If Congress passed a law requiring everyone in the United States to get a license to be considered for a job or rent an apartment, the nation would rise up in protest. The irony is that such a system already exists and its validity is rarely questioned: the license is, of course, your credit score.
It can open doors or cause them to be slammed shut. A quarter of unemployed Americans undergo a credit check when applying for a job, and many landlords refuse to rent an apartment or a house to a person who has no or low credit. The influence of your credit rating on the availability or price of financing for a car or home can be drastic: For a $100,000, 30-year mortgage, a buyer with a FICO score of 760 will pay almost $70,000 less in interest compared with a buyer with a score of 620, which is close to the average score for people in their 20s today. (See this report from the Credit Builders Alliance.)
The bigger problem is that some 54 million people in the United States (and 4.5 billion people globally) have no credit standing at all. They have been dubbed “credit invisibles” (video). This doesn’t mean that they are unreliable or inactive.
In the United States, it just means is that their economic behavior—what amounts to a substantial portion of the nation’s daily work—remains outside the purview of the three major credit rating agencies.
The credit invisibles are disproportionately minorities, young adults and new immigrants, and although many have been reliably paying rent, utilities and phone bills for years, this information hasn’t been captured by credit agencies (except in some cases when payments are late or delinquent). As a result, millions are marginalized. They can’t access attractively priced, responsibly delivered credit to start businesses or buy cars or homes, and when they need bridge loans or quick cash to cover basic living expenses or emergencies, they frequently have to pay exorbitant rates at check cashing operations or payday lenders.
The good news is that there are lots of people today working to solve this problem—in government, in the nonprofit sector and increasingly in business. In fact, some of the approaches that promise the greatest potential for growth are emerging at the nexus of technology and for-profit financial services.
“Tens of millions of people are misclassified by the system, at the hand of prejudice or any other number of factors,” says Arjan Schutte, the founder of Core Innovation Capital, a venture capital firm that invests exclusively in companies aiming to serve “underbanked” consumers in the United States so they can improve their lives. “It’s a social problem but it’s also the basis for a commercial opportunity: not to give a fraudster a loan, but to give someone who is deserving a loan. And so many people who are deserving are misclassified.”
Like many leaders working to improve financial services for low-income people in the United States, Schutte was inspired by the work of the Grameen Bank, and the pioneering community development bankers Ron Grzywinski and Mary Houghton, co-founders of Chicago’s ShoreBank, which closed in 2010. A little over a decade ago, with a grant from the Ford Foundation, ShoreBank conducted a study examining the problems faced by America’s un- and underbanked population. That led, in 2004, to the creation of the nonprofit Center for Financial Services Innovation (C.F.S.I.), which has played a leading role building and influencing a network of nonprofit organizations and companies working to improve financial services and products. Schutte learned the ropes alongside C.F.S.I.’s founder and chief executive, Jennifer Tescher, helping large financial entities make sense of data and research so they could see the possibility of bringing millions of new customers into the financial system responsibly.
In 2010, he launched Core and raised $45 million in investment. His goal was ambitious: to achieve venture-capital-level returns while assisting millions. “Our impact goal was to have 10 companies in our portfolio that were each reaching one million people and helping them save $50 per month,” Schutte says.
To date, Core has invested in eight companies. It reports that in 2013, its portfolio companies provided financial services to 6.1 million low- and moderate-income people that allowed them to collectively save $2.4 billion. (The data come from internal reports, which I reviewed. Core and its investees remain privately held.)
One of its investments is in a firm called L2C, based in Atlanta, with about 30 employees, which has developed an alternative credit scoring method that is used by dozens of auto lenders and banks, including several of the top 10. L2C amasses alternative data for consumers who have little or no credit histories or would be considered “subprime.”
“The credit bureau primarily captures the liability side of the balance sheet—how much you owe on a car or house or revolving lines of credit,” explains Mike Mondelli, the company’s chief executive and one of its co-founders. “But most of the folks we’re dealing with don’t have balance sheets; they only have income statements.”
L2C acquires and analyzes data about utility or rental payments, checking account usage, and even payments for subscriptions. L2C and Core report that the score increases the chances that a “thin file” or “no file” applicant will be approved for a loan and get a lower interest rate.
Consider the difference for an auto loan. For many people, a car is their biggest purchase, and it’s essential for work. But interest rates vary widely—from 2 percent for prime, to 13 percent for subprime, all the way up to 24 percent for high-mileage cars at “buy here pay here” dealerships. Core estimates that in 2013, L2C scores allowed 3.8 million low- and moderate-income applicants to gain access to lower priced credit, saving an average of $480 in interest costs, or roughly $1.9 billion in total.
Another lender in this space is Progreso Financiero, which currently works with Hispanic customers in California, Texas and Illinois who have minimal or no credit histories. (Almost half of the nation’s Hispanics are “un- or under-banked,” according to the F.D.I.C.) Progreso calls itself a mission-driven company, and is a federally-certified community development financial institution (PDF). It has 120 branches — storefronts in Hispanic neighborhoods and kiosks within Hispanic grocery stores—and has lent $1.2 billion in small, short-term loans to more than 400,000 people. Its employees are drawn from the communities they serve.
Progreso’s credit scoring integrates a multitude of factors that shed light on its clients’ ability and willingness to repay loans, and their stability. Its business revolves around the financial patterns of Hispanic families. For instance, Hispanic households are more likely to include people from extended families. Often, multiple individuals will contribute to bill payments, but only one may show up in a “trade line” that builds credit.
Progreso looks at each individual’s contributions to, and share of, rent or living expenses. It schedules loan payments to coincide with income flows. Loan officers check in periodically and make a point of reminding borrowers when their first payment is coming due. Loans typically range from $500 to $5,000. Top uses include medical expenses, basic living expenses and education, as well as starting a business, fixing a car, applying for citizenship or visas and paying for funerals.
“Technology has allowed us to underwrite a population that today is considered under-scorable, and it’s allowed us to scale in a way that a nonprofit with a similar mission couldn’t do,” explains Raul Vazquez, Progreso’s chief executive, who grew up in West Texas and whose parents are from Mexico. “The customers we serve would be my cousins, my uncles, my aunts.”
The loans are not cheap. The average annual percentage rate (A.P.R.) for a loan is 36 percent, which is at the top end of the Consumer Financial Protection Bureau’s guidelines for short-term, small-dollar lending (PDF). Initial loans cost more and subsequent loans less. However, the alternative for many customers would be payday lenders, where a 400 percent A.P.R. on a two-week loan is common (PDF).
The key consideration is whether a loan is actually helpful for a poor person—in both the short run and the long run. The most important aspect of Progreso’s work is that it reports its loan data to the major credit rating agencies. “The average borrower within two loans has built a credit score of 680,” Schutte says.
Establishing such a credit history is essential for financial advancement, researchers say. “Most low-income people who don’t have access to affordable sources of credit cannot build wealth or assets to generate wealth to generate surpluses,” explains Michael Turner, president and C.E.O. of PERC, a group that works to reduce “credit invisibility” around the world. “Credit is a precondition for meaningful savings. We’ve demonstrated this point empirically in numerous studies.”
From a pure business perspective Progreso’s decision to report its customer’s loan performance could be seen as unwise: It gives its best customers options to go elsewhere. But Vazquez measures success in two ways: “Someone borrows from us, they have a great experience and the next time they need capital, they consider us again,” he says. Or “someone gets a credit score and they’re able to work with a larger organization that can provide financial products or prices” that Progreso does not currently offer.
“Even for companies like Progreso that are trying to do socially responsible loans, it’s really hard to do those loans cheaply,” observes Lisa J. Servon, a professor at the Milano School of International Affairs, Management, and Urban Policy at the New School, who has written extensively about the financial lives of low-income communities (and worked as a teller at a payday lender herself).
“We need to ask why so many people need these loans and products,” she adds. Why has liquidity become so crucial? “Wages have declined since 1972 and income volatility has doubled in the past 30 years,” Servon says. One measure of the problem is the “liquid asset poverty rate.” In 2010, 44 percent of all families, and 63 percent of minority families, did not have enough liquid financial assets to sustain their households at the poverty level for three months if they lost their income.
All of this can make life highly stressful—and unhealthy. “Many people have tremendous uncertainty about the amount and the frequency they’ll be paid in any given week,” says Jennifer Tescher, from C.F.S.I., who has worked with the Financial Access Initiative at New York University on a project called U.S. Financial Diaries, which tracked the financial behavior of 200 low- and moderate-income households for a year. “There’s a lot of juggling and it’s intensely complex and there are not particularly good systems and products to help do it better.” (See links below for examples of emerging products.)
Servon points to two things that banks could do to make life easier for people who have no cushion: Shorten the time it takes to clear a check and allow deposits any day. “Banks will take money out of your account seven days a week but will only put money in five days a week,” she notes.
There is a beauty in large-scale solutions. But one of the most soulful models being advanced is one that’s hard to grow quickly, but harkens back to the original basis of credit—which derives from the Latin credere, “to trust.” It’s the way the Mission Asset Fund (MAF) is helping thousands of people in informal lending circles, like tandas, get their payments reported to credit bureaus. Within 15 months, 90 percent of participants achieve a credit score and many move into the “prime” category.
“We have this beautiful tradition of people coming together, holding each others’ money, no paper, no bank, just their social knowledge, and the faith that goes along with that,” explains José A. Quiñonez, MAF’s founder. “And now we add the benefit of building your credit score.”
Here are some useful links for people who have concerns about their credit or financial management:
CoverHound, an insurance marketplace with a multitude of smaller insurance carriers, can help consumers find lower rates. (I did a search for renter’s insurance and found a rate that was one-quarter the price of my current policy.)
Credit Karma helps users keep track of their credit scores.
Digit offers a platform to help people see how much money they can afford to save on a daily basis.
Prism is seeking to make bill payments free and easy.
Level Money is a sort of Fitbit for personal financial management, sending information in real time to your phone.
This post first appeared on the New York Times’ Fixes blog.