Yesterday, the Consumer Financial Protection Bureau (CFPB) Office of Research published a report that showed one in ten adults in the U.S. have no credit scores.
For some folks, this is a non-issue. If you tend to pay cash for everything and avoid lenders altogether, your credit score is basically meaningless to you. But for home buyers who need a mortgage loan to finance their purchase, having no credit score could create additional hurdles during the mortgage application and approval process.
When a Home Buyer Has No Credit Score
Consumer credit scores are computed based on information found within a person’s credit reports. The reports compile financial data relating to credit card use, auto loans, and other forms of borrowing. Credit-scoring systems like FICO and VantageScore turn this data into a three-digit number.
Mortgage lenders use these scores to determine the risk and “creditworthiness” of a particular borrower, and also when assigning the interest rate on a loan. The problem for some home buyers is that they don’t have enough of a credit history to produce a score.
According to the CFPB study released yesterday:
“If a consumer does not have a credit record with one of the NCRAs or if the record contains insufficient information to assess her creditworthiness, lenders are much less likely to extend credit. As a result, consumers with limited credit histories can face substantially reduced access to credit.”
As mentioned, mortgage lenders use credit scores such as FICO and VantageScore when deciding whether or not to lend, and how much to charge. Borrowers with higher scores are viewed as a lower risk to the lender, and therefore have an easier time qualifying for home loans. On the flip side, borrowers with lower scores have a harder time getting approved for mortgage loans, and they usually end up paying higher interest rates if they do get approved.
Then there are those home buyers who don’t have a credit score at all. The Consumer Financial Protection Bureau puts these people into two broad categories — “invisible” and “unscorable.”
- Invisible: According to CFPB, these are people who have no records maintained by the Nationwide Credit Reporting Agencies (NCRAs), and therefore no score.
- Unscorable: These are consumers who have a credit record that doesn’t contain enough information to produce a three-digit score. Mortgage lenders refer to this as a “thin file.”
In both of these cases where a home buyer has no credit score, the mortgage lender might have to look at alternative data to make a lending decision. And there have been some recent advancements in this area.
Using ‘Alternative Data’ to Make a Lending Decision
It has long been known that many consumers don’t have credit scores. The CFPB simply added some hard data to the conversation. The U.S. credit-reporting companies (Experian, TransUnion and Equifax) have been exploring ways to use “alternative data” to fill credit reports and generate scores.
In a traditional report, the data used for scoring comes from credit card accounts, student loans, auto loans, retail charge cards and the like. The alternative approach is to use utility payments, rent payments, and other non-credit and non-loan types of payment history. This would at least show lenders how responsible (or irresponsible) a person has been with his or her obligations in the past, even in the absence of loans and credit cards.
The idea is to give mortgage lenders some way to measure risk, for home buyers and loan applicants who do not have a credit score for one reason or another.
FICO, the company that created one of the most widely used credit-scoring systems in the U.S., recently announced it was starting a pilot program to increase the number of consumers who could be assigned a credit score based on alternative data, such as utility and phone bills.
According to Jim Wehmann, executive vice president of scores at FICO:
“FICO’s focus is on expanding access to credit; not simply scoring more people. Our approach also addresses a paradox for people seeking their first traditional credit product – you often need a credit history before you can get traditional credit.”
These and similar efforts could benefit financially responsible home buyers who don’t have credit scores.
Editor’s note: Mortgage shoppers without credit scores should not be discouraged by all of this. Lenders have been working with such borrowers for many years, for as long as the scoring systems have been in place. As mentioned in this story, there are alternative methods for determining a person’s creditworthiness. While it might create some additional hurdles, it is rarely a cause for rejection on its own.