What Is an Alternative Credit Score and How Does It Work?

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What happens when you want to apply for a loan, but your credit history is virtually non-existent? In the past, it would mean your chances of getting approved were zero, but now you stand a fighting chance. For years, lenders have only relied on traditional credit scoring through models such as FICO Score. But recently, a new type of credit scoring has taken on popularity among both lending institutions and creditors: alternative credit score.

In this article, we evaluate the most significant aspects of traditional credit scoring and alternative credit scoring, including what it is and how it works, pros and cons, FAQ.

Alternative Credit Scoring

First, consider the alternative credit score definition.

For credit risk assessment, alternative credit rating refers to the use of data from digital platforms and applications on client behavior. Credit bureaus were once the only source of consumer credit data, used by lending institutions to reduce bad debt and market risk.

This alternative method is mainly used for people with poor credit scores or no credit scores. Alternative credit scoring assists individuals—who had previously been unable to access the credit system—by providing them with simple loans and access to the system, allowing them to begin building their credit scores. Using this credit assessment tool expands the credit to a new targeted audience, helping lenders gain access to the underbanked parts of the population. This also reduces alternative lenders’ losses, while lowering borrowers’ interest rates based on their alternative credit ratings.

Traditional Credit Scoring vs Alternative Credit Scoring

Traditional and alternative credit scoring models both seek to accomplish the same goal but differ in how a certain credit score is calculated. Although there are multiple differences between traditional scoring and alternative credit scoring, the key disparities lie in the factors needed for the calculation.

Traditional Credit Scoring

Lenders use traditional scoring to assess a risk associated with a borrower, i.e., how likely a borrower is to default on a loan. To calculate a credit score, credit rating agencies would need a variety of data, including:

Payment History

Payment history provides insight into whether a borrower has ever missed a payment or defaulted on a loan.

Credit Utilization Ratio

This type of ratio indicates whether a borrower has a diverse borrowing portfolio.

Number of Open Accounts

The number of accounts a borrower has played a large role in credit scoring. It shows how the borrower has managed multiple payments in open accounts.

Current Debt

More debt equals more financial attachments that need to be managed. This poses a bigger question of whether a borrower can handle another payment, on top of everything else.

Length of Credit History

Credit scoring models always take the length of your credit history into consideration. Older accounts display a sense of better payment history.

Credit bureaus can also use public records to obtain a more comprehensive image of a borrower’s financial history. They’ll then assign a score between 300 and the better number of 850. Commercial banks may set their own lending minimum credit ratings, but anything over 700 is usually considered “excellent,” according to Experian. This is why many turn to popular credit repair companies to bump up their score.

Fixing your credit score to get a loan, however, is not that simple, since not everyone has a credit history. As a result—despite having the financial means to make monthly payments on time—a considerable unserved portion of the market (roughly 1.7 million people, worldwide) is left behind. This is why the alternative credit score is slowly gaining ground among lenders and even among credit bureaus. Alternative scoring is used to determine the risk posed by a borrower who either has a low traditional credit score or no credit score.

Alternative Credit Scoring

This type of scoring provides borrowers (with no credit history) an opportunity to get a loan by calculating their score based on a variety of factors. To calculate an alternative credit score, a lender typically needs the borrower to provide data from their:

Rent, Utilities, Cable, or Cell Phone Payments

Does a borrower make payments on time and in full? This information would indicate responsible behavior on the borrower’s part.

Account

Checking account data suggests whether a borrower’s financial situation is stable, which further adds to an overall alternative credit score.

Shopping History

A person’s shopping history says a lot about how they manage their finances. Will a borrower make unneeded or frivolous transactions if they lack the financial resources to support them?

Property Records

Has a borrower made an investment in a home? If a borrower has invested in property, this usually shows the capability to responsibly handle larger debts and pay them off.

Payments toward these bills or properties demonstrate the applicant’s willingness and ability to pay monthly bills on time. All of this contributes to a better alternative credit score. Some alternative credit scoring models would also look at a borrower’s education, occupation, and even social media activity—although such activity adds very little value to a final alternative credit score.

What Are Alternative Credit Scoring Models Based on?

An alternative credit report is based on factors that make it more accurate when assessing the borrower’s current financial situation and potential. With such alternative credit scoring models, credit scoring companies use a method of evaluation based on three factors of the borrower:

  • Ability to pay on time—based on rent, utility, cable, or cell phone payments.
  • Financial stability—based on checking account data.
  • Willingness to pay on time.

Companies using alternative scoring models care about the borrower’s ability and willingness to repay a loan and if they are financially secure enough to guarantee full repayment.

Who Provides Calculations for the Alternative Scoring Model?

The necessary information for alternative credit calculation is provided by Loan Origination Software (LOS). For lenders of various types of loans, LOS manages the submission and issuing process. For lenders, these technologies automate significant portions of the loan process, and for borrowers, they streamline the application process. This alternative credit scoring software is designed to automate credit scoring, thereby minimizing risk—giving customers more control through a self-service platform while managing loan-related documentation. It also gives lenders complete visibility toward who is receiving loans.

Benefits of Alternative Credit Scoring

Alternative credit scoring provides many benefits for both borrowers and lenders, such as:

Improved Assessment

This type of method of evaluation focuses on the borrower’s current parameters, instead of historical data. Alternative credit reporting uses a variety of financial data, including utility payment history and rental payment history, to provide previously invisible borrowers with greater access to borrowing opportunities.

Increased Market Reach

Alternative credit scoring financial inclusion can be achieved through credit scoring, which has created a niche for lenders who are willing to extend loans to a specific target group, based on payment discipline and alternative credit score. This target group consists of a significant majority of the unbanked population, as well as those with bank accounts but no credit history—those who are unable to apply for loans.

Enhanced Customer Experience

Lenders can reduce loan origination costs by using automated alternative credit scoring systems, which they can pass on to applicants in the form of lower interest rates. Lenders can greatly minimize bias and errors associated with manual underwriting by using automated underwriting processes.

Better Deals for Existing Borrowers

Current borrowers are able to refinance their loans at lower interest rates, thanks to alternative credit scoring based on real-time data from past e-commerce purchases, bill payments, bank transfers, and more.

The Future of Alternative Credit Scoring

Using alternative credit data to determine a credit score is now a widely used model in the US. It has aided both fintech-powered lenders and new borrowers by increasing credit availability. Alternative credit scores are expected to shift the lending landscape in such developing countries as India and China, according to industry insiders.

Drawbacks of Using Alternative Credit Scoring

Alternative credit scoring is not without drawbacks. According to any potential borrower, the main disadvantages of this type of credit scoring include:

  • People are not willing to disclose such information as shopping habits, work history, or detailed aspects of utility bills.
  • Concerns about privacy issues.

Although some information is beneficial to alternative credit lenders, not every borrower wants to disclose data about their shopping habits or work history when applying for a loan.

One of the biggest concerns that borrowers have is the impact on privacy. Obtaining an alternative credit score requires giving a lot of personal information, such as rent, utility, cable, and cell phone payments, as well as checking account data and property records. It’s only natural that people can be put off by this, as a thin line exists between gathering data that would benefit a borrower’s portfolio and violating their privacy.

Who Is the Best Candidate for Alternative Credit Scoring?

Alternative credit scoring has many benefits for both the lender and the potential borrower, especially for those with low credit scores.

According to credit score statistics, traditional credit scoring methods show that any score below 580 is a poor credit score. If this is your credit score state, you’re a high-risk borrower, which lowers the chance of your application getting approved.

There are ways on how to get a loan with bad credit and no money, but these methods are few and far between and are usually quite costly. Traditional scoring models reveal scores from data on past activities of your credit history, which might not reflect your current situation. Alternative credit scoring, however, aims to be as recent and as applicable to your current financial situation as possible.

No Credit Score

There are many in the US who have bank accounts but no credit score, including students, homeowners, and retirees. These may have the ability to make monthly payments on time but still have no credit score. Having no credit score deems you to be a high-risk borrower. Alternative credit scoring gives people a chance to build a credit score that reflects their true creditworthiness. Also, you can explore credit builder loans, maybe that will help you if you don’t have a credit score.

Lenders Looking to Expand Services to the Unbanked Section of the Market

Although credit history is the conventional and most popular way to determine creditworthiness, it’s simply not available to unbanked citizens. However, in case you have a bad credit score, check these personal loan lenders. Credit lines for the unbanked are now quicker, cheaper, and more creditworthy, thanks to alternative credit scoring and predictive models.

Conclusion

Alternative credit scoring is a way to determine creditworthiness based on alternative data for credit scoring, i.e., existing, relevant, and easily accessible data. It allows any high-risk borrower (the unserved portion of the market) a possibility to build a credit score, which can subsequently aid them on credit applications. Alternative credit scoring also ensures better deals for existing borrowers, improved assessment of your credit score, and enhanced customer experience.

FAQ

What’s a credit scoring system?

A credit scoring system enables lenders and other financial institutions to determine creditworthiness. If a person’s credit score is poor, they would likely pay more to borrow money, buy a house, or finance a car.

What’s the purpose of a credit score?

Credit scores are used by such lenders as banks and credit card firms to assess the risk of lending money to borrowers and reduce losses, due to bad debt. They are also used by lenders to decide who is eligible for a loan, at what cost, and with what credit limits.

Do utility bills affect alternative credit scores?

This question is often raised both for traditional scoring and alternative credit scoring. Your utility costs can be taken into account when calculating your alternative credit score. In most cases, you’ll need to sign up for a program to receive the benefits.

ABOUT AUTHOR

I learned a lot about finance after working for a digital marketing company specializing in investing and trading stocks, forex, etc. After that, I got exposed to other verticals such as wealth management and personal finance, which further improved my understanding of the financial world.

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