In the finance and banking industry, lenders prefer thick credit files. The thicker the files, with more historical data about the applicants' borrowing history, better are their chances of getting their loan sanctioned, and if they have a good score, they even stand to get a better interest rate.
But what happens when a loan application does not have any credit history? This could be a case when the application is from a fresh applicant, who could be a student, homeowner, retiree, anyone who does not have a proper credit history to reflect. This directly impacts their credit score, which does not allow them to apply or be eligible for loans and hence, they are incapable of fixing their credit scores.
This vicious cycle is, unfortunately, one of the best examples of the chicken-egg story. The lack of credit scores of the less and underbanked sector led to traditional banks to refuse their applications and cater to the loan requirements of applicants with thick credit files. This instead led to a major gap in the lending industry. A potentially large segment of the population, across the world, cannot access credit due to the lack of credit score. The number of unbanked people in the world crosses a staggering 1.7 Bn which shows that this market holds a lot of potentials if served.
The arrival of fintech slowly changed this scenario. In fact, it was as early as the 1990s when alternative credit scoring emerged for the first time. Before that credit scores were generated by data furnishers, like collection agencies and lenders who would share their borrower’s credit information with the credit bureau. The credit bureau would then update this information to the borrower’s credit report. So, when this borrower would again apply for a loan, the new lender would then buy the applicant’s credit report from the credit bureau, for their underwriting purposes.
In this entire process, there was no way for the loan applicant/borrower to add any other accounts that could reflect their creditworthiness.
Fintech saw the gap in this process and the rigid credit scoring system and found a way to provide credit scores to even first-time borrowers or people who don’t have a borrowing history for a long time. They did so by introducing alternative credit scoring.
As mentioned earlier, credit scoring was very rigid in olden times with lenders and credit bureaus referring solely to the applicant's borrowing history to ascertain their creditworthiness. This not only makes applicants with zero-credit history ineligible for a loan but also makes them pay higher interest rates on loans they do manage to get, after all.
Alternative credit lending addresses this issue by using current, relatable and easily available data about applicants to ascertain their creditworthiness, such as their digital footprint.
Alternative credit scoring helps people who were incapable of entering the credit system, by giving them easy loans and access into the system, thereby providing them with a much-needed break to start establishing their credit scores.
On the other hand, it helps lenders gain access to the underbanked sections of the population, by using alternative credit scores to extend credit to this new target group. This brings down risks for alternative lenders, as well as, lowers the interest rates for borrowers, based on their alternate credit scores.
When using factors other than credit scores from past loans, credit scoring companies use the applicant’s social and digital data to ascertain the above three factors, i.e., their ability and willingness of paying back the loan and if they are stable financially to ensure complete repayment.
To put together an alternative credit score, credit scoring agencies use tools that run the following kinds of data through AI and ML-powered algorithms:
• Utility bill payments
• Bank account details
• Telecom payments
• Rental and lease payments
Payments towards these bills and services show the applicant’s intent and ability to pay their monthly dues in a disciplined manner. Often, this portrays a person’s creditworthiness in a much better manner than a traditional credit report would.
This is because the credit ratings reflected on traditional credit reports tend to last for 2-3 years. During this time, the applicant’s financial discipline could have changed for better or worse. Somebody who might be showing a good credit score might be having trouble paying their bills at the current date, and hence they might receive loan approval. On the other hand, a person without a credit score, who’s able to and intends to pay all their bills on time, isn’t able to get a loan because of the lack of credit score.
However, the real-time data, mentioned above, along with business models that deftly analyse the applicant’s behavioural information based on their social media engagements, provide a more reliable credit score for the applicant, than could be measured ever.
The social credit system is a reality in China and the US has largely adopted alternative credit scoring, already. However, in the US alternative data took some time to become a part of the data used for alternative credit scoring due to anti-discrimination laws. But, of late, credit rating agencies have been partnering up with fintech firms to use more valuable and reliable data to create better assessments that deliver accurate results.
Lenders are more likely to gravitate towards those credit rating tools that are known to give the best and most accurate results. This, in turn, will lead to the strengthening of the lending industry and coverage of otherwise unbanked masses.
Keeping this in view, various agency leaders of the US government openly stated that credit rating in the US has now officially moved beyond the usual traditional factors and methods, during the December, last year.
Alternative credit scoring is extremely beneficial for the lending industry specifically and the finance industry, in general, given the immense opportunities it offers to both lenders and borrowers. Here’s a look into some of the other factors that make alternative credit scoring such a popular concept.
Alternative credit scoring is focused on current parameters more than historical data. This makes it a better option for applicants with no credit score, as their report can be generated based on their current financial discipline and habits, as well as, their social interactions which provide a better view of their ability, stability, and intent of paying back the money they have borrowed. As such, alternative credit scoring emerges as the clear winner when it comes to accuracy, as compared to traditional scoring methods.
Given the absence of credit scores, a large portion of the unbanked population, along with people with access to banks, but no prior credit record, cannot apply for loans. Even if they do, chances of their loans getting sanctioned are relatively less, as lenders do not want to increase their risk by lending to applicants whose credit history, they are unaware of. Alternative credit scoring has opened up the marketplace for such applicants and lenders who would be eager to lend to this particular target group based on their payment discipline and alternative credit score. This not only opens up a new market for lenders but also provides applicants with more credit options and competitive interest rates to choose from.
By using automated alternative credit scoring processes, lenders can minimize loan origination costs and transfer this benefit in the form of lower interest rates to applicants. By using automated processes for underwriting loans, lenders can also significantly reduce bias and errors that are common in manual underwriting.
Existing borrowers who received loan approvals based on limited past credit information might be subjected to higher interest rates, as they are perceived risky by lenders given their limited credit history/data. But with alternative credit scoring with real-time data using their behaviour on past eCommerce purchases, bill payments, bank transactions and more, existing borrowers stand a chance to refinance their loans at better interest rates. Therefore, this not only helps borrowers but also lending firms who use alternative credit scoring, as they can receive additional business in the form of clientele choosing their services over that of traditional lending firms.
- The future of alternative credit scoring
Alternative credit scoring is already a well-accepted model in the US and has helped both fintech-powered lenders and new borrowers a lot by making credit accessible. Industry influencers have predicted that alternative credit score is all set to change the lending landscape in developing countries like India and China. The scope for its growth and adoption is even higher in India where a large part of the population remains unbanked. While lending firms in metros have already embraced alternative credit scoring to provide quick short-term loans to applicants, such as payday loans, tier 2 and tier 3 cities are yet to benefit from the ingenuity of alternative credit scoring.