Alternative creditworthiness metrics (ACMs) are qualitative and quantitative data that predict consumer default risk based on present-day circumstances, contrary to FICO and other conventional models that rely solely on historical information.
Common examples include income, bill payment, non-mortgage debt-to-income (DTI), settled delinquent accounts, job stability, inquiries on account, and other proprietary data lenders collect and compute.
ACMs are not the same as alternative data for investing, which refers to the use of geo-spatial and social media data to predict movements in the secondary stock market. These are data investors use to gain a competitive edge in choosing securities, but they are not relevant to ACMs.
Summary
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Alternative data is information not included in FICO scores.
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It focuses on consumers present-day circumstances rather than historical data.
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It reflects consumer capacity to handle debt.
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It is growing in importance and will likely be included in scoring in the future.
Key Takeaways for Consumers
Lenders that use alternative data give consumers more credit for their current situation than their past, for good or worse. They consider the present a better indicator of trustworthiness than the past.
It's important to note that creditworthiness is not a judgement of individual character but rather of numerical risk. Honest, hardworking Americans can find themselves in tricky situations that force them to skip a payment.
Definition
Alternative creditworthiness metrics assess borrower risk based on current financial circumstances at the time of a loan application, rather than relying solely on historical credit report information used in traditional scoring models like FICO.
Different than Credit Scores
The important distinction to make is that alternative metrics are wholly separate from credit scoring models such as FICO and VantageScore. These scores are numerical representations of the information included on credit reports, which exclusively contains historical borrowing and spending habits.
Alternative metrics focus on information about borrowers' current circumstances, such as income. The advantage of using up-to-date information is relevance. The argument is that current circumstances more accurately reflect a borrower than his/her past.
In a sense, creditworthiness models make assumptions about human behavior. Past behavior may or may not inform the future. FICO assumes the past informs the future, but its calculation is not absolute. Even before thinking about the math, it's easy to imagine examples to the contrary.
For example, a young student may default on credit cards because he has no source of income, then move into a high-paying profession. His past does not accurately reflect current trustworthiness.
Moreover, a successful entrepreneur can go broke. He may have an impeccable record, then suddenly default on new personal loans.
Alternative metrics assume that a person's current circumstances are more representative than past behavior. The issue with alternative metrics is that they are smaller in number. Past behavior encompasses years of behavioral details, but the present only provides a snapshot in time.
Finally, some metrics do not clearly fall under past or present. Stable employment, for example, is an ACM, but it is a factor that started in the past and continues in the present.
Examples
Many proponents of alternative creditworthiness metrics, especially lenders, use marketing terms such as "cash score" by Petal, but underneath the branding are a finite number of indicators. They include
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Income. Current, stable salary is considered a sign of creditworthiness because it demonstrates an ability to maintain earning stability. Note that salary, and not freelance or other 1099-style income is less dependable.
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Cash on deposit. Borrowers with a significant amount of cash on deposit display an ability to manage the spread between income and expenses, which suggests a mature understanding of money management.
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Stable employment. Employment is similar to income but refers to maintaining the same employer over a long period of time. Some consider this factor contradictory because salary increases are typically accompanied by changing employers, but the reality is that maintaining an employer suggests stability for creditworthiness purposes.
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Non-mortgage debt-to-income. Debt-to-income ratio is not new, but specifying a DTI without mortgage information is informative because it not only shows how much space for unexpected expense the borrower has but also his/her tendency to use debt for nonessential purposes (things other than a home for living).
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Bill payments. Staying up-to-date on recurring bills such as mobile phone and cable TV payments, as well as some popular subscriptions, shows reliable behavior on expenses that most Americans have.
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Unpaid debts (currently). Unpaid debts are obligations that borrowers does not pay. They are not the same as debts with regular intervals still being reimbursed. For example, an unpaid credit card debt that has charged-off is still due for payment from the borrower even though collection activity has stopped. Unpaid debts signal a present-day risk because they represent a current tendency to ignore debt.
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Recurring account withdraws & deposits. Regular banking withdraws and deposits provide insight into consumer habits.
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Stable housing situation. Longstanding rental or home-ownership circumstances signal stability for creditworthiness purposes.
Concept of Creditworthiness
Creditworthiness is a measure of borrowers' likelihood to understand and reimburse their debts according to standard installment and revolving debt practices, and more specifically, according to each debt agreement they sign. By reverse logic, creditworthiness is also a measure of the risk that borrowers default on their debt obligations.
Many consumers mistakenly interpret creditworthiness as a judgement of their honesty and character. The reality is that well-meaning Americans with a strong reputation for keeping their word can find themselves in situations where they have no choice but to not make payments (or miss one due to technical errors).
In other words, creditworthiness is a numerical assessment of risk based on factual evidence and not an assessment of the person's character. This is true despite FICO's claim to predict default risk based on personality.
It can be likened to an all-star athlete who suffers a crippling injury. All of the evidence suggests she will perform well, but her injury raises serious doubt about future performance.
Purpose
The purpose of alternative creditworthiness metrics is to provide near real-time risk-assessment data so lenders can make more accurate decisions than they would by depending solely on historical information such as credit reports and FICO scores.
Lenders who adopt ACMs often combine them with conventional data, which provides a holistic picture of default risk. However, the possession of data is not the same as its analysis, and ACMs' position in loan underwriting is still nascent in 2023 due to a lack of model development.
Instead, the primary use for ACMs is the subprime lending space, or more specifically, in credit building. This is the primary use case for ACMs, discussed next.
Use Cases
The primary use case for alternative metrics today is credit building products. For example, many unsecured credit builder loan (CBL) lenders employ ACMs to accept borrowers with below-average credit and provide money up front.
This dynamic stands contrary to normal CBLs that withhold funds until the total value is paid into a secured account.
Positioning in the "5 Cs" Credit Risk Framework
A longstanding framework for assessing creditworthiness is called the "5 Cs of Credit." These "Cs" are capacity, capital, conditions, character, and collateral.
Capacity refers to the borrower's income and debt. Capital refers to personal cash contributed under a loan agreement. Conditions refers to the use of the debt. Collateral refers to assets pledged in case of non-payment. Character refers to the borrower's past relationship with debt—good or bad.
Alternative metrics primarily impact capacity. They consider elements in the borrower's current circumstances that impact his or her ability to fulfill debt obligations. However, they can range from transactional data on credit cards to social media behavior analysis.
Conclusion
Alternative metrics paint a clearer picture of borrower risk by focusing on present-day circumstances rather than solely on past behavior. They examine information absent in classic scoring models such as FICO, and notably create borrowing opportunities for consumers with below-average credit profiles.
Despite the current separation, however, FICO's VP of Scores & Predictive Analytics, Ethan Dornhelm, expects to include more alternative data in future FICO scoring models.
