points collected from the company’s personal experience with a borrower. An example of an out-of-house score is one that’s generated from behavioral information like checking account activity. Consumers get extra points when they have a checking account when they use it to pay bills each month when they have auto-pay set up for installment loans when they maintain an average account balance of at least $400, and when they don’t bounce checks. Another out-of-house score is based on monthly payment activity for things like rent and utilities.
A still emerging credit score is the psychometric profile. Entrepreneurial Finance Lab (EFL) has been assessing personality to support credit decisions for the banking industry since 2006. One EFL lending client claims the questionnaire helped grow their customer base by 53% while reducing defaults by 72%. The score is based in part on risk aversion. The better borrower exhibits a steady, consistent approach to life.
Some large financial organizations and Lending-as-a-Service (LaaS) platforms have developed their own proprietary credit scoring algorithms. The more sophisticated LaaS platforms use machine learning to constantly fine-tune their calculations, and the platform subscribers enjoy the benefit of cutting-edge alternative scoring without incurring the cost for technology and in-house expertise.
Unbanked Consumers Decline Due to Digital Lenders
According to an FDIC study, a full 20% of the American population is unbanked or underbanked. And the number of banking deserts has increased as institutions like RBS, Lloyds and HSBC close underperforming local branches. US banks closed 1,700 branches last year, and European banks closed more than 6,000 branches in the same timeframe.
On the bright side the FDIC study shows that, while 20% of adults remain unbanked or underbanked, this percentage has decreased since the last dataset was collected. It’s the first time this figure has gone down since the FDIC began to gather this information in 2009. We believe the shift is due in part to digital lenders who use alternative scoring to actively approach and approve new populations.
Alternative Scoring Used by 100+ Lenders
Mike Mondelli, the senior vice president for alternative data services at TransUnion, was recently quoted in a New York Times financial article. According to Mondelli, “About 100 companies – primarily automobile lenders and online lenders, but increasingly credit card companies – are using or testing the (TransUnion) model in credit decisions.” He went on to say, “…the model lets lenders approve 20% more applicants.” A key advantage of the new scorecard is that it allows lenders to book more new accounts without increasing portfolio risk, compared to conventional scoring models.
As alternative scoring goes mainstream it becomes more important for all lenders to adopt strategies and technologies that will keep them competitive. This is especially true for credit unions, local banks, or any organization that’s been slow to upgrade their technology.
Deploying an Alternative Credit Scoring System
Alternative scoring isn’t reserved for big financial organizations.
Small to mid-size lenders, as well as credit unions and local banks, can access these same scoring methods; even if they don’t have in-house risk managers, advanced data analytic capabilities, and cutting-edge technology.
An effective and cost-efficient approach is a fully managed Lending-as-a-Service platform like Turnkey Lender. Our award-winning platform delivers faster, better credit decisions. Our clients gain 4 key advantages over the competition:
- State-of-the-art alternative scoring methodologies, including a proprietary credit scoring algorithm with machine learning that continually optimizes the formula.
- Easy deployment from our secure, cloud-based platform. Your team gets up-to-speed quickly with intuitive process flows, user-friendly training modules, and 24/7 support.
- Automated processes that increase the speed of approval, reduce human error and improve overall process efficiency.
- Up-to-date regulatory compliance that conforms to new rules as they’re published by regulatory agencies.