Can You Really Borrow Your Way to Better Financial Health?

There’s something deeply American about the notion that you can improve your financial health by borrowing (more) money. Yet this is the claim that a number of fintech companies have made as the number of these firms has grown dramatically since the Great Recession. 

The pitch often goes something like this:

“Bad credit score or no credit history at all? Taking a loan can help you build your credit history and raise your score.”

This confusingly positions taking on increased debt as a road to better financial health. Unfortunately, the reality of these products isn’t so simple, and if the goal is to leverage financial product design and technology to improve financial health, there are better options. 

Targeting the Most Vulnerable Consumers

Consumers with a poor credit history, or little to no credit history at all, are often considered subprime. While “subprime” is often treated as synonymous with “poor”, that isn’t always the case. Someone who conducts most of their transactions in cash (or a debit card) could be considered subprime because little tradeline data exists about them on the three major credit bureaus.

Because they lack a robust credit file and FICO score above 640, they’re automatically disapproved for many credit products. If they qualify, they often pay punishingly high interest rates. Credit history is also often used in applications for apartments, employment, even cell phones and utilities. A low score can result in lost job opportunities, fewer housing options, and large deposit requirements for basic services.

For these consumers, who often lack knowledge about finance and the credit scoring system, borrowing (at high rates) is often pitched as a responsible behavior that can improve their financial health.

(Screencap from Risecredit.com on 9/23/2019)

Companies like LendUp (disclosure: I worked at LendUp from 2014-2016), Elevate, and OppLoans ply consumers with loans that promise a “brighter financial future” (Elevate/RISE), “larger loans at lower rates” and increases in your credit score (LendUp), and “cheaper and safer lending” (OppLoans), while still charging triple digit interest rates. Some lenders in the space even offer feel good financial education, despite evidence that it is almost completely ineffective at changing consumer behavior.  

Better Solutions to Improving Credit History & Scoring

While it’s true that consumers who are able to successfully make their payments on time can see an improvement in their credit scores, default rates on these products remain high (20+%), and even when borrowers make their payments on time, they’re often left in a worse financial position.

For the explicit purpose of credit building, there are better solutions. With a “credit builder” loan, the money you “borrow” is held in an account while you make payments, with the full balance and any interest returned to you at the end of the loan term. This functionally serves as a savings product, rather than a credit product, and the monthly payments are reported to credit bureaus, building a history of on-time payments.

Using a secured credit card to build a credit history is another option, where the credit line of the card is secured by a cash deposit. While these cards do charge interest if carrying a balance, if the balance is paid in full each month, users pay no finance charge.

The Opportunity of “Alternative Data”

Another opportunity to democratize credit scoring is “alternative data”. The main component of credit reports used to generate a score is tradeline data reported to the major three bureaus. Think credit cards (limit, balance, and payment history), mortgage, student loans, car loans, and so on. Historically, other recurring obligations - rent, utility payments, cell phone bills - would only be reported if payments were missed and the account sent to collections.

The types of data used in traditional credit reporting and scoring have disadvantaged lower income consumers less likely to use or be approved for these products. Including alternative data - those utility and cell phone payments - in credit files can give a better picture of an applicant’s risk for someone who otherwise might be considered “thin file” or “no file”.

Another alternative data approach is to look at how applicants have manage their checking account. Examining balance patterns and transaction data over time - is there regular and stable income? has the account been overdrawn? - can provide a more informed picture of an applicant’s stability and creditworthiness.

Align Customer + Company Success

Given the Silicon Valley “making the world a better place” mindset, it shouldn’t be surprising to see high interest rate loans positioned as helping disadvantaged consumers to improve their financial health. While no single change to credit reporting or individual new product can solve all challenges consumers face, plenty of opportunities remain untapped.

VCs, the finance industry, and regulators should focus on increasing investment in democratizing the practice of credit reporting and scoring and building products where customer and company success are truly aligned (even if that results in lower revenues).

Liked this article? Please “like” or reshare it on your favorite social media channels. Agree? Disagree? Let me know in the comments.