Financial institutions and finance companies in the market of the financially underserved certainly face a much higher risk of defaults. Yet for those lenders who figure out how to reach this market, there’s much money to be made.
By focusing on getting consumers to show their simple behaviors in the form of payment patterns, overall loan balances, savings and checking account levels — or even a propensity to take short finance tutorials — some fintechs are showing these practices are key barometers to gauging credit risk.
A few providers have focused on the current behaviors of the subprime tier in order to lower lending risk. Ascend Consumer Finance, a fintech lender based in San Francisco, gets many of its customers to agree to have their bank and credit reports monitored in exchange for better loan pricing. Another firm, Revolution Credit, uses a financial management platform, along with education tutorials, to amass a group of borrowers it can then recommend to client lenders for loans. eCredable collects from its users' bill payment data — such as rent, utilities, insurance, cable TV and mobile phones — to help them build a credit score.
Some fintechs are showing these practices are key barometers to gauging credit risk.
What's different here is not in the backward-looking data of credit history. That data is available to all lenders via the credit bureaus. Instead, these fintechs have developed systems that are attracting better borrowers upfront by focusing on real-time behaviors, then using them to either predict future repayment probability or give them a score.
"We have been able to now get customers to self-select into different buckets," says Steve Carlson, chief executive officer of Ascend. "They have self-selected themselves in, and we have gotten them through their performance to display behaviors that we know are directly correlated to risk, and we can price them better for that."
For all the talk of analytics and data, the focus on current financial practices of borrowers could prove to be the best predictors, especially when customers agree to opt-in and show how they’re responsible.
What’s different here is not in the backward-looking data of credit history.
"It's enabling people to provide some indications in their behavior and giving lenders a sense of their intent to repay the loan," says Josh Sledge, a director at the Center for Financial Services Innovation (CFSI), a Chicago nonprofit organization focused on improving financial health of consumers. "With some of the fintech players, we are going from theory to practice."
The troubled tier
The efforts to expand into subprime come at a time when the financial industry as a whole has shied away from boosting retail lending in general. Retail loan balances in 2016 hovered around $12.7 trillion — exactly the same as 2013 balances and $1 trillion less than in 2008, according to Aite Group, a Boston-based research firm.
In the process, subprime borrowers are left behind. Generally borrowers from this group have a credit score below 640. The group is vast: there are about 121 million American adults defined as 'credit challenged' — those borrowers with credit scores below 600, according to CFSI.
In part, it's a tough group for profitability purposes, and upstarts have been burned. Lending Club, Prosper and Avant have recently endured higher loan losses and a souring base of investors, who are demanding higher premiums on the loans they buy off the books. Another provider, CircleBack Lending, has stopped making loans altogether.
The losses show just how tricky lending to subprime can be. Ascend, for example, lends only to people with a credit score of 580 or higher, generally up to 660. This tier is fraught with the difficult phenomenon of 'credit migration,' Carlson notes. About one-third of the group will improve credit scores dramatically over the next six to 12 months, another third will stay in the band, and the other third will fall below 580 — into deep subprime. That means by lending blindly to this segment, lots of loans will go bad. "That's not awesome," Carlson says.
The trick is finding the borrowers on the upswing. Maybe it's someone who just got divorced. Or another borrower who just found a good job after a year of unemployment. Or a recent college graduate who has no credit, but recently got hired. To tap into these 'hidden gems,' Ascend makes an offer of one of two loans.
One has a lower APR, say 27 percent, with a standard 36-month term. The other one, branded 'RateRewards,' is a similar loan at a slightly higher rate of 29 percent, but with incentives for customers that could cut the effective interest rate by as much as half. If a consumer lets Ascend monitor its bank and credit reports — watching key behaviors such as reducing debt and increasing savings — the borrower can lower interest payments by as much as 10 percent. Pledging an auto title as collateral yields another 20-percent discount. Monthly credit card spending under $600 could bring another 10 percent.
Rewarding good behavior
In another twist on rewarding good behavior, Revolution Credit encourages users on its platforms to educate themselves on good financial habits via video lessons that build awareness, helping it identify upwardly-mobile customers, then selling the information to banks. "Some of banks may decide if certain people have a financial education, they might be willing to take a chance on them, even if they are marginal," says Christine Pratt, a senior analyst at Aite.
These new providers of self-selected groups could bode well for better underwriting, Pratt adds. "There are some good opportunities to put different types of alternative data into the mix," she says.
The combination of real-time data and behavioral analytics will eventually become just another part of lending.