Balancing Credit and Savings Financial Realities for Working Americans
by Kirk Chartier, Chief Strategy Officer
Americans work hard to build a better future for themselves and their families. The ability to fully participate in our economy, including access to credit when they need it, is important to help create a better life. Good financial credit provides people the ability to pay for things over time and is essential to how Americans manage their family finances. Loans and lines of credit can provide a buffer to manage monthly budgets and cover unexpected expenses when savings aren’t enough. People with few assets to borrow against, or with non-prime credit ratings, face limited opportunities to get loans from banks.
Consumer Credit in the U.S.
Total credit card debt in the U.S. is nearly $840 billion, according to the Federal Reserve Bank of New York. Americans depend on credit to manage their monthly budgets with the average person’s credit card debt being $5,221 and half of Americans having equal or less in personal savings. The harsh reality is that 39% of Americans cannot cover a $400 emergency expense. A recent Bankrate survey found that nearly 70% of Americans do not feel financially secure.
Those average figures conceal a deeper reality for the 30% of Americans that Experian reports have subprime credit scores. Only 17% of credit card accounts are held by consumers with non-prime credit (FICO scores below 670). Because non-prime consumers are rejected four times more often than those with scores over 680, the majority of households do not have access to traditional credit options.
With a potential recession looming, banks have further tightened credit. This can mean that Americans must choose between a range of bad options, including bouncing checks, missing payments, selling valuables or forgoing essentials. Research shows that for those people turned down for a personal loan (often from a traditional bank lender), 48% paid bills late and generated fees, 42% bought less food, 29% pawned possessions, 24% had utilities shut off and 9% were evicted.
FICO Scores Aren’t Perfect
Banks and credit unions find it difficult to serve this group for two reasons. First, the FDIC limits insured institutions’ risk exposure to unsecured and non-prime lending. Second, banks lack the tech infrastructure needed to service non-prime borrowers. They tend to overly rely on FICO scores to judge applicant credit worthiness. Many alternative lenders and FinTechs have invested in technology and data analytics for underwriting with proprietary credit scores that they claim are 30% more accurate than FICO in predicting consumer loan default probability.
FICO scores are more accurate for people that take out and pay off more loans, which isn’t always true for middle income workers. In recent years people are older and more established in their careers when they move from renting to owning their homes and many minority households are under-represented for other major debt uses like auto loans. Banks are focused on consumers and small businesses that take mortgages and car loans, or have credit cards with high credit limits, and less focused on customers who regulators classify as more risky, thus banks primarily use FICO scores for lending. Alternative lenders have developed the ability to gather and use additional data, like looking inside the FICO score at the payment behavior being reported or considering employment history or other regular payments like mobile phone services, that aren’t consistently reported enough to be part of FICO calculations. The use of underwriting algorithms to describe borrower ability and likelihood to repay a loan beyond FICO scores, or risk of having a possession taken back by a bank, has enabled forgotten consumers to access financial products that previously were only available to Prime credit rated people.
Better Models, Better Outcomes
Non-bank lenders that focus on serving non-prime borrowers have developed an in-depth understanding of their ability to repay. Additionally, because they are not subject to the structural and regulatory constraints that force banks and credit card companies to use metrics suited for prime borrowers, they have invested in developing more accurate models for the populations they serve.
For instance, by leveraging 40 million data points on customer historic payment habits, alternative lenders like Enova (NYSE: ENVA) have developed analytics that are 30% more accurate in predicting potential payment default versus credit bureau scores alone. Those companies use machine-learning technology to continue to learn so the company’s human analysts can further optimize their risk-based lending decision making.
From Better Outcomes to Better Credit
Alternative lenders have worked over the past ten years to develop more flexible products with multiple, risk-based price points that fit products to borrower preferences, lender risk management needs, and regulatory requirements. A recent White House Competition Council report recognized the importance of non-bank lenders on the competitiveness of credit markets.
When borrowers are more successful managing their budgets and making payments on time, they avoid negative outcomes like utility disconnects, car repossession, or loss of credit and checking accounts, and instead build credit histories that can help improve their credit scores. Getting credit when they need it and repaying successfully helps put people on a path to mainstream credit access.
Whether the loan comes from one of the special programs banks and credit unions who have started offering loans for some of their customers, or from alternative lenders who specialize in lending to near prime and subprime borrowers, successful use of credit products can help consumers and small businesses reach their goals. According to a recent Morning Consult Survey, many consumers who borrowed from an alternative lender or fintech company saw credit scores increase 12 months after taking out their loan. In the same survey, lower- and middle-income groups saw the largest net improvements, while Black and Hispanic consumers said their credit scores improved most.
By improving creditworthiness, borrowers can level up to more favorable products with larger loan amounts and more flexible terms at lower rates. Enova sees this in our customers as they improve credit scores and graduate to lower-rate products. Instead of a downward cycle of debt, quality, fair loan options create an upward cycle of credit.