Nonprime Lending: Risky Repeat or Savvy Adaptation?
What’s the first phrase that occurs to you when you read the words “2008 financial crisis?” “Subprime mortgages” is probably a strong contender. You might recall that, in the early 2000s, access to mortgages rapidly expanded, even to under-qualified borrowers with poor credit histories and low or no current income. By 2006, these subprime mortgages accounted for 20 percent of all U.S. mortgages. Subprime borrowers predictably struggled to make payments and began to default on their home loans in large numbers, triggering a wave of defaults that fueled worldwide financial upheaval. Now, ten years later, the subprime mortgage industry is gaining ground again under a new name: nonprime lending.
What’s the deal here – is the financial sector heading for disaster again? And what new credit scoring technologies could help distinguish safe bets from truly risky borrowers?
Let’s begin by unpacking “nonprime” lending.
What is Nonprime Lending?
Nonprimelenders.com defines nonprime lending as “the ‘new and improved’ version” of subprime lending. That distinction, however, appears to be rooted more in marketing than in revised financial standards.
The U.S. Federal Reserve Bank of St. Louis defines subprime loans as, among other possible criteria, all loans made to borrowers with FICO scores below 620. Nonprime lenders such as Santa Ana-based Carrington Mortgage Services are reported to offer mortgages to borrowers with FICO scores as low as 550, well below the subprime threshold. According to CNBC, “recent credit events, like a foreclosure, bankruptcy or a history of late payments are acceptable” to nonprime lenders like Carrington.
FICO credit scores can’t fully represent a potential borrower’s creditworthiness – more on that below – but a history of financial mismanagement leading to a low credit score should be a universal red flag to lenders. So: what’s pushing lenders to make risky home loans again, and why the rebranding?
Why Lend to Risky Borrowers?
In short: because when lenders loan more, they make more money.
As we’ve covered before, big lenders depend on securities sales to generate cash flow. By lowering their credit standards, lenders can offer loans to more borrowers – and as long as investors feel confident enough to continue purchasing their securities, lenders continue to bring in cash for continued operations. By rebranding the infamous “subprime” mortgage as nonprime lending, lenders hope to signal to securities investors that they’ve left the risky practices of the financial crisis behind them.
The lender-investor relationship, like the lender-borrower relationship, will always depend on trust to some extent. Investors need confidence that lenders’ securitized mortgages will generate a profit – and that means trusting that borrowers will repay their home loans. Some emerging financial technologies are empowering lenders to more accurately assess nonprime borrower risk – and, by extension, put more trustworthy and profitable financial instruments on the market.
Minimizing Risk in the Nonprime Era
For lenders, risk minimization and short term cash flow seem to be at odds. Emerging alternative credit scoring technologies aim to address this by offering lenders a more complete picture of prospective borrowers’ financial habits. More information, after all, means more opportunities to say “yes” to the consumer.
As early as 2015, FICO began considering alternative consumer data from credit data firms LexisNexis and Equifax. LexisNexis advertises their Fico Score XD as a solution for risk mitigation in nonprime lending. The score considers data points outside of traditional borrower behavior, including telecommunications and utility account history. By considering a new, underscored applicant’s history of utility bill payment, lenders unlock a powerful predictor of future financial responsibility – and a reason to expand confidently into new markets, without scaring away securities investors.
To learn more about how new sources of data are powering the future of risk mitigation, check out our eBook, It’s Time to Rethink Credit Scoring. And if you’re ready to learn how Urjanet’s Utility Data Platform can help you lend with confidence, contact us today to speak with a specialist.
If you like what you’re reading, why not subscribe?
About Nick Arehart
Nick Arehart is a marketing intern at Urjanet who specializes in financial services and sustainability. He's passionate about content that informs and inspires. When he isn't writing for us, he's finishing up his chemistry degree at Emory University.