Fintech 101: Alternative & Mainstream Credit Data

By: Ben Quaye & Myles Jackson

Intro

There’s no escaping the impact of your credit score. Credit data influences the rates you receive from lenders, and whether or not you qualify for a loan, insurance, housing, and more. Despite the fact that credit data points play such a major role in our lives as consumers, many people are “unscorable” by the big three credit bureaus (Experian, TransUnion, and Equifax) because they cannot get access to the mainstream credit products that establish and build their credit history. The numbers are not insignificant: nearly 40 million Americans are “credit invisible” in the eyes of major US credit bureaus. To help paint a picture, we’re talking about a population roughly the size of the entire state of California living in the US without a credit score.

Like many other facets of wealth inequality, credit invisibility disproportionately affects minorities. According to the Consumer Financial Protection Bureau, Black and Latinx people are overrepresented in the credit invisible population — about 15 % of the Black and Latinx are credit invisible (compared to 9 % of White and Asian people) and an additional 13 % of Black and 12 % of Latinx people have unscored records (compared to 7 % of White people). Of course, the catch-22 is that without a mainstream credit score, it’s difficult for these individuals to build a real mainstream credit history. As a result, they are relegated to alternative ways to access financial services, making them vulnerable to hidden fees, scams and bad actors. Building credit without a personal financial safety net is difficult, and in the worst-case scenario, it may prevent individuals from ever qualifying for standard loans like home mortgages and student loans.

Alternative credit data: a new way to think about credit scoring

The credit problem hasn’t gone unnoticed — especially in the startup world. And the resounding answer from Silicon Valley has been three words: alternative credit data. Simply put, alternative credit data points are the regular payments, like rent and utilities, that demonstrate ability to pay on time. Alternative credits models appear to be on promising, scoring-wise: according to Transunion, looking at alternative data sources (such as property, tax, deed records, checking and debit account management, payday lending information, address stability and club subscriptions) have proven to accurately score more than 90% of applicants who otherwise would be returned as no-hit or thin-file by traditional models. Moreover, by incorporating alternative data into credit decisions, companies can offer their products and services to a wider range of customers, who are at many times, underserved by the mainstream banking system.

Alternative data includes, but is not limited to:

  • Utility payments
  • Rental payments
  • Subscription payments (ie. payments for Netflix, mobile phones, etc)
  • Bank accounts

The limitations of alternative credit data

Alternative credit data scoring makes sense — a financially responsible person with a good track record should have their ability to pay reflected in underwriting decisions. But there’s the catch: alternative credit data doesn’t go into a mainstream credit score. The reason for this is that alternative credit data indicates a person’s “ability to pay”, but not their “willingness to pay”, and that “ability to pay” alone is not enough to prove “creditworthiness” (the nuances of this are well articulated in a16z’s July 2020 blog post The Allure of Credit Builder Products). Because alternative credit data does not reflect willingness to pay, it can only contribute to new, alternative, credit scores. And while these new, alternative scores are all the rage, the fact is that they are not widely used by major lenders, property owners and insurance companies.

The idea that alternative credit scores will be quickly adopted is far from a sure thing. Several of the common credit scores that incorporate alternative data are still in limited beta, and whether or not they will be adopted by the companies that rely on credit scores to make decisions (insurance, property managers, lenders, etc.), is yet to be determined. In this interagency statement jointly issued by the US financial regulators, it is recognized that alternative data may improve the speed and accuracy of credit decisions and may help firms evaluate the creditworthiness of consumers who currently cannot obtain credit in the mainstream credit system. The statement notes that these credit score models are still in infancy, saying that “these innovations reflect the continuing evolution of automated underwriting and credit score modeling, offering the potential to lower the cost of credit and increase access to credit”. As exciting as this potential is, there are a lot of realities that could get in the way of widespread adoption.

The fact that alternative credit data is unproven doesn’t mean it’s not promising. Alternative credit scoring has the potential to transform the credit landscape, both in the US and abroad. In the US, there is real momentum towards financial inclusion, and lenders that leverage alternative data could go a long way towards that end. And outside of the US, in countries where banking penetration is low and mainstream data is scarce, alternative credit models might end up leapfrogging typical credit models altogether. That being said, lenders in the US and abroad rely on archaic, proprietary credit decision modeling — whether or not they will adopt the use of alternative data and extend credit successfully to a larger customer base remains to be seen.

In the meantime, consumers are handing over their financial data through free mobile applications, betting on the promise of their alternative credit scores. These early adopters may or may not ever see the benefit of their data reporting, but the companies collecting that data certainly will. In the recently released documentary ‘The Social Dilemma’ put it simply: “if you’re not paying for the product, you are the product”. For the moment, this appears to be the case with alternative credit data.

Given the demographics of credit invisibility, alternative credit data may end up having another unintended consequence: the creation of a segregated banking system. Offering alternative credit options (which may or may not be adopted at scale) to underbanked minorities, is problematic. Assuming that these models will be a fair replacement for access to the mainstream banking system sounds a lot like “separate but equal” banking.

The best option, the one that avoids the pitfalls described above, would be to revise mainstream credit scoring to include alternative data. This might happen…at some point. But the truth is that credit invisible people can’t afford to wait and see how alternative credit pans out. They need to be able to do the things that build wealth — get educated, buy a home, get insured against financial shocks — and they need to do them now. They need to be able to build a mainstream credit score.

Clowte’s response to the problem (how you actually increase your credit score and “get that mortgage”)

In a world where consumers have to establish credit somehow, the proper way to do it is by making credit available to all the people who are willing to repay their balances. And while we sit and wait to see exactly what the uptake of alternative credit data means for the financially vulnerable, we must rely on systems already in place, like the mainstream system, which relies on tradelines at reporting agencies. Clowte is a platform designed to help underserved consumers build credit when they buy products and services. Clowte users can use this model to purchase the products and services they want and build their credit score without the burden of debt. Clowte can get to know customers “before extending liquidity” to them and incorporate the findings into a credit model that appropriately addresses the risks of the market over time.

The road ahead

In 5, 10, or 20 years alternative data may unlock a scalable way to offer today’s under-served population access to credit. Along the way, as a technology driven data furnisher, Clowte can help you impact your customers’ mainstream credit scores, debt free.

If you’re a business that is interested in getting early access to Clowte and learning how you can impact your customer’s credit score, click here.

API infrastructure that turns everyday transactions into debt free credit events and allows businesses to impact their customers’ credit history.