Credit scores that look only at traditional credit data can tell lenders how financially responsible a person is when it comes to paying back debt – but only as far as their credit reports show. Learn how alternative data is changing credit scoring.
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Credit scores that look only at traditional credit data can tell lenders how financially responsible a person is when it comes to paying back debt – but only as far as their credit reports show. For people who don’t have credit cards, loans or other lines of credit in their name, establishing and building good credit can be a challenge.
The use of alternative data, however, is bringing changes to credit scoring. The goal of this effort is to safely, responsibly expand credit access – to those with no score, first time homebuyers, millennials and Gen Z new to credit, and those with less than strong credit scores – and help these groups reach their financial goals.
What is alternative data?
Alternative data consists of information that is found outside of the three major credit bureaus and is used to add more diverse insight into a consumer’s potential to handle credit responsibly.
For example, FICO® Scores, which are used by 90% of top U.S. lenders, are based on five key factors:
- Payment history (35% of your score)
- Credit utilization (30% of your score)
- Credit age (15% of your score)
- Credit mix (10% of your score)
- Inquiries for credit (10% of your score)
Those factors are predictive of how people manage credit. For instance, if you have a credit card or a personal loan in your name, lenders can report your payment history and balance to the credit bureaus. That, in turn, would provide data for a credit score to be calculated on your behalf.
Alternative data, on the other hand, goes beyond credit accounts, including, for example, assessing how responsible people are when it comes to managing their money and keeping up with financial obligations. This can provide a more comprehensive view of a borrower’s ability to responsibly manage debt for those with less traditional credit data available from the credit bureaus while still enabling lenders to focus on keeping with the fair lending laws designed to ensure they provide fair and uniform services and credit decisions. For example, it can include things like:
- Utility and cellphone payments
- Rental payments
- Checking and savings information
“The use of alternative data means lenders are now in a position to find value in nontraditional data sources, such as public records, utilities and rental history, says Solomon Semere, senior director of credit risk, LexisNexis Risk Solutions. “This has created an opportunity for financial institutions to address the significant challenges faced when trying to serve unbanked or underbanked adults.”
Alternative data seeks to provide a comprehensive view of consumers’ risk profiles
The inclusion of alternative data in credit scoring models is designed to help lenders gain a more robust view of a borrower’s creditworthiness. The obvious upside is that borrowers who may have been denied credit cards or loans in the past could gain access to credit with more ease.
In other words, the use of alternative data enables lenders to create a more complete picture of a potential borrower’s financial health. In place of credit card or loan payments, lenders can gauge a person’s ability to repay debt and their likelihood of doing so based on how they pay their rent and other bills or how they manage their bank accounts. This helps dispel one of the myths about unscorable consumers, which is that they’re somehow inherently not creditworthy.
According to Semere, LexisNexis research shows that alternative data can score between 80% and 90% of otherwise unscorable consumers. Of those newly storable consumers, more than half have financial habits and credit usage patterns that put them on par with prime or near-prime borrowers, he says. “Once these consumers are brought into the mainstream economy, they can build a more traditional credit profile.”
How to score with little or no credit history
If you’re one of the 50 million or so people with thin or no credit history, you might be wondering how you can make the most of alternative data for credit scoring. At this time, its use is still limited, but there are ways you can put it to work.
For example, FICO uses alternative data to calculate its UltraFICO™ Score. This scoring model allows you to create an account and securely link your checking accounts, savings accounts and/or money market accounts. Data from those accounts, such as balances and transaction history, is then used to generate an UltraFICO Score.
FICO estimates that as many as 15 million Americans could have an UltraFICO™ Score, even if they lack the traditional credit history to establish a standard FICO® Score. Additionally, FICO suggests that 7 in 10 consumers who maintain positive balances in their bank accounts and keep cash on hand consistently could have a higher UltraFICO Score than a FICO Score based on traditional data.
FICO® Score XD is a similar product, although it uses other alternative data sources such as payment history from telco and utility companies as well as public records. According to recent data, FICO Score XD gives lenders the ability to assess the risk of more than 70% of consumers applying for credit who do not have enough credit history to receive a standard FICO Score based upon traditional credit bureau data.
Signing up for Experian Boost is another option. This service, offered by the Experian credit bureau, allows you to get credit for paying utilities, cellphone service and streaming services on time each month. According to Experian, the average user saw a 13-point improvement in their FICO® Score 8 by using this service.
While you could reap the benefits of alternative data by continuing to pay rent and other bills on time and manage your bank account responsibly, you can take things one step further. For example, you might consider applying for a secured credit card.
Secured credit cards can be easier to qualify for if you have thin or no credit. The catch is that they usually require you to make a cash deposit, which also doubles as your credit line. But if you can spare a few hundred dollars for the deposit, you could begin using a secured card to demonstrate credit history.
The most important rules to remember are making your secured card payments on time and keeping your balance low relative to your credit limit. Those habits can help you demonstrate positive credit history over time, in addition to any benefits associated with the inclusion of alternative data.