More households are depending on credit to meet day-to-day expenses, and that’s fueling worldwide credit delinquency. Credit scores for lower-income consumers have dropped to their lowest rates in years, making it even more critical for lenders to have an accurate credit picture before they offer a product.
In his new report, Credit Scoring: A Cornerstone to Credit Extension and Management, Javelin Strategy & Research Senior Analyst of Credit and Commercial Ben Danner explores the traditional and alternative methods to measure creditworthiness. He also examines trends in credit migration and regulation that could shape the industry for years to come.
Traditional Mainstays
Traditional scoring models have been mainstays because they solid predictors of creditworthiness. Individuals in the super-prime segment (with credit scores above 720) generally pay their bills on time, while consumers in the subprime segment (with credit scores between 580 and 619) might struggle.
“There’s a reason why 90% of banks use FICO scores,” Danner said. “There are alternatives like VantageScore, but they don’t quite have the market size FICO does. FICO is the original recipe for credit scoring models, particularly the FICO Score 8. It’s the gold standard of credit scoring for a simple reason. It works.”
The success of the metric hasn’t stopped companies from trying to improve upon it. Credit bureaus have created several models geared to expand upon traditional scoring and measure different aspects of creditworthiness.
Lenders can purchase models that examine a potential customer’s worthiness for a mortgage or auto loan. The models are built off historical datasets, including past home and car transactions. Lenders can even run multiple models on a prospective customer before signing them.
Alternative Answers
There isn’t always historical data to reference, however, which makes it difficult to accurately score an individual. That’s why alternative scoring models have been developed. The models mostly address two populations: unscored consumers, who don’t have a traditional credit score already, and the “thin file” segment.
Thin file individuals could be younger customers who don’t have a mature credit history yet. The segment could also include recent immigrants to the U.S., who don’t have a traditional credit score.
These consumers still want lending products, and there’s been an influx of companies who have created ways to score them. Some of the traditional bureaus like Experian, Equifax, TransUnion, and FICO are also developing products to address the growing niche.
“The reason it’s called alternative scoring is because they’re looking at things like rent payments,” Danner said. “They’re looking at phone bill payments, utility payments. It’s the consumer themselves who provides this data to the bureau because they want a credit score. They might also link their bank account to the bureau to prove they’re ready for credit.”
Migrating Scores
Economists have discovered that credit scores are increasing across all segments. The term they coined to describe the trend is credit score migration, and it started not long after the COVID-19 pandemic.
“The consensus is people took their government stimulus money and paid down their debt, particularly their credit card debt,” Danner said. “In the traditional scoring model that decreases their credit utilization rate and increases their credit score.”
There could be adverse effects to credit migration. If a former subprime consumer increased their credit score, they’re now eligible for cards they might not have been able to obtain a year before. And the stimulus money was only temporary.
“There could be a significant pool of underqualified customers that are now in higher-level products,” Danner said. “Unfortunately, some people will go back to their bad habits and stop paying their bills, leading to increased delinquency and chargeoff rates. As things normalize, credit score models will have to take credit migration into account.”
Buy now, pay later is another popular trend that hasn’t been fully accounted for in the traditional credit scoring model.
“It’s basically little short-term loans, and they haven’t figured out a good way to integrate it yet,” Danner said. “It would actually penalize consumers if it was put into the scoring model as is.”
Cognizant of the Effects
The importance of accurate credit scores means bureaus have to be cognizant of the effects inaccurate reporting has on consumers. The Consumer Financial Protection Bureau has created a consumer complaint database, and there’s been a significant uptick in recent complaints
One of the most common issues is that incorrect information from credit bureaus is impacting an individual’s credit score. Unfortunately, there has been a disconnect on the part of the bureaus when it comes time to investigate inaccurate data.
“It should be one of their highest priorities to follow up with consumers and keep them informed,” Danner said. “It’s extremely stressful if someone has to complain to the CFPB about their credit score. It’s not like disputing an incorrect order a store sent you. This affects an individual’s entire creditworthiness for so many different things in life. It’s a serious thing, and the consumer shouldn’t be left to figure it out themselves.”