‘Alternative’ Credit: Your Scores Still Matter

Startup and traditional lenders alike are looking for the new prize: creditworthy people who don’t have good credit scores.

To find them, companies are experimenting with all kinds of alternative data that’s typically not part of credit reports, such as utility bills, social media posts and how often you change your address.

In addition, some online lenders proclaim they don’t use credit scores in their decisions or don’t have a minimum score requirement.

You could be forgiven for thinking that credit scores no longer matter. But that could be an expensive mistake. Here’s why.

Most lending decisions still use credit scores

Nine out of 10 lending decisions are still made with some version of the FICO scoring formula, while a growing number of lenders use VantageScore, the main FICO rival.

“There are over 10,000 lenders in the United States, and practically every single one of them uses a credit report and some form of a credit score to assess the risk of doing business with you or continuing to do business with you,” says credit expert John Ulzheimer, who has worked for both FICO and credit bureau Equifax.

Even alternative lenders look at credit

Lenders want to be repaid, so they’re not going to ignore evidence that you’re a bad risk, such as late payments on your credit reports. And good scores calculated from those reports will improve your chances with those who look at alternative metrics as well.

“All online lenders look at your credit score when they’re trying to decide if you’re a good risk or not,” says Amrita Jayakumar, a NerdWallet writer who specializes in personal loans. “Lenders that say they have no minimum score or consider social data don’t ignore your credit — they simply look at it as one part of your bigger financial picture.”

Lenders use alternative methods primarily to find people who are new to credit or who used credit responsibly in the past.

“While alternative credit will open doors for consumers who have either not used credit in the past or who have not used it recently, credit scores based on traditional credit information aren’t going anywhere,” says credit expert Barry Paperno of SpeakingofCredit.com, and who previously worked for FICO and Experian.

Good credit can save $100,000 over a lifetime

In my book “Your Credit Score,” I use the example of two hypothetical friends, Emily and Karen. With each edition, I update prevailing interest rates to calculate the difference between Emily’s 760 FICO score (considered excellent) and Karen’s 660 score (typically considered “fair” or average).

I assume each woman carries an $8,000 balance on her credit cards, starting at age 22 and continuing to the end of her life at 78. Each buys a new car with a $20,000 auto loan every six years starting at 22, purchasing the last one at age 70. Each buys two homes, the first with a $350,000 mortgage at age 30 and the second with a $450,000 mortgage at 40. (Mortgage and auto rates are averages from Informa Research Services Inc. via MyFico.com, while credit card rates are from NerdWallet’s database of credit cards.)

Although her penalty varies by the type of credit and prevailing interest rates, Karen ultimately pays a lot more in interest over her lifetime.

Expenditure	Emily: Excellent credit	Karen: Average credit
CREDIT CARDS
Interest rate	9.99%	17.99%
Annual interest costs	$799	$1,439
Lifetime interest paid	$44,744	$80,595
» Karen’s penalty: $35,851
AUTO LOANS
Interest rate	3.32%	6.76%
Monthly payment	$362	$394
Interest cost per loan	$1,733	$3,629
Lifetime interest paid	$15,597	$32,661
» Karen’s penalty: $17,064
MORTGAGE 1 ($350,000)
Interest rate	3.43%	4.04%
Monthly payment	$1,557	$1,679
Total interest paid (10 years)	$107,177	$127,600
Karen’s penalty: $20,423
MORTGAGE 2 ($450,000)
Interest rate	3.43%	4.04%
Monthly payment	$2,002	$2,159
Total interest paid (30 years)	$270,686	$327,153
» Karen’s penalty: $56,467

Karen’s total penalty over her lifetime for having a lesser credit score adds up to $129,805.

Missed opportunities could cost $1 million

The cost to Karen could be much more. The rates cited are averages, but people with excellent credit are typically offered low-interest or even 0% deals on credit cards and cars. The penalty for fair credit often rises when economies go sour, such as in the 2008-09 recession, as lenders try to shed higher-risk customers.

This analysis also leaves out the higher cost of auto and homeowners insurance when you have less-than-perfect credit. A recent NerdWallet study found single drivers with average credit-based insurance scores paid 28% to 37% more per year than those with the best scores. A poor score drove up rates even higher — 75% to 123% more than someone with great credit.

The examples also don’t include the wealth Karen could have built had she not been paying so much interest. If Karen had been able to invest that money instead, she could have grown her net worth by nearly $1 million by the time she was 70.

Bottom line: Lenders may hunt for creditworthy customers their competitors miss, but their search won’t displace the importance of credit scores in our financial lives.

“We will never see the day where a traditional credit reports and credit bureau risk scores, like FICO and VantageScore, are no longer important,” Ulzheimer says.

Liz Weston is a columnist at NerdWallet, a personal finance website, and author of “Your Credit Score.” Email: lweston@nerdwallet.com. Twitter: @lizweston.

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