Why a Good Credit Score Doesn't Mean Much
Worked really hard to maintain a credit score of above 700? Well, there is a good chance that you may have overestimated its efficacy. There is growing evidence which suggests that the traditional credit scores might well be on their way to become obsolete. Financial institutions are now looking to supplement and in some cases even replace the credit score with a range of non-traditional factors, such as payment of utility bills, rental payments, whether you have a criminal history and even which professional degree you hold.
Limitations of the traditional credit scoring methods
As the financial services industry prepares for the future, there is a growing acceptance about the limitations of the traditional credit scoring methods and the need to implement new strategies to assess creditworthiness which looks beyond the confines of historical financial data. By focussing solely on the credit history of an individual, traditional methods have turned a blind’s eye to the market potential of billions of customer who do not possess one. As per World Bank, as of 2014 around 38% of the world’s adult population does not have an account with a formal financial institution. People who lack a formal credit history are even more numerous. Not only do these methods limit the growth opportunities for banks, they are also detrimental to the vision of financial inclusion.
Alternative credit scoring methods
Evolving customer habits and a dynamic economic environment has further reinforced the need to look out for new ways to reach the consumer. To tackle this situation, an increasing number of financial institutions have now started using alternative credit scoring methods. These methods typically rely on a combination of non-financial information such as utility bills, telecommunication bills, rental payments and even social media footprints. These data points help in providing deeper insights into the consumer’s behavior and can be used in conjunction with tradition financial data to get a more complete picture of an individual’s creditworthiness. The fact that they are so readily available makes them even more appealing.
The incredible growth witnessed in the field of big data analysis and machine learning has also played an important role in the proliferation of alternative credit scoring methods. Numerous financial technology companies have now emerged who use proprietary software to sift and sort through thousands of data points and use predictive technologies to generate insights from them. They abide by the principle ‘All data is credit data’ and make use of diverse data points ranging from mobile bill payments to the use of grammar or punctuation in a text message or the time of day that people call their friends
In addition to opening up new revenue streams for financial institutions, the use of alternative data can also reduce the risk of default by providing a more holistic view of the individual’s personality. Although alternative credit data was initially used as a supplement for people who lack an extensive credit history, there is a growing trend of using this data even for customers who have a positive credit history. Many financial lending start-ups such as Sofi, Affirm, Avant, and Earnest have completely done away with the traditional financial scoring methods. Even FICO, which is the industry leader in traditional credit scoring has embraced alternative methods to make credit available to the unbanked population.
This trend may also bring in a new set of concern for the customers. In traditional credit scoring method, there were a limited set of known variables which affected the score and it was possible for an individual to voluntarily shape his credit profile. However, in the alternative methods, this task becomes insanely difficult as the number of factors being analyses is innumerable. Moreover, there is opacity regarding the exact methodology being applied to arrive at the lending decision.
Even though the alternative credit scoring system is still in its nascent stages and it still has to overcome the challenges of privacy and transparency, it is reasonable to assume that it is here to stay considering the enormous potential benefits it has in store both for the financial institution and the unbanked population. Taking note of this, an individual must be cognizant of the fact that a good credit score alone may not make him eligible for a loan. It is equally important for him to make timely payments on every financial commitment and to avoid any blemishes that can potentially have a negative impact. As we move toward a more holistic approach toward lending, customers also need to embrace this philosophy and move toward building an ethical, dependable and trustworthy personality