For decades, lenders have relied on credit scores when deciding whether to provide a mortgage or other loan to a potential borrower. That system has left millions of people on the sidelines of the modern economy, unable to secure loans to finance purchases of homes or cars, for example. More than 45 million Americans either have no credit history or have no recent activity to create a traditional score, according to a report form the Consumer Financial Protection Bureau.
Those consumers got a bit of good news Thursday. FICO, the analytics company that provides the credit scores used by lenders, announced that it will broaden its offering of an alternative credit score, potentially helping those who otherwise have been shut out of the debt markets. The new rating, called FICO Score XD, uses public records as well as a consumer’s phone, cable and utility payment history to devise a number on the same 300-850 scale used for the standard FICO scores.
The expanded use of the new score, developed through a pilot program that started a year ago, reflects a growing interest among both the traditional credit bureaus and a handful of startups in using alternative data to extend credit to more consumers. Lenders who participated in the pilot program, for example, found that up to half of credit applicants had scores of at least 620, making them eligible for entry-level credit cards and other loans. Once those consumers can open a credit card and make regular payments on it, they’ll be able to build a more traditional credit history, unlocking access to rewards credit cards, larger loans like mortgages and better insurance rates.
How FICO Scores Have Worked — and Haven’t
Traditionally, credit scores have tracked how potential borrowers have managed their debt payments over time and factor in a person’s payment history, amounts owed, length of credit history, mix of debt types and how much new credit they’ve drawn.
“That works really well for borrowers with a robust credit file who pay all their bills on time and for screening out borrowers with heavy delinquencies and derogatory information,” says Nick Clements, consumer banking expert and co-founder of MagnifyMoney.com. “It doesn’t work as well for borrowers where there is limited or no information available.”
Borrowers with high credit scores are considered less risky and get the best rates and terms, while those with lower scores are seen as riskier and receive higher rates or don’t get approved at all. Borrowers without a credit score are also considered a high risk and have trouble securing credit.
Young people and immigrants tend to have lower scores simply because they don’t have a long history of managing credit. Seniors can also be affected, since retirees who have paid off their mortgage or prefer debit cards may find themselves with a low or nonexistent credit score.
Under the traditional scoring system, they get no credit for paying their other, non-debt bills for rent, cell phone or cable. Transactions made with a debit card or cash also aren’t counted. Cash flow and income are left out, although lenders look at these factors in conjunction with credit scores.
“That can be really frustrating for people who feel like they’re paying their bills on time every month but not getting any credit for it on their credit reports,” says Thomas Bright of Clearpoint Credit Counseling.
There are compelling reasons to use this payment data as a way to qualify a borrower. Factoring in rental payments into a credit history improves overall credit scores and scores consumers who previously were unscorable, according to a recent analysis by Experian. And eight in 10 lenders who used alternative data to score applicants reported experiencing tangible benefits, while two-thirds said they have reached more creditworthy customers, according to a recent TransUnion survey.
“Most creditors are trying to look at this alternative data in order to find more customers and be more inclusive,” says Gerri Detweiler, head of market education for Nav, a website that helps entrepreneurs build and manage their business and personal credit profiles.
Big Players Making Big Changes
Responding to that need, TransUnion in October introduced its CreditVision Link that incorporates other data such as property, tax and deed records, checking and debit account and payday lending information in calculating a score.
Meanwhile Fannie Mae and Freddie Mac, which dictate the terms of most mortgages and still have rigid FICO score standards, are studying how to incorporate alternative data into their underwriting processes. The Federal Housing Finance Authority instructed the two government-sponsored entities in its 2016 Scorecard to come up with a plan for implementing the use of such scores.
When pressed on the timeline for any changes, however, an FHFA spokesperson wouldn’t commit. “Migration to any new model will be costly, complicated, and will take considerable time for Fannie Mae, Freddie Mac, and lenders of all sizes to implement,” she wrote in a statement. “For these reasons, we are continuing to talk with a broad range of stakeholders including lenders, consumer groups, investors and credit score modeling companies.”
Startups Step In
Nonbank lenders are also stepping in to fill the gap. Lenny Loans, which has only been around a month, is focused on super small loans to subprime borrowers who may have otherwise been forced to turn to payday lenders for short-term needs. The company is eyeing much bigger products and will eventually take its alternative credit model, which factors in LinkedIn profiles and educational background, to auto loans and mortgages, says CEO Joe Bayen.
Startup eCredable has gotten some traction working with consumers directly to build scores based on other, non-debt bills that they pay. Once scored, clients deemed creditworthy can obtain an American Express card via BBVA Compass Bank, or apply for a mortgage with Churchill Mortgage or South Pacific Financial Corp.
And start-up SoFi in January stopped using FICO credit scores altogether in its lending decisions. The company — which offers student loan refinancing, mortgages and personal loans — instead considers three factors: employment history, track record of meeting financial obligations and monthly cash flow.
“We’re proud to be the only major lender that does not use the score for any lending,” said SoFi CEO and co-founder Mike Cagney in a statement at the time. “Instead of relying on a three-digit number to tell us who’s qualified, we look for applicants who have historically paid their bills on time and make more money than they spend. It’s that simple.”