In 2015, the Consumer Financial Protection Bureau (CFPB) released a study finding that 26 million Americans did not have a credit history, and another 18 million were “unscorable” because their histories were too limited. Since then, policymakers, advocates, and the financial industry have all proposed ways to help people without credit scores, many promoting the use of alternative data.
It’s likely that the CFPB study numbers have increased since the research was commissioned. Historically, many lenders have assumed that consumers with limited or nonexistent credit histories are bad credit risks. However, a LexisNexis study found that nearly two-thirds of these consumers are low-risk and could be considered good and profitable customers for lenders. If alternative sources of data can help correctly gauge these consumers’ risk, auto lenders may be able to generate credit scores that more accurately reflect default rates and therefore expand credit access to this broader population.
Be mindful of regulations
There are many unanswered questions about the use and accuracy of alternative data in general. Data mining to determine credit, employment, or insurance is covered under the Fair Credit Reporting Act. Before you tap into any data providers, make sure they are in compliance with the law. If alternative data is used in credit decisions, the Equal Credit Opportunity Act also applies, and lenders must ensure that there is no disparate impact on protected groups.
In 2017, the CFPB issued a request for information (RFI) regarding the use of alternative data and modeling techniques in the consumer credit marketplace. The CFPB sought to understand the potential benefits and risks of alternative data and modeling techniques, as well as to assess the responsible use and to lower unnecessary barriers, including any unnecessary regulatory burden or uncertainty that impedes such use. However, no statements have been issued by the CFPB on the use of alternative data, and in light of the agency’s other challenges, commentary may not be forthcoming any time soon.
Although clear and practical guidance from regulators remains elusive, the use of consumer protection products attached to auto loans does give lenders some direction on the “value” of the consumer’s credit worthiness. It’s definitely something to consider.
Consumer protection products attached to an auto loan can be associated with alternative data, positively impacting credit worthiness.
Consumer protection products have the potential to reduce risk by addressing the consumer’s ability to make their loan payments when life takes a turn. For example, consider a consumer rebuilding their credit and savings who may be living paycheck to paycheck. For this consumer, a deviation from their monthly budget can challenge their ability to make a car payment. Products such as vehicle service contracts and vehicle return protection can lower the disruptions of timely vehicle payments when the unforeseen occurs.
For those customers who have no, or limited, credit histories, consumer protection products signal to prospective lenders that this consumer is invested in protecting their assets and deserves a second look as a potential good credit risk. But be careful how you position consumer protection products. Remember, they are not a “fix” for sketchy credit. Instead, they are another way lenders can better protect their portfolio from default and delinquency, and should be considered as another data point in the alternative data evaluation.