Ann Kaplan is a president and CEO of iFinance Canada, a consumer finance company.
Are you credit worthy?
The answer lies in one magic number: your credit score. Voila! It's as simple as that. Or is it?
The financial industry has long banked on credit scores as the primary way for assessing a person's ability to repay a loan. It's been the accepted standard for more than two decades now, in part because credit scoring is an easy and inexpensive process and no one has really pushed to change it. Credit scores are used by more than 90 per cent of top lenders.
If it's such a universal practice, what can possibly be wrong with this system of evaluating borrowers and their potential risk? Do we need to look at more than a credit score when we're determining whether a consumer can pay back a loan? A growing community of experts thinks so.
In recent years, we've seen compelling research that is unlocking deep insights into the multiple ways to measure a consumer's financial health, beyond just the revered credit score. These revelations suggest that many in the industry have maintained serious tunnel vision regarding credit worthiness evaluations. Somewhere along the line, the person behind the credit score was removed from the equation.
Since we humans are a complex and diverse lot, why should a person's ability to handle money and debt really boil down to this single computation?
The reality is that the practice of only considering a credit score is a narrow – and outdated – approach. While valuable, it's not a broad enough measurement. A credit score is just one piece of the puzzle. And consumers deserve better.
To determine creditworthiness and truly grasp a person's financial risk, banks and other lenders should seek an expanded and more nuanced understanding of an individual's unique circumstances. A myriad of factors may impact a person's ability to pay back debt, including employment history, salary and living situation. Even the type of references on a loan application can shed light on red flags – or green lights – in a candidacy for borrowing.
Remember the global financial crisis that ignited in 2008? Many lenders used credit scores as the main "proxy" for ability to repay. They irresponsibly handed out mortgages and loans to individuals they knew would not be able to repay their debt, failing to examine the specific factors of each debtor's life. Coupled with deregulated lending practices, it led to widespread financial collapse – and revealed that credit scores alone aren't necessarily a good predictor of risk.
While the experience in Canada has been different, there's a similar industry reliance on credit scores. Consider the disconnect between household debt levels, which have reached a historic high, and the fact that 71 per cent of Canadians continue to maintain a good or excellent credit rating.
It's time to overhaul the credit score-dominant system, in Canada and globally. And governments can be pivotal catalysts in driving more responsible lending. We need stronger regulation requiring lenders of all sizes and shapes to more thoroughly vet loan applications beyond credit scores. This is crucial to protect both borrowers and the financial system. By assessing credit eligibility in diverse ways, financial providers can better predict risk among a range of consumers.
My studies in this area for the past 10 years have led me to focus on how we assess our clients differently.
More specifically, we use an algorithm called CHAI – Credit History and Additional Information – that combines information from a credit score with other details from a standard credit application, such as length of employment, years at address, total debt servicing, amount of loan and more.
We examine the monthly payments of the potential loan, together with other monthly debts to determine whether a person can afford the loan. From this information trove, CHAI quickly generates an automated rating. Often, lending decisions hinge on the lender taking possession of the asset in the event of default, and selling it. The CHAI model is typically used when there is no collateral or asset attached.
Responsible lending is the future. It's not where we should go; it's where we have to go. By harnessing new tools and data, we can paint a more complete picture of borrowers that translates into better lending decisions, untapped markets, enhanced customer loyalty – and, most importantly, longer-term revenue gains.
The credit-granting business may always be a numbers game. But providers that factor in an array of financial-health criteria will achieve a competitive edge, while heralding in a fairer, more accurate and safer approach for consumers.