Since 1989, the three digits of a FICO score have made the difference between credit or no credit for America’s consumers and small businesses. Fair, Isaac Corp. (now called FICO just like its product) created the score to help lenders evaluate a person’s financial history and decide whether he or she poses a lending risk. The FICO score was a definite improvement over the archaic way in which lenders evaluated creditworthiness in the past (like looking for a firm handshake). FICO score evaluation has evolved over the years, thanks to changes in the data collected by the three major credit bureaus, like last year’s decision to handle medical debts differently than other unpaid bills.
These changes were necessary, but have not been sufficient to help all of the U.S. small businesses that need additional capital. This is why more than a few of the technology-fueled companies in alternative finance are challenging the value of consumer credit ratings, like FICO, in business lending decisions.
More than your score
Alternative finance companies recognize a poor credit score is only one measure of a business owner. It offers some relatively objective insight into a person, but is only one of the many data points which alternative finance companies like mine use in our underwriting. It does not tell us everything we need to know about a person’s willingness to repay funding. Willingness is a far different thing than an ability to repay, and it is far more complex to judge.
What’s more, there are times when a person’s credit score does not accurately reflect their creditworthiness. If a credit card issuer cuts your credit limit, your score will drop, even if you’ve regularly paid your card bill on time. Some small business owners have been hit with healthcare costs which have necessitated that they delay paying other bills, damaging their score. But those setbacks have often made these small business owners even more determined to grow their business: in these cases, their willingness to repay becomes stronger, not weaker.
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Alternative finance companies have been investing in technology to discover less conventional ways of measuring creditworthiness. By looking at the volume of credit card transactions which come through a restaurant or store, they are able to better understand seasonality and the overall strength of the business. They are also looking for patterns in other data, like cell phone usage.
According to a Wall Street Journal story last year, companies are trying to find whether there’s a link between how many text messages a person gets and his creditworthiness. ZestFinance, which has been applying machine learning to large volumes of credit data, has discovered that people who fill in applications in all uppercase letters are more likely to be credit risks than those who don’t. Other companies in the alternative finance space are looking into adding so-called unstructured data, words–not numbers–from those used in its prospective customers’ social media posts or its phone calls with underwriters. (Professors from Columbia University and the University of Delaware are researching the latter in a study entitled “When Words Sweat”.)
companies are trying to find whether there’s a link between how many text messages a person gets and his creditworthiness
Some alternative finance companies are pairing their findings with traditional FICO scores to come up with a blended, but proprietary, score. Some are abandoning FICO altogether. The Wall Street Journal reported in January that Social Finance Inc., a company which deals in consumer finance, will no longer use FICO scores to make its credit decisions. Interestingly, SoFi is still collecting FICO scores from its applicants because the investment firms that buy its loans want them for its evaluation process.
All of this work is important because the better finance companies can gauge credit risk, the better they can prepare and price funding solutions for its small business clients. It also is important because many new small business owners are coming from the ranks of America’s unbanked–people who don’t have a history with a traditional lending institution. It will be interesting to see how more and more lenders in the space react to the news coming out of Silicon Valley and if these new models are sustainable.