What Is Alternative Data and How Is It Being Used for Loans?
The CFPB just issued a no-action letter to Upstart Network, an online lending platform, which uses alternative data to make credit and pricing decisions. This means the CFPB will not take legal action against the company for actions that are not technically legal, but are acceptable as long as Upstart provides certain information to the CFPB regarding the loan applications it receives, how it decides which loans to approve and how it will mitigate risk to consumers. The CFPB wants to study how alternative data can be used to better serve the credit needs of underserved populations.
What is Alternative Data?
Alternative data uses “big data” to help banks make better lending decisions by considering factors that traditionally are not considered during the loan application process. “Virtually all banks look at the following factors: credit score, income, current loans, down payment percentage,” according to Discover. These factors often exclude low-income individuals and those without a significant credit history from obtaining loans. But what if an applicant has been using cash to pay for everything? This would not be considered in a credit score and a potentially good applicant would be denied.
Alternative data uses additional factors such as:
- Income Prediction Analysis
Income prediction analyses use census data such as: age, class of work, education level, occupation and relationship status—to create an accurate prediction of the earning potential of an individual.
- Education Benchmarks
It is no secret that those with higher education earn more. “Bachelor’s degree holders make 84% more than non-degree holders over their lifetimes,” according to the Census Bureau. Education benchmarks include college, major, grades and even standardized test scores.
- Payment History
If you do not have a credit card, your credit score is significantly affected. Alternative data takes into consideration rent, phone and cable payment history.
- Social Media
Some companies are analyzing applicants’ social media habits and time spent on each platform. Although controversial, a person’s social media profile can give more insight into a person’s behavior and verify they are who they say they are.
Why Use Alternative Data
Finding new revenue streams with low risk is difficult for banks that are tightly regulated. So how does a bank increase the number of LMI loans it issues, when those people would traditionally not qualify? How does a bank minimize its risk associated to lending to LMI borrowers? That is where alternative data comes in. A large part of the moderate-income market are Millennials. Millennials often don’t have the credit history or a high income-to-debt ratio, compared to traditional applicants. This causes many loan applications to be rejected and lenders miss out on an entire market. Alternative data gives lenders the ability to approve potentially credit worthy applicants that might normally be denied.
The Problem with Alternative Data
Using this data to make lending decisions is problematic, especially when denying a loan. According to the Equal Credit Opportunity Rights, lenders are not allowed to deny a loan based on sex, race, marital status age or religion. For this reason, the CFPB issued the no-action letter to Upstart. The information the CFPB receives from Upstart will determine whether regulators allow this data to be used to make lending decisions. Whether applicants are willing to give companies permission to look deeper into their personal information is another story. In the end, incorporating alternative data in a responsible, ethical way could lead to more people qualifying for loans, mitigate risk for banks and fill the lending gap for low to moderate-income individuals.