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How valuable is a credit score?

How valuable is credit score

This blog was inspired by a recent panel discussion that Harris Chen moderated with Carmen Perez, Solutions Architect at Alloy, and Lucy Jackson, Director of Strategy and Business Development at Petal. During the panel, the group discussed the challenges of traditional credit scores and how FIs can leverage alternative data to fill the gaps.

Lending decisions have relied heavily on credit scores since they were first introduced in the late-1950s by Fair, Isaac and Company (known these days as FICO). By providing a standardized system for determining creditworthiness, they’ve achieved widespread adoption among financial institutions (FIs) and become recognized as a key measure of a borrower’s financial health.

However, some FIs have recently started incorporating alternative sources of data into their lending decisions. After more than 60 years of trusting credit scores, what is prompting our industry to rethink them?

The limitations of a credit score

One of the main problems with traditional credit scores is the number of errors in credit reports. According to the nonprofit organization Consumer Report, more than one in three consumers who responded to a survey earlier this year found errors in their reports, potentially lowering their score. Among the most common errors were unrecognized accounts, unrecognized debt reported to collection agencies, wrong addresses and misspelled names. Further research shows that 10% of Americans have non-existent credit and 30% of Americans have non-prime scores, but only a fraction have defaulted on a loan.

Another problem with credit scores is they can be unreliable. A default from several years ago may result in the rejection of a loan application even if the borrower’s financial health has dramatically improved since. Meanwhile, the unbanked or underbanked sectors of the US economy can’t get a credit score because they don’t have a credit or payments history. That makes accessing the financial system harder for those who need it most.

Credit scores also penalize rational financial behavior. Even if a consumer pays off a loan, their score may drop if it’s their only installment account (as opposed to a revolving account like a credit card) or if they’re still paying off other loans with higher balances.

Finally, the major credit bureaus are vulnerable to cyberattacks. Equifax recently agreed to a settlement for a breach in 2017 during which hackers accessed the personal information, including social security numbers, credit card details and driver’s license numbers, of 147 million Americans.

A more holistic view of creditworthiness

FIs have begun to leverage alternative data to overcome these limitations. Some use transactions from checking and savings accounts, which banks have relied on for generations to process applications for credit cards. Others use on-time payment history for household bills such as rent or mortgage payments.

As part of Alloy’s mission to make a more equitable and accessible financial industry, we built this functionality into our Credit Underwriting solution, enabling FIs to access alternative data sources to help them make smarter lending decisions.

However, moving away from the system established by FICO all those years ago presents challenges. To start with, transaction data is unstructured, which means FIs need to clean and categorize it before they can use it. Even data provided by aggregators doesn’t always support sophisticated lending decisions.

FIs also have to educate stakeholders. Consumer lending is highly regulated, so FIs must persuade regulators that they’re sticking to the rules when they use alternative data. As for consumers, open banking has put them in control of their financial information for the first time, but they may be reluctant to share such sensitive information, especially with third parties.

Looking ahead

Regulation supporting the use of alternative data for credit scoring seems to be forthcoming, which should drive adoption. The Biden administration has made financial inclusion one of its main economic policies, while the Office of the Comptroller of the Currency launched Project REACH in 2020, a consortium of public and private institutions dedicated to improving access to financial services for unbanked and underbanked Americans.

Wider acceptance of open banking should also help. Legislation isn’t imminent, but industry standards like those set by the Financial Data Exchange provide consumers with added peace of mind.

Smart lending decisions don’t have to be hard

Combine credit bureau data and over 120+ data sources with Alloy Credit Underwriting.

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