Evaluating Unscorable Individuals: Alternative Credit Scores

Credit scores have long since been used as the gold standard for evaluating an applicant's financial capabilities for a loan.

As lifestyles evolved, consumers today are considered "unscorable" for several reasons. In fact, research has found that 28 million American adults in the US alone have no visible credit scores. This makes it important for lenders to consider alternative credit scoring models.

Read on to discover more about integrating alternative credit scores into your system and what other factors you should know.

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What are alternative credit scores?

Alternative credit scores are an evaluation method for assessing an individual's creditworthiness. They are used instead of traditional credit reports to help lenders better understand a person's financial state and potential risk factors that may not be considered.

These alternative credit scoring models utilize non-traditional data sources and criteria to determine whether a person is able to repay debts.

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When is alternative credit scoring necessary?

Financial institutions may need to use alternative credit data for many reasons. The most common situation is for credit invisible or "unscorable" individuals. This refers to people who don't have credit scores either because they are too young, are migrants, or actively choose to transact only with cash. People who come from rural areas and underbanked locations may also be counted as such.

Additionally, financial institutions can use alternative credit scoring as another layer of security to determine creditworthiness, as this evaluation method can pull more data beyond a credit report.

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Traditional credit score vs. Alternative credit score

Traditional crediting scoring and alternative credit scoring both seek to assess an individual's creditworthiness. However, they each take a different approach to what data to use. The traditional method looks into scoring visible on credit reports, while the alternative method considers many factors with regard to financial behaviors.

Let's take a closer look at their differences.

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Chart summary of traditional vs alternative credit scores. Please see the draft I made below.

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Traditional credit scores

Traditional credit scores work with data from credit reports. Two scoring models that lenders will consider for these credit reports are FICO, which is mostly used in the U.S., and VantageScore, which was developed by three main credit bureaus (Equifax, Experian, and TransUnion).

The criteria

When it comes to scoring, it may differ based on the method of scoring models lenders use. Some of the most common factors that are included in the criteria include:

• Payment history
  This is calculated based on the record of on-time payments made as opposed to the number of late payments. It contributes to 35% of FICO's scoring.
• Amounts owed to any entity
  Debt and credit utilization play a considerable part in scores. It can make up to 30% of the score.
• Length of credit history
  This looks into the amount of time the account has been around. It can likely make up at least 15% of scores.
• Credit mix
  How many credit accounts an individual has will matter. Although this may not be a big factor, it can still affect up to 10% of scores.
• New credit
  Scores also factor in how many accounts were recently opened. It can have a similar percentage to the credit mix, which can be up to 10%.

Advantages

The pros of using traditional credit scoring models lie heavily in how well they are known. As it is tried and tested, most lenders will choose to work with this.

• Traditional scoring is an established approach and is widely accepted by many lenders globally
• It is a standardized and regulated approach to evaluation, which ensures consistency in credit evaluations
• It offers a historical view of credit behavior seen by businesses and financial institutions

Disadvantages

Traditional credit scoring comes with its flaws. Some disadvantages to solely using this scoring model include:

• It excludes those who are credit invisible, who have no or limited credit history
• It isn't able to consider non-traditional financial behaviors that can indicate whether their credit risk is low or high
• It can be slow to reflect some of the more recent financial improvements of an individual

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Alternative credit scores

Alternative data sources play a crucial role in alternative credit scoring models. Borrowers identified as unscorable can greatly benefit from this modern approach. This credit scoring process was initiated by fintech companies and startups seeking to cater to the millions who have yet to build credit histories.

This scoring method utilizes machine learning and AI algorithms to determine borrowers' creditworthiness.

Criteria

The factors that can impact a borrower's score in the alternative credit scoring model include proof of payments and other data that can suggest their financial behaviors.

• Cash flow from earnings or paychecks
• Saving and spending habits as suggested by their purchases
• The consistency of bill payments that go beyond credit card data

Advantages

The biggest advantage of alternative credit scoring models is their capability to qualify more loan applicants than traditional scoring. This approach promotes financial inclusion for the millions who have yet to build a credit history.

• Credit invisible or unscorable individuals who have limited or no existing credit histories can be considered
• You can gain a more holistic view of an individual's financial health and creditworthiness
• Enables real-time insight into recent changes in the borrower's financial behavior
• Businesses can customize the evaluation standards based on how they see fit

Disadvantages

The challenge of using alternative credit scoring is that it heavily depends on information that must be kept private.

• Providing data for evaluation may pose privacy concerns for a borrower
• There is no set standard for algorithms in assessing a borrower's financial data
• It is less recognized and accepted, which means both lenders and credit unions must consider whether alternative credit scoring is truly beneficial for the business

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What is alternative data in credit scoring?

Alternative data in credit scoring refers to non-traditional information used to assess an individual's creditworthiness. This data goes beyond the conventional data sources used by traditional credit scoring models, such as credit reports from major credit bureaus. It includes many other financial and personal information that isn't normally evaluated.

Using alternative data makes financial inclusion possible with a comprehensive and fair assessment of a borrower's ability to manage credit and repay debts.

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Types of alternative data

Since unscorable applicants have limited or no credit histories, the kind of data needed can vary depending on what participating financial institutions have as a standard or what they can provide. This can additionally serve as an added layer for verifying documents that can help determine whether they are low or high-risk individuals.

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Payment history on non-credit accounts

Payment histories can prove a borrower's capacity to fulfill financial responsibilities regarding bills. This includes the following:

• Rental payments
  Timely rent payments demonstrate a strong financial responsibility, which can be pulled from property management companies or bank transactions.
• Utility bill payments
  Paying for other bills such as electricity, water, gas, and other utilities is also considered.
• Phone bill payments
  Mobile and landline phone bill payments can likewise show a borrower's creditworthiness.

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Bank account information

Lending organizations and financial institutions can examine bank account information to determine a customer's financial history. This can show the customer's saving and spending habits.

• Checking and savings account transactions
  Data that can be checked here are cash flow patterns, balance history, and other financial habits.
• Direct deposits and withdrawals
  Regularity and sources of income can also be checked to ensure there is steady income.

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Employment and income data

Ensuring an individual is financially stable can impact their ability to accomplish payments.

• Employment history
  It's important to evaluate the stability and duration of an individual's employment or if they have ample savings in between jobs.
• Income levels
  The regularity and amount of income are often verified through an individual's payroll data.

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Public records

Checking public records can be a good way to determine whether a borrower has invested in properties or other assets and can help ensure that they are legally free of other issues.

• Property records
  Checking ownership and mortgage history can back up an individual's financial responsibility.
• Court records
  Bankruptcies, liens, and other legal and financial obligations can be seen in court records.

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Other financial commitments

Financial commitments can show how often and how diligently an individual deals with other payments.

• Insurance payments
  Seeing whether an individual has a regular premium payment can help improve an individual's credit score.
• Child support and alimony
  Having a payment history and obligation for child support can also impact credit scores.

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How to effectively gather data for alternative credit scoring

Collecting data for alternative credit scoring involves gathering non-traditional financial and personal information from the above sources. The goal is to compile a comprehensive profile of an individual's financial behavior that proves their stability and capacity to support financial responsibilities and loans.

1. Establish data partnerships

Having partnerships with companies and organizations that make access to relevant data seamless can streamline the process and make it easier for individuals as well. Having a platform or set standard pulling data will make it easier to evaluate credit-invisible individuals.

You should consider collaborating with landlords, utility companies, payroll providers, and other financial institutions and fintech companies.

2. Obtain user consent

Consent is crucial when gathering data, and compliance with data protection and privacy laws set by the World Bank is essential. Before collecting an individual's data, you must obtain clear and explicit consent from individuals to use their information for credit scoring.

By including this in straightforward and transparent terms and conditions, you can ensure all parties are safe. Whether you're working with a physical or digital onboarding process, it's important to make obtaining consent the first step.

3. Use APIs and data aggregation services

APIs and data aggregation services allow you to automate the full data collection process. Most up-to-date financial institutions and other service providers have APIs for accessing transaction and payment data.

4. Incorporate tools that use machine learning and AI

There are many tools that can assist you in evaluating a traditionally unscorable individual. Using a risk assessment tool can also allow you to identify any transaction patterns that suggest the amount of risk they pose for illicit activity.

At Vespia, we automate the risk-scoring process based on rules that you can set. Machine learning and AI technology run a comprehensive analysis of collected data so you can ensure the individual is low-risk.

5. Ensure data security and compliance

Implementing robust data security measures is a non-negotiable decision, considering the large amount of sensitive information that will be handled in the assessment for alternative credit scoring.

Stay on top of the necessary compliance regulations, such as Europe's General Data Protection Regulation (GDPR) and the California Consumer Privacy Act (CCPA).

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The opportunity for alternative credit scores

While traditional credit scoring systems can provide insight into an individual, they leave out millions who lack credit history or access to financial institutions. Evaluating unscorable or credit invisible individuals by using alternative credit scores presents a valuable opportunity for financial inclusion as it considers data that isn't solely limited to credit histories.

Financial institutions and businesses that use both traditional and alternative credit scoring not only broaden their customer base but also provide a clearer insight into understanding customers.

Vespia understands the value of accurately assessing a customer before moving forward with a business relationship. This is why our Risk Assessment Tool pulls the most relevant data and checks it against public and private databases for utmost accuracy.

Find out how you can implement it into your system. Book a demo today.

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