Alternative Credit Scoring

Credit scoring is the process through which financial organisations (mainly lenders) assess an individual’s or a business’s creditworthiness.

It occurs during the loan application process for a variety of financial instruments, including mortgages, private loans, and even microfinancing.

Credit reports have always been used. In order to reduce losses from bad debt, the applicant’s credit history is utilised to establish their score.

How Is Credit Scoring calculated?

Credit bureaus are in charge of credit scoring. In simple words, it asks, “How probable is it that the debtor will repay the loan?”

Historically, the following information was used to answer that question:

income statement evidence
evidence of phone or electricity bill payment debt trail credit card usage

In the United States, credit scores are calculated using the FICO model, which has a range of 0 to 999. In the United Kingdom, Experian, Equifax, or TransUnion will construct a credit report, and the credit score will be determined on a scale of 0-999, 0-850, and so on. A lower score, regardless of the maximum on any scale, is always deemed a higher risk of default.

What is the definition of Alternative Credit Scoring?

Alternative data is used to assist the loan application in alternative credit score by asking their payment history for other common services such as phone bills or utilities.

This is an example of “lending faith”. If other firms believe this consumer will pay their bills on time, this customer is more likely to return their debts. Proof of employment plays a similar function, since someone who earns a regular wage is obviously less of a danger than someone who does not.

Employment data can also be linked with industry data, allowing the lender to estimate the debtor’s income level and make offers appropriately.

As you can see, this is a typical technique appropriate for past generations, in which the credit score procedure is based mostly on services they were anticipated to use.

The “online generation” is not only equipped with smartphones and data plans; they are also active on social media and have subscribed to a variety of online services.

Our online presence, often known as our digital footprint, may speak for us more than a thousand words. As a result, this data can be a valuable source of alternative data for credit scoring algorithms.

What is alternative credit scoring?

Credit scoring used to be quite strict, with lenders and credit bureaus relying exclusively on the applicant’s borrowing history to determine creditworthiness. This not only disqualifies applicants with no credit history from receiving a loan, but also causes them to pay higher interest rates on loans they do obtain.

Alternative credit financing solves this issue by assessing applicants’ creditworthiness using current, relevant, and widely accessible data, such as their digital footprint.

Alternative credit scoring assists those who were previously unable to enter the credit system by providing them with cheap loans and access to the system, allowing them a much-needed break to begin improving their credit ratings.

On the other hand, it assists lenders in gaining access to the underbanked segments of the population by extending loans to this new target group utilising alternative credit ratings. This reduces risks for alternative lenders while also lowering interest rates for borrowers based on their alternative credit ratings.

The core of alternative credit scoring is based on 3 tenets:

• Capability

• Consistency

• Willingness

When employing criteria other than credit scores from previous loans, credit scoring firms utilise the applicant’s social and digital data to determine the above three aspects, namely their capacity and willingness to repay the loan, as well as their financial stability to assure full payback.

Credit scoring organisations utilise technologies that run the following types of data via AI and ML-powered algorithms to create an alternative credit score:

• Utility bill payments

• Bank account information

• Telecommunications payments

• Rental and lease payments

Payments for these bills and services demonstrate the applicant’s willingness and capacity to pay their monthly dues on time. This frequently represents a person’s creditworthiness considerably better than a typical credit report would.

This is due to the fact that credit scores displayed on regular credit reports often endure for 2-3 years. During this period, the applicant’s financial discipline may have improved or deteriorated. Someone with a strong credit score may be having difficulty paying their bills on time, and so they may be approved for a loan. A person without a credit score, on the other hand, who is able and plans to pay all of their payments on time, is unable to obtain a loan due to the lack of a credit score.

However, the above-mentioned real-time data, along with business models that expertly analyse the applicant’s behavioural characteristics based on their social media interactions, produce a more trustworthy credit score for the application.

The social credit system is a reality in China, and the United States has already substantially accepted alternative credit scoring. However, due to anti-discrimination rules, alternative data took some time to become a part of the data utilised for alternative credit score in the United States. Credit rating agencies, on the other hand, have recently partnered with fintech businesses to employ more useful and dependable data to develop better evaluations that offer accurate findings.

Lenders are more inclined to lean toward credit rating technologies that are considered to produce the most accurate and reliable findings. This, in turn, will contribute to the strengthening of the lending industry and the inclusion of hitherto unbanked populations.

Keeping this in mind, numerous US government agency executives explicitly acknowledged in December of last year that credit rating in the US has now officially evolved beyond the ordinary traditional criteria and methodologies.

What are the benefits of alternative credit scoring?

Because of the numerous options it provides to both lenders and borrowers, alternative credit scoring is tremendously advantageous to the lending sector in particular and the finance industry in general. Here are some of the additional variables that contribute to the popularity of alternative credit scoring.

– Improved assessment

Alternative credit scoring is more concerned with current factors than with past data. This makes it a better option for applicants who do not have a credit score because their report can be generated based on their current financial discipline and habits, as well as their social interactions, which provide a better picture of their ability, stability, and intent to repay the money they have borrowed. As a result, when it comes to accuracy, alternative credit scoring emerges as the obvious victor.

– Increased market reach

Due to the lack of credit ratings, a huge section of the unbanked population, as well as persons with access to banks but no past credit history, are unable to qualify for loans. Even if they do, the likelihood of their loans being approved is low, since lenders do not want to increase their risk by lending to applicants whose credit history they are ignorant of. Alternative credit scoring has created a market for applicants and lenders that are keen to lend to this specific target group based on their payment discipline and alternative credit score. This not only creates a new market for lenders, but it also gives applicants more loan alternatives and competitive interest rates to select from.

– Enhanced customer experience

Lenders can reduce loan origination costs by employing automated alternative credit scoring procedures, which they can then pass on to applicants in the form of cheaper interest rates. Lenders may considerably minimise bias and mistakes associated with human underwriting by employing automated methods for loan underwriting.

– Better deals for existing borrowers

Existing customers who secured loan approvals based on minimal historical credit information may face higher interest rates since lenders view them to be riskier due to their short credit history/data. Existing borrowers, on the other hand, have a higher chance of refinancing their loans at lower interest rates thanks to alternative credit scoring with real-time data based on their prior eCommerce purchases, bill payments, bank transactions, and more. Since a result, this not only benefits borrowers but also lending businesses that employ alternative credit scoring, as they can get extra business from clients who prefer their services over those of traditional lending organisations.

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