Synopsis: Alternative credit data sources give lenders more comprehensive information at lower costs but can also often need to be more accurate. Today’s article discusses the benefits and drawbacks of alternative credit data sources that lending institutions use to determine a borrower’s creditworthiness.

Alternative credit data refers to non-traditional sources of information used to evaluate creditworthiness. It’s frequently used to enrich traditional credit data, including credit scores, credit histories, and credit reports. 

Using non-traditional credit data, you can acquire a more comprehensive view of someone’s financial activity and credit risk. With so many new ways of analyzing a company’s creditworthiness, credit departments using alternative credit data sources can gain a competitive advantage. 

However, alternative credit data sources, such as spending patterns and digital footprints, are also prone to inaccuracy. Plus, they pose privacy issues. These are just some cons; read along as we discuss the benefits and drawbacks of alternative credit data sources in more detail. 

Benefits Of Alternative Credit Data Sources 

Lenders frequently employ traditional data that may not reflect a person’s current activity and do not provide a holistic view of the borrower’s financial health. That said, alternative data sources could provide more current, real-time information. 

Here are some more advantages of alternative credit data sources: 

1) Drives Financial Inclusion 

Financial inclusion is not a novel concept, but businesses are now positioning it at the top of their agendas. According to a survey, more financial institutions prioritize financial transparency and inclusion, although they confront obstacles.  

Alternative data can assist a business in using fresh data to reach a much more extensive range of demographics by ignoring prejudices and providing chances for clients who want to avoid using the traditional financial system. 

2) Peer-To-Peer Lending 

The peer-to-peer lending market will be valued at over $800 billion by 2030. This expansion is driven mainly by the number of startups and small enterprises seeking to avoid traditional loans due to a lack of credit history.  

A loan approval doesn’t have to be a risky decision when alternative credit options are available. To assess your business’s creditworthiness, lenders can evaluate the diverse credit data sources, including social connections, online activity, and other non-traditional information. 

3) Risk Assessment 

Credit departments can improve risk assessment by understanding a customer’s financial health and business performance. Alternative data can also help credit professionals make more accurate credit decisions, improving decision-making.  

Moreover, non-traditional credit data can also assist teams in differentiating between high-risk and low-risk accounts in an account receivables (A/R) portfolio. This allows them to deploy resources better and optimize their portfolios. 

4) Tailored Solutions 

Commercial credit departments can better understand each customer’s unique financial demands and issues by using alternative credit data. Credit managers can now design more tailored payment arrangements.  

Managers can also develop stronger relationships and boost customer satisfaction by aligning solutions with the customer’s goals. 

5) Enhanced Predictions 

Alternative data can help a credit department predict payment defaults. You can monitor A/R portfolio performance more effectively by incorporating this data into your risk management strategy

Plus, you can better deploy loss mitigation measures with insights from alternative data — modifying payment terms or providing further assistance to needy consumers. This proactive technique can assist in reducing customer nonpayment losses and increase company income. 

Drawbacks Of Alternative Credit Data Sources 

Using alternate data could penalize or reward specific groups or behaviors unpredictably. Government employees, for example, may move frequently, giving the perception of instability, which may impact their ability to obtain credit. 

Some more disadvantages associated with alternative credit data sources are: 

1) Lack Of Security 

Alternative data is susceptible to substantial changes in opportunities, as it can be affected by fraudulent actions. A seasonal increase in energy consumption, for instance, can have a significant negative impact on the financial situation of low-income groups in some places. 

Similarly, almost 20% of social media accounts affiliated with ten large worldwide brands are bogus. With one out of every five social media accounts being fake, using social media data for creditworthiness assessment requires proper data integrity standards.  

2) Inaccurate Or Incomplete Data 

Though traditional data can also be inaccurate, certain types of alternative data may be more prone to errors if the criteria controlling those data are different or weaker than those governing traditional data. Also, some alternative data may be inaccessible or unavailable, preventing you from discovering and correcting errors. 

For example, your business may primarily rely on cash transactions or operate in a predominantly cash-based community. In such cases, their financial data may need to be accurately reflected in traditional credit reporting systems, leading to incomplete or inaccurate credit assessments. 

3) No Transparency 

Traditional creditworthiness assessment frameworks, while flawed, are rarely faulted for a lack of transparency. For example, the CIBIL score comprises different parts, and everyone with a credit score knows what factors affect it.  

However, private institutions use thousands of data points to create alternative frameworks. This makes it difficult for businesses to understand factors that influence their creditworthiness. 

4) Rigged System 

On the flip side of transparency, is having too much knowledge; which leads to customers rigging the system. Once the customer is aware of the factors that impact their credit scores and profiles, they can find different ways to tip the odds in their favor. 

For example, if a customer gets to know that their social media activities are a factor affecting their creditworthiness, they might start deleting posts, engage differently and reduce their usage altogether. 

To sum up 

Incorporating alternative credit data into your credit analysis methods certainly provides numerous benefits. However, you also need a strategic plan to address the issues of gathering, analyzing, and interpreting non-traditional data sources. 

Incorporating alternative credit data into existing procedures requires a combination of classic and non-traditional data sources. Though this may take some heavy lifting, it can enable credit departments to develop a more robust credit scoring model and enhance credit risk projections.