It’s a vicious cycle: because some people in the low- and moderate-income community either lack traditional credit histories or rely on financing from non-mainstream credit providers that aggressively market to those lower-income communities, these consumers often have no other choice but to turn to payday and other predatory lenders where interest rates are extremely high, leading them to fall behind on their payments. This, in turn, negatively impacts their credit scores…and the cycle continues.
For many creditworthy low- and moderate-income consumers, it’s a challenge just to get a car loan, let alone a mortgage loan. And yet, for the housing market to work for everyone, a new way for determining creditworthiness for these consumers must emerge. This is not about lowering the bar of creditworthiness; it’s about changing the way we look at creditworthiness that reflects new demographic shifts and market realities.
Here’s the challenge: The government-sponsored enterprises (GSEs), through their seller-servicer guidelines, force mortgage lenders to rely on credit scoring models that were developed more than a decade ago. By the same token, Federal Housing Administration (FHA) loans also require similarly outdated credit scoring models.
These older credit scoring models needlessly lock out an estimated 35 million consumers, including millions of consumers new to the market and infrequent users of credit. In an internal study, an estimated 7.6 million of these consumers have credit scores of 620 or higher. Undoubtedly many low- and moderate-income consumers are included in this population.
Newer, more inclusive credit scoring models have been developed that more accurately assess credit behavior by taking advantage of more granular data, incorporating highly advanced segmentation and analytics, and factoring in alternative data including rent, utility, and telecom payments if they reside on a consumer’s file. Moreover, the latest models ignore collection accounts that have been reported as paid in full.
A recent Experian study explored the benefits of using new, alternative data and found that 20 percent of “thin file” consumers (those with limited credit histories) migrated to thick files when alternative data was included. Also, the study found that the subprime population reduced by 47 percent when a credit scoring model that includes positive energy-utility data is used and those alternative accounts are considered. These models provide low- and moderate-income consumers the ability to access mainstream credit with more favorable terms and interest rates, thereby allowing them to restore their credit profiles more easily.
Some critics of the usage of alternative utility data (including Woodstock Institute) argue that some lower-income consumers would be harmed because they might, for example, allow heating bills to go past due during the winter months knowing that their heat will not be turned off. It’s a fair point, but because of the huge potential for positive impact to millions of consumers, VantageScore believes that allowing for the possibility that a few scores may go down is necessary in order to see meaningful change.
Director Mel Watt, who oversees the GSEs, recently ordered the GSEs to “assess the feasibility of alternative credit score models and credit history in loan-decision models, including the operational and system implications.” Also, in a recent symposium focusing on access to credit in the mortgage market, Secretary of Housing and Urban Development Julián Castro called for expanding mortgage credit to non-traditional borrowers and promised to review ways to incorporate alternative credit scoring models into the FHA automated underwriting system.
If and when the GSEs and FHA take the important step of opening up the credit scoring system to other providers, it will open up the marketplace to a more competitive and dynamic credit evaluation environment and enable low- and moderate-income borrowers who have been hesitant or unable to enter the housing market to move one step closer to homeownership.
These borrowers were disproportionately impacted by the recession and the housing crisis, and it is time they stopped bearing the burden of the mistakes that led to it.