It is a little secret that, globally, traditional models of credit scoring are “broken.” In the United States alone, several attempts have been made in recent years to overhaul the system lenders use to determine an applicant’s creditworthiness. These attempts have produced relatively little success, leaving lenders and consumers alike struggling to find an answer.
No amount of reform, though, can address one of the central problems of credit scoring as we know it today: There is a large segment of potential borrowers who have the ability and willingness to repay their debts, but who lack the credit history to qualify for traditional lending.
The sheer number of potential borrowers who are underbanked and lack credit history is staggering. Globally, 1.7 billion people – roughly 20% of the world’s population – do not have an account active with a financial institution or a mobile money provider.
China has the largest number of unbanked citizens in the world 225 million. About 190 million of India’s citizens are unbanked, as are 70.4 million in Bangladeshand 100 million people in Pakistan. Millions more in Indonesia, Mexico, and other countries also lack the financial stability that a bank account can provide.
Similarly, countless millions around the world do not have credit scores. In the United States alone, 22% of consumers do not have credit scores.
Of these consumers, half do not have any credit history reported to Equifax, Experian, or TransUnion, the country’s three major credit reporting bureaus. These consumers are considered “credit invisible,” meaning that their credit files contain no information.
The remaining half have “thin” or “stale” credit files, meaning that the information is inadequate or too old to use in calculating the consumers’ credit scores and therefore assess their creditworthiness.
The Paradox of Having No Credit History
Clearly, the problem of being unbanked and having no credit history creates an insurmountable obstacle for a large portion of the world’s consumers.
Many of these people are eager for an opportunity to prove their creditworthiness, and to earn the chance to borrow larger amounts in the future. The leverage that credit could provide them could, in many cases, give them the opportunity to give their families comfortable lives for the very first time.
Yet these same people lack the very opportunities that could dramatically change their futures, keeping them stuck in a cycle of misfortune that can last for generations. They cannot convince potential lenders to “take a chance” on them, so they can’t build the kind of credit history lenders look for when evaluating applications.
These consumers are repeatedly turned down, not because they have demonstrated the inability to repay their loans on time, but because they cannot demonstrate any credit repayment activity at all.
This, of course, creates a classic paradox – consumers can’t obtain credit because they need evidence of previous credit repayment;however, they can’t provide evidence because they haven’t been able to obtain credit.
These consumers avoid credit requirements whenever possible by paying for items in cash. For large purchases, financial emergencies, and other necessities, though, buying with cash is not always possible or practical. Likewise, there are circumstances when cash is not an option – in many states across U.S, UK and the EU, for example, car rental companies do not authorize rentals without a valid credit card. Examples stretch as far as South Asia like Bangladesh and India where majority of hotel bookings and travel tickets require a credit card, with rare acceptance of debit card and cash is not an option.
Businesses Suffer Along with The Unbanked
The traditional credit scoring system doesn’t just set consumers up to become stuck in an unbreakable cycle of needing credit but being unable to obtain it; it sets financial institutions up to miss out on loyal customers who pay on time and are grateful for the opportunity to borrow.
In Bangladesh, lenders are missing out on the chance to access the market of 71.75% of small business owners and around 55 million low-income salaried individuals who currently do not have credit scores. Similarly, businesses around the world are settling for sub-par revenues and profits because they cannot reach millions of unbanked and credit invisible customers.
The lack of a stable credit scoring system that accounts for more than just a consumer’s borrowing and payment history is critical for these businesses to tap into this audience of consumers.
In many cases, businesses would need to do little else to experience double-digit growth in a short amount of time. They would likely be able to sustain this growth as additional unbanked and credit-invisible consumers enter the marketplace.
Why don’t current alternative lending solutions work?
When presented with the problems faced by today’s credit-invisible consumers, economists typically point to the non-traditional lending industry such as microfinance institutions as a solution to help these people obtain credit.
While these lending solutions have certainly helped certain consumers build attractive, consistent credit files, there are several problems that make them a poor choice for many potential borrowers:
- They often come with exorbitant interest rates– in most cases, as high as 40%. Some of the so-called payday lending companies in the US dragged interest rates as high as 589% at the peak of the pandemic in 2020.
- They frequently have terms that are particularly dangerous to consumers – missing a payment by even a few days could dramatically affect a loan’s interest rate, and that’s on top of late fees that could be $40 or more. These not only increase the overall cost of the purchase; they increase the risk of default if the consumer is unable to absorb these financial penalties.
- They’re designed for borrowers with spotty credit histories, not for first time borrowers or borrowers with no credit history at all. Every aspect of a typical non-standard loan is designed to give maximum protection and profit to the lender up front, in case the borrower defaults on the loan. This places unduly heavy demands on consumers that may never end up missing a single payment.
These lending solutions certainly have their place in the global lending landscape. Because of their purpose and design, though, they are often ill-suited for unbanked and credit-invisible consumers who deserve access to better options.
Many unbanked and credit-invisible consumers believe they have no options, except for high-interest non-traditional lenders whose practices are borderline predatory.
Fortunately, a movement is slowly but steadily emerging to give new hope to consumers who lack credit histories and/or bank accounts:
Alternative Credit Scoring gives consumers a chance – and a choice.
Although the current, rigid credit scoring system used by traditional lenders today has changed very little in the past several decades, a new alternative approach to credit scoring is slowly emerging. With it comes the promise of lending opportunities for hundreds of millions of consumers around the world.
These consumers get the leverage they need to build a future for themselves and their families. Businesses get the ability to sell to these consumers; more importantly, though, they get the opportunity to become “go to” brands for the consumers they help.
Simply put, an alternative credit scoring model uses information outside of an applicant‘s payment history to determine the applicant’s ability to repay. It gives previously “invisible” consumers easy access to the lending they need, without the high interest rates and unfavorable terms of non-traditional lending.
Alternative credit scoring factors in much more than simply the applicant’s previous credit history. Advocates know that a lack of credit does not equal the inability to pay, and that lenders should examine a variety of other factors when insufficient credit history is available to make a confident lending decision.