Understanding Alternative Credit Scoring
August 8, 2018
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Although many proponents of strict debt-free budgets will advise you to steer clear of credit cards and loans, that advice is simply not tenable for the average consumer. At the very least, consumers should have at least one credit card to establish and build their credit profile so they can obtain credit when the time comes to buy a car or purchase a home.
But that’s not the only place your credit profile comes into play. In today’s marketplace, a variety of non-lender parties are now checking credit profiles, including potential employers, landlords, and utility companies. Credit profiles are also commonly used as a form of identity verification, a security measure that’s becoming increasingly important.
Despite its importance, however, a large number of people don’t have a credit profile or have a limited credit history, called a thin file. Without a reported credit history of at least six months, thin-file consumers are not eligible for a credit score, which can prevent them from obtaining credit or cause them to pay more for credit.
In an effort to reach the millions of consumers without a credit score, alternative credit scoring models are being developed that incorporate non-traditional data into their algorithms. While many of these models are operated by smaller companies, major scoring agencies FICO and VantageScore are also working on ways to expand access to alternative scoring models.
What Counts as Alternative Data?
In general, any type of consumer information not pertaining to credit falls under the broad umbrella of alternative data. The most popular form of alternative data used in scoring models and lending decisions is non-credit payment history, which can include regular bills like rent, utility payments, car insurance, and cellphone plans.
Some non-payment data is also being used to flesh out otherwise thin risk profiles, including employment history and educational background data. For example, a steady work history can be an indicator of greater financial stability and indicate a reduced financial risk level.
But the data doesn’t stop there. The digital era is full of interconnectivity and tracking, allowing companies to determine everything from the kind of mobile device you use to what you purchase online. This data has been used extensively in product marketing and targeted advertising, but is now being considered for its applications in alternative credit scoring models, as well.
Given that the vast majority of consumers will have pertinent data from at least one of these sources, millions of additional people may qualify for credit scoring under alternative scoring models. However, it isn’t quite that simple; alternative scoring must overcome a number of major hurdles before it can become a viable method of consumer risk assessment on the broad stage.
The Problem with Obtaining Alternative Data
Perhaps the most pressing issue with alternative data usage in credit scoring is the difficulty inherent in obtaining the data in the first place. Traditional credit scoring data is reported by lenders to the three major credit bureaus — Equifax, Experian, and TransUnion.
Currently, non-credit payments are sporadically reported to the three major credit bureaus, which typically have utility or cellphone payment information for less than 3% of consumers. Additionally, non-payment data, such as retail purchase behaviors, aren’t collected by the credit bureaus at all, often due to privacy or regulatory compliance concerns.
Because alternative payment data isn’t easily accessible from the credit bureaus, scoring agencies must turn to third-party data collection companies to obtain data. This requires thorough vetting of sources for accuracy, security, and regulatory compliance, which not only takes time but can also use up significant resources.
Are Alternative Scoring Models Effective?
Beyond obtaining alternative data, the biggest question becomes one of whether alternative scoring models actually work to accurately predict consumer credit risk. While we have decades of data on the accuracy of various credit scoring models, alternative credit scoring has had significantly less research attention, making the validity of the models a virtual unknown.
Long-term studies of how well alternative scoring models really evaluate consumer risk are required to determine their actual effectiveness — and not just for the scoring agencies. One of the biggest hurdles alternative scoring advocates face is simply getting lenders to use alternative scoring models as part of their decision-making process.
In the end, credit scoring agencies have enough trouble simply encouraging lenders to use new credit scoring models based on traditional credit bureau data, such as the FICO Score 9 released several years ago. Many lenders, instead, stick to older scoring models, such as the FICO Score 2, 4, or 5 models, or the FICO Bankcard Score 2, 4, or 5 models.
Overall, even those lenders who use alternative credit scoring models or alternative data in their own calculations tend to do so only as a general supplement to traditional credit bureau data. While this may help consumers with especially thin files (or nonexistent ones), it’s hardly the widespread adoption that would turn millions of scoreless consumers into creditworthy borrowers.
Building a Credit Score the Old-Fashioned Way
Although alternative credit scoring is a grand idea, it’s simply too early to rely upon alternative data in place of a traditional credit profile. Thankfully, establishing a scorable credit profile and building a good credit score doesn’t have to be a complicated task — nor does it need to be an expensive one.
One of the easiest ways to establish your credit history is to open a credit card. A number of credit card issuers offer consumers with no or limited credit specially designed entry-level credit cards, many of which don’t charge application or annual fees, meaning it won’t cost you anything to open the account or to keep it open.
Additionally, the majority of credit cards come with an interest-free grace period, which means you can avoid being charged interest on your purchases if you pay off your full balance by your due date. So, if you open an annual-fee-free credit card and use it to make regular purchases, then pay off those purchases in full each month, you can establish and build your credit profile without it costing you a dime.
Of course, it’s important to remember that the interest-free grace period only applies to the balance from new purchases. Other transaction types, such as balance transfers or cash advances, will typically start accruing interest as soon as they post to your account (they also tend to come with service fees, so read your cardholder agreement before making these types of transactions).
As you build up your credit profile, be sure to keep track of your credit score progress. Regularly checking your credit score is also a good way to detect any changes to your credit reports between checks. Even better, it doesn’t have to cost you anything to check your score; CreditSoup can give you access to your free credit score in just a few minutes.