One axiom of lending has held true for decades — a consumer’s past behavior is the best predictor of his or her ability to repay a loan.
While that is as true today as it ever was, the data lenders use to assess creditworthiness is undergoing a sea change.
Consumers with tarnished or no credit history can now build their profiles by demonstrating stable cash flow, along with on-time rent and utility payments, to credit reporting firms. On the flip side, the big three credit reporting agencies, Equifax, Experian and TransUnion, have just begun excluding paid-off medical debt from consumer credit reports. New medical bills won’t appear on a person’s record for at least a year, up from six months, to allow for more time for repayment or negotiating payment plans.
And the recent boom in buy now/ pay later loans is also generating data that could help a lender evaluate a consumer’s creditworthiness.
These changes hold the promise of democratizing credit, benefiting millions of consumers — including newly arrived immigrants — who were previously consigned to the subprime category because of past financial difficulties or thin credit files.
“With credit scores becoming more reflective of consumers’ actual financial picture, to say we’re entering a golden age of credit scoring innovations wouldn’t be an understatement,” said Silvio Tavares, president and CEO of VantageScore, one of two companies that considers data from multiple sources, including the three major credit reporting bureaus, to assess individual borrowers’ creditworthiness with a three-digit score.
A golden age?
FICO, founded more than 60 years ago as Fair, Isaac & Co., and based in San Jose, California, pioneered the familiar three-digit credit scoring system, ranging from 300 to 850 in 1989. Use of FICO’s credit score expanded significantly in the mid-1990s, after Fannie Mae and Freddie Mac began requiring them on mortgage applications. VantageScore, of Stamford, Connecticut, developed a competing version of the three-digit score in 2006.
Of course, the underlying reason FICO and VantageScore have grown so ubiquitous is that they work. They do a very good job of predicting consumer behavior and have helped tens of millions of consumers qualify for credit cards, auto loans and mortgages.
Problem is, they may have worked too well.
Millions of would-be borrowers who may have possessed adequate financial wherewithal have been locked out of the conventional credit box by the credit scoring system. Research published earlier this year by Experian and Oliver Wyman estimated nearly 106 million Americans either have files so thin they’re rendered credit invisibles, or can only obtain credit at elevated subprime rates due to problematic histories. The National Foundation for Credit Counseling puts the number at 132 million Americans with no or poor credit.
This credit-impaired population includes disproportionate numbers of low-income, younger and minority consumers, according to the Consumer Financial Protection Bureau. Adjusting the data sets on which credit scores are based with an eye toward boosting inclusion could have dramatic benefits, making credit available to more consumers, even narrowing the racial homeownership gap, “something everyone wants to see happen,” said Karan Kaul, a principal research associate in the Housing Finance Policy Center at the Urban Institute.
“People have been talking about using alternative credit data for a very long time,” Kaul added. “The issue they ran into previously was that there was very little availability of such data.”
To Tavares’s point about a “golden age,” things are changing rapidly. Technology is making it easier to collect alternative credit data, and institutions as disparate as community banks and fintechs as well as FICO and VantageScore are scrambling to put it to work. Like Tavares, Kaul contends a transformation involving the data used for credit scoring is underway, though he says it will be years before its effects become mainstream.
“A lot of things have changed in recent years to allow us to move from merely talking about this type of data to actually beginning to operationalize it, but it’s going to take a very long time … for volumes to kick in,” Kaul said.
The shift in the handling of medical bills — which took effect in July — can be seen as a start. It will affect about $88 billion in outstanding debt. Although large bills remain on the books, they will no longer cast such a large shadow over a borrower’s immediate credit prospects.
“The way medical debt traditionally was handled — often caused by an unexpected event and handled by intermediaries like insurance companies — wasn’t very predictive of consumers’ actual creditworthiness,” Tavares said.
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This article was originally published on American Banker on August 16, 2022.