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Alternative credit scores are proving to be useful to new lenders

Jul 16, 2015 Walt Wojciechowski

Alternative credit scores are proving to be useful to new lenders

Many Americans are ignored by traditional credit rating systems, which only take into account certain factors that do not apply to everyone. For example, FICO's scores focus primarily on big ticket items like mortgage payments, auto loans and credit cards.

But the nation is evolving, and many millennials have chosen not to partake in traditional methods of accruing credit. The generation does not, as a whole, place a large emphasis on home or car ownership and credit card use. This means that some of its constituents may find themselves in very financially stable circumstances, but unable to generate a credit score, and therefore unlikely to successfully apply for a loan from the bank.

Good news for those with insufficient credit histories - new lenders don't care

The alternative lending market emerged as a major player in the distribution of capital to businesses and consumers alike shortly following the economic collapse. Banks became more stingy and significantly raised the bar for their loan requirements as a way to remain viable in the midst of global financial despair.

Entrepreneurs saw an opportunity to fill the lending void for those without immaculate credit histories, and thus, the alternative lending sector was born. Today, the industry is well-established and competing directly with banks. A major reason for success in this vertical has been the development of alternative credit scores.

USA Today reported that lending startups do not favor traditional ratings, instead evaluating a variety of other factors that they believe more accurately assess risk. For example, the source said that alternative lenders are looking into publicly available information such as tax histories, social media profiles - particularly LinkedIn connections - and, in the case of small businesses, even looking at reviews on Yelp to best quantify the risk that is attached to each applicant.

In most cases, those who fail to generate a credit score simply do not have an extensive history of making payments because they have not made any expensive investments or purchases, USA Today suggested. Instead of punishing this demographic, alternative lenders are getting a better sense of their situations by looking into rent, cable and mobile device bill payments, among other factors that improve rating accuracy.

FICO scores are being ignored by alternative lenders
Forbes contributor Nick Clements argued that FICO scores, which have long been the standard to which traditional lenders adhere, have been given a disproportionate role in determine credit risk. However, the source also said that this tool proved to be woefully inaccurate after the economy collapsed, as banks that had exclusively used the scores to ascertain the viability of lending to borrowers turned out to be completely wrong in their estimations.

Clements noted that since millennials represent one of the largest consumer groups on earth, but many do not use credit cards, FICO scores are essentially useless at this point in time. Members of this demographic are shunning credit cards because of apprehension that stems from the financial crisis, and are accumulating savings. Avoiding credit should not eliminate someone from contention for a loan, he asserted, especially since millennials as a whole exhibit favorable credit risk.

Instead, new score generators are evaluating cash flow, savings and utility bills paid, among other factors. This development can open up new opportunities for those with insufficient credit to generate a score to potentially receive funding for their entrepreneurial aspirations, among other purposes. The millennial generation is not participating in traditional methods of generating credit to the same extent that its predecessors did, so it is important for lenders to identify more appropriate methods of measuring the risk of such applicants.