From Underbanked to Understood: The Rise of Alternative Credit Scoring

As the unbanked and underbanked population grows and changes, it’s time to introduce a new approach to credit scoring

What happens when you get your paycheck? Or when you go to a restaurant and it’s time to pay the bill?

These might seem like strange questions to ask and ones that seem to have obvious answers — checks get deposited into your bank account and restaurant tabs get paid by a credit or debit card. But for a growing population of unbanked and underbanked Americans the answers are not always so obvious.

What Does It Mean to Be Unbanked or Underbanked?

According to survey data from the Federal Deposit Insurance Corporation (FDIC), 27% of US households are “unbanked” or “underbanked.” Specifically, the FDIC reports that approximately nine million U.S. households are unbanked and 24.5 million are underbanked. The FDIC defines these terms as follows:

  • Unbanked: No one in the household has a checking or savings account
  • Underbanked: The household has an account at an insured institution, but also goes outside of the banking system to alternative financial providers for services and products like money orders, check cashing, international remittances, payday loans, refund anticipation loans, rent-to-own services, pawn shop loans, and auto title loans

Although a majority of unbanked households cited “not enough money to keep an account” as the primary reason for their status, many other reasons also surfaced among the larger unbanked/underbanked population, including privacy concerns, a lack of trust in banks and high or unpredictable bank account fees.

Who Makes Up the Unbanked and Underbanked Population?

There’s no one type of person that comprises the entire unbanked and underbanked population. However, the FDIC did find that younger adults (currently those in the Millennial generation) were one of a handful of cohorts with measurably higher unbanked/underbanked rates.

Various research studies on Millennials’ financial habits also support this finding and attempt to provide an explanation for the trend. For example, a recent study from Packaged Facts finds that Millennials make up a new type of unbanked consumer — one who sees not having a checking or savings account through a conventional bank as giving them more options rather than less.

The Packaged Facts research also suggests that many Millennials see “checking” as antiquated and are far more comfortable with online-only options. Consider the case of Amazon Cash, a new venture from Amazon that allows shoppers without credit, debit or bank cards to load cash directly to their Amazon accounts. Consumers can simply deposit cash to their accounts at retailers like CVS, Sheetz and Speedway and easily make purchases online without any bank involvement.

Meanwhile, TechCrunch aims to shed more light on why so many Millennials distrust banks, pointing out that this generation’s views are largely shaped by major world events like 9/11 and the Great Recession. The fact that Millennials are saddled with higher student loan debt than any generation prior doesn’t do much to improve this group’s trepidation towards financial institutions either.

Why Does Banking Status Matter?

If more and more of the unbanked and underbanked population is comprised of Millennials and others who simply don’t trust banks or are looking for more convenient ways to manage their finances, what’s the big deal? In a nutshell: Credit.

Individuals receive credit scores based on factors like the number of accounts they have open and the length of time for which those accounts have been open, their credit bill paying history, and outstanding debts. And those scores are important when it comes to receiving credit from banks, which consumers need for any number of things, such as getting a home mortgage.

While those who are unbanked and underbanked may choose to go outside traditional financial providers for various reasons, this status creates a problem when it comes to their credit scores. Because these individuals don’t partake in a lot of (if any) activities that typically go into credit scoring, they end up in one of two groups:

  • Credit Invisible: This group has no file with any of the major credit bureaus. The US Consumer Financial Protection Bureau estimates that 26 million Americans are credit invisible.
  • Unscorable: This group has a file with at least one of the major credit bureaus but the information is either too little or too stale to generate a reliable score. The US Consumer Financial Protection Bureau estimates that 19 million Americans are unscorable.

These statuses leave the unbanked and underbanked facing an uphill battle when it comes to obtaining credit from financial providers. At the basic level, this makes sense, as no one can fault lenders for turning down consumers whose credit scores (or lack thereof) indicate a potential risk when it comes to making payments.

However, as the makeup of the unbanked and underbanked population skews more toward Millennials and like-minded individuals who choose to retain this status because of a lack of trust in banks and/or the mindset that it provides more options (rather than simply having no choice due to a lack of income), it may be time to explore alternative methods of credit scoring for these individuals.

How Can Alternative Credit Scoring Help?

Traditionally, a lack of a credit score or a low credit score has indicated a risky prospect due to an inability to predict payment behavior or a history of missed or past-due payments. But as more and more individuals actively choose not to engage with traditional financial institutions due to factors like lack of trust, an increasing percentage of the population will be credit invisible or unscorable simply due to a lack of conventional scoring data.

As a result of this shift, the accuracy of credit scoring in terms of predicting likelihood to make payments as expected will decrease, and may prevent people who would actually be good candidates for something like a home loan from receiving one.

One ideal solution to this challenge is to introduce alternative credit scoring models that rely on information that extends beyond the traditional data points like credit card limits and debt repayment history. For example, pulling payment history data on utility bills, mobile phone bills, or rent payments can easily demonstrate an individual’s propensity to pay bills on time and therefore can be used to create a new kind of credit score.  

In fact, VantageScore Solutions estimates that this type of alternative credit scoring could help approximately 7.6 million consumers that are currently unscorable to earn a credit score of 620 or higher.

What Does Alternative Credit Scoring Entail?

Alternative credit scoring sounds like an excellent solution to increasing access to credit for the millions of unbanked and underbanked Americans while minimizing risk for lenders, but what does it actually entail?

Of course nothing is ever perfect, and alternative credit scoring does have its downsides, but depending on the type of data used (e.g. utility bill data is one of the more reliable types of data proposed), the pros far outweigh the cons. Stay tuned; we’ll be publishing more content soon on the mechanics of alternative credit scoring and how it’s developing.