Alternative Credit Scoring: How Excited Should We Be?

Over the past few years, U.S. lenders and credit bureaus have become enchanted with the notion of alternative credit scoring—the process of looking at non-traditional accounts to determine a person’s creditworthiness. It’s no longer just about how well people pay off their credit card balances and mortgages, but also their rent, electricity, insurance, and phone bills, even their day-care accounts.

Industry folk like to cast this development as a great way to bring people with no or paltry credit histories into the financial mainstream. At a recent conference, an Experian V.P. proudly stated that by taking into account rent payments, the credit bureau is able to generate credit scores for 87% of the people it otherwise wouldn’t be able to. At first blush, this is indeed an exciting development, especially since adding rental data generally improves the credit scores of people who already have them.

Yet the more important issue for financial access types is what happens to people who are thrust into the credit-score spotlight for the first time. The broad thinking tends to be that having a credit score is better than not having a credit score, but the more pertinent question is whether having a bad credit score is better than having no credit score. After all, there are probably reasons a person has decided not to open a credit card or take out a mortgage. Indeed, using Experian’s rent data, the vast majority of people who get a credit score for the first time wind up with a subprime score. That’s probably not the way most people would like to enter the financial mainstream.

The waters get really muddy once you consider how long-lasting and far-reachingbad credit can be. Credit reports are not particularly forgiving things. My own Experian report still shows the payment history of a credit card I closed in 2002—and will continue to do so for another four years. Thank goodness I never missed a payment.  And thank goodness I haven’t experienced the severe income volatility that is common among low-wage workers. Lucky for me, I’ve never had to make the decision between paying my phone bill and paying for food— and I’ve never had to have that decision haunt my credit report for more than a decade.

But what’s even scarier about the idea of creating a whole new class of people with subprime credit is that companies increasingly use credit scores to make decisions completely unrelated to creditworthiness. For example, an entire 60% of employers now run credit checks on job applicants. With alternative credit scoring, does this mean that a person struggling to make ends meet who does the responsible thing and stays away from credit suddenly has a tough time finding a job because she was late on a couple of utilities bills?

The flip side to these arguments is that people who are deliberately trying to rebuild good credit might benefit from the addition of things like rent payment history. Fair enough. But under federal law, people already have the right to present lenders with evidence of regular payment of rent and other bills. Of course, if the mainstream credit-scoring system were to incorporate this information, lenders will surely give it more weight. Alternative credit scoring definitely presents an upside for many people, especially the large number looking to rebuild credit in the wake of the recession.

What’s often missing from the conversation about alternative credit scoring is a deliberate weighing of the upside against the down. Change brings winners and losers. For those trying to help people living on the financial fringe, it’s important to think about both groups.

Barbara Kiviat is a David Bohnett Fellow at New York University's Wagner Graduate School of Public Service.