While President Obama's recent announcement to cut mortgage insurance premiums is good news for first-time home buyers, it doesn't address the challenge of meeting the needs of individuals looking for loans at the same time banks strive for near-zero lending risks while concurrently trying to expand their customer base. This problem continues to stymie the recovery of the housing market and vex the economy in general. A solution exists: using alternative data for underwriting mortgages.
While the traditional FICO score is calculated on data that is inside a consumer's wallet, such as credit card debt, alternative data is calculated on what's outside of a consumer's wallet, such as address stability, education and property ownership.
Old habits are hard to change. It's true that the FICO score has been transformative to the lending process since it became a turnkey solution for credit underwriting in the 1980s.
However, in the time since FICO was first endorsed for use in credit decisions, a range of other Fair Credit Reporting Act-compliant solutions have been brought to market. Yet, these solutions have not gained a foothold in mortgage underwriting because the underwriting system is so heavily coded to the FICO score.
If the purpose of credit underwriting is to identify the credit risk of applicants, it is imperative that Fannie Mae and Freddie Mac open the process to other players in the market. Doing so will invite competition and innovation from which both consumers and banks benefit. And consumers with less favorable trade-line histories, sometimes referred to as the "credit invisibles," may qualify for credit based on positive histories identified though other data sources.
Fannie Mae and Freddie Mac are considering opening the mortgage underwriting process to scores derived from other types of data. Specifically, Fannie Mae and Freddie Mac are opening testing to VantageScore, which is widely known as another credit bureau score option. Yes, VantageScore broadens the scope, but it doesn't affect factors that open the system in general. VantageScore is based largely on the same data as the other credit bureau scores so that the systemic risk is the same. The bottom line is that even that step forward to use VantageScore isn't nearly enough to stimulate more and better lending.
The systemic risk is unsettling. Fannie Mae and Freddie Mac mandate the use of FICO credit scores in mortgage underwriting, and so the mortgage industry moves to what those entities require. Danger exists in this business model because consumers who don't have credit data would not qualify for a mortgage. For example, if mortgage lenders used baseball statistics, instead of FICO scores, as their single source of data, then only baseball players would be able to buy a home.
More important, by opening the process to other predictive elements like FCRA compliant non-tradeline behavioral data (such as property ownership, address stability, and economic health), lenders could make responsible lending offers to consumers that are currently disenfranchised by the existing credit system. Roughly one in four borrowers cannot be scored using credit bureau data.
LexisNexis Risk Solutions statistical modelling shows that as many as 70% of the credit-invisible population could qualify for prime or near-prime credit offers if alternative data was part of the underwriting system. By expanding the decision to allow commercial decisions based on other appropriate data, the country's mortgage dilemma can be solved: lenders control risk, and consumers enjoy more opportunity for affordable credit.
Further, minorities are almost two-times more likely to be unscorable based on tradeline data alone. In our research, we found that roughly 60% of credit-invisible minorities would qualify for prime or near-prime credit if alternative data were allowed into the underwriting process.
To enable more previously disenfranchised people who have thin or no credit files to be more successful in the underwriting process, Fannie Mae and Freddie Mac must open the process to additional analytic solutions to implement other reputable scores created based on other data sources. Doing so would invite new "swap-in" consumers that are less risky than their credit bureau scores would indicate.
The call to action is clear. While lenders should control risk in the underwriting process, it would be in the best interest of lenders and consumers to open this process to competition and to allow considerations of FCRA compliant datasources other than credit bureau tradeline data. Doing so will empower consumers and allow lenders to extend credit fairly to a larger and varied consumer base.
Jeffrey Feinstein is LexisNexis Risk Solutions senior director, Analytic Strategy. With almost 20 years in the industry, he is an expert in the use of non-tradeline and credit bureau tradeline data for credit risk, fraud and compliance use cases. He is responsible for developing the LexisNexis RiskView Credit Risk Score as well as managing the development of other financial services solutions based on LexisNexis data.