Even though credit scores play a key role in determining who gets a mortgage and at what terms, the current credit system disadvantages a disproportionate share of low-income consumers who don’t have enough information in their credit files. To better allow these consumers to access credit or access it at better terms, lenders can leverage alternative data not found in traditional consumer credit reports.
These consumers are disproportionately people of color who, by choice or circumstance, manage their financial lives mostly with cash. Without using credit, they don’t have credit scores or have subpar scores. This can compound historic inequities and prevent them from accessing the generational wealth-building opportunities available via homeownership and other credit opportunities. As of October 2020, 31.5 percent of Hispanic consumers and 45.1 percent of Black consumers had subprime credit scores, but only 18.3 percent of white borrowers did. Using alternative data could provide an on-ramp that could allow many of these consumers to improve their credit prospects.
Experts from government, nonprofits, and industry discussed the benefits of alternative data at a recent Urban Institute virtual event moderated by Laurie Goodman, vice president for housing finance policy at Urban. These data could enable credit scoring for more than 50 million currently unscoreable consumers and raise credit scores for those with thin files.
Alternative data could improve the accuracy and fairness of credit scoring
During the event, speakers unanimously stressed the need for greater use of alternative data, particularly data that consumers have specifically granted potential lenders access, or “consumer-permissioned data.” Keynote speaker Grovetta Gardineer, senior deputy comptroller for bank supervision policy at the Office of the Comptroller of the Currency (OCC), emphasized that millions of consumers without traditional credit scores “may be hard-working, responsible people who regularly pay their bills on time” and could be deemed creditworthy if scored using “their full financial record.” These records could include history of paying monthly rent, utilities, and cell phone bills, as well as consumers’ general management of deposit account cash balances.
She cited FinRegLab research that “found cash-flow data to be predictive of credit risk across providers, products, and borrowers.” Gardineer said that lenders using alternative data “need to be sure what they’re looking at are indicators of risk—not race.” OCC’s Project REACh, a collaboration of business, banking, technology, community, and civil rights leaders, is looking at options for equitably scoring alternative data to expand inclusion, particularly for people of color and those historically excluded from full participation in the financial system. The group hopes to announce pilots later this year to test potential ways of scoring alternative credit, Gardineer said.
Research by FinRegLab supports greater use of alternative data, finding that cash-flow data can predict credit risk where traditional bureau data are not available and provide additional insights when two sources can be used together. Kelly Cochran, deputy director of FinRegLab, noted that “about 20 percent of US adults can’t be scored using traditional credit reporting because of insufficient information.” But 96 percent of US households have a bank or a prepaid account, and 91 percent of US adults have at least one utility account in their name. As such, these data have become a major focus of efforts to leverage consumer-permissioned data to improve the accuracy and fairness of credit scoring and underwriting.
But achieving those goals also depends on how alternative data are used. Shawn Rife, director of risk scoring at Experian, explained that consumer-permissioned alternative data can give consumers an entry point into building credit and empower consumers “to take charge of their credit.” Consumers would control which alternative data prospective lenders can access for credit evaluation, which can help improve their credit prospects.
Currently, traditional credit bureaus generally see only if someone has unpaid utility or cell phone bills that have been turned over to collections agencies. But with consumer-permissioned data, a consumer could permit lenders to access their record of paying bills on time. Instead of only being penalized for missed payments, a consumer could get rewarded for on-time payments.
Alternative data can also be fed into credit scoring models to generate more accurate credit scores. FICO offers two alternative data scoring products—FICO Score XD, which uses utility, phone, and TV bill payment data, and UltraFICO Score, which uses deposit account information. David Shellenberger, vice president for scores and predictive analytics at FICO, said that alternative data such as utility, phone, and TV bill payments or deposit account information make it possible to “score millions of consumers and help them obtain their first credit.” Similarly, an Experian offering allows consumers to boost their credit score by providing information pertaining to their TV, phone, and utility bill payments. For millions of consumers at the margin, such additional information can be the difference between getting approved or being denied.
Questions remain over the implementation and regulation of alternative data
Despite the benefits of alternative data, panelists cautioned that taking alternative data at face value could perpetuate inequities already baked into it. Michelle Singletary, personal finance columnist for the Washington Post, stressed the need to put data in proper context and noted that low-income households may struggle to pay rent “not because they are not responsible but because housing is very expensive.” Similarly, using bank account balances as an indicator of financial management can disadvantage people with low-paying jobs.
Other questions remain about who collects alternative data and how, what laws and regulations govern the companies that use the data, and what data security and privacy protections are needed. The Consumer Financial Protection Bureau is already digging into these questions and will issue a rulemaking on consumer access to financial records that will play a significant role in determining the safeguards needed for accessing and transmitting customer-permissioned data.
Even if these hurdles are overcome, there is no guarantee that regulators will permit regulated entities to use alternative data for underwriting. This is especially true in the mortgage lending space where the government-sponsored enterprises, under the regulatory authority of the Federal Housing Finance Agency, require lenders to use an outdated version of FICO even though improved scores are available. Because government-sponsored enterprise originations constitute, on average, 50 to 60 percent of all originations in most years, their adoption of alternative data is necessary for widespread downstream adoption in underwriting mortgages.
Our traditional system of credit reporting works well for those with established credit histories, but it unfairly penalizes people who don’t use credit. Although alternative data will not create equality, it could reduce financial inequities and improve the accuracy of underwriting. But the panelists agreed that making progress toward adopting alternative data will require buy-in from policymakers, regulators, industry, and other stakeholders.