Identifying Lender Risk
The face of lending has changed and evolved a great deal since the deepest depths of the Great Recession. One of the most intriguing changes has been the rise of alternative lending platforms, particularly those that allow investors to take a direct role. This alternative approach to lending money benefits both borrowers and lenders — borrowers get the money they need to start a business, grow their company and get out of debt, while investors get a far better return than they otherwise would in today’s zero interest rate environment.
The reasons for the rise in alternative lending platforms are many. For one, banks and other traditional lenders have significantly raised their credit standards in the wake of the credit crisis. Banks were roundly criticized just a few years ago for ignoring risk and loosening credit standards to a damaging degree. Now many of those same banks have swung the pendulum in the other direction, tightening their standards and steadfastly refusing to lend to all but the most creditworthy borrowers.
Alternative lenders have stepped into this strange new world, filling an important gap and allowing everyone from small business owners to ordinary consumers to get the funds they need. The growth of this new kind of lending presents both challenges and opportunities for the men and women with money to lend, and one of the biggest roadblocks has been how to assess the creditworthiness of borrowers.
Banks have traditionally relied on a number of different metrics to assess the creditworthiness of borrowers. As we saw during the credit bubble and the resulting Great Recession, these standards did not always work the way they should have. Now that the credit crisis is over, alternative lenders may find that these traditional metrics are not sufficient to their needs either.
Factors like credit scores and payment histories only go so far, and alternative lenders must rely on a variety of different data to make an intelligent and informed decision. After all, the key to success in alternative lending is to make smart loans and avoid lending to bad clients — borrowers who will struggle to pay the money back and may ultimately default on what they owe.
What Data Do Alternative Lenders Use to Spot Problem Clients?
Lending to clients with slim or nonexistent credit histories can be a minefield, but lenders have been learning valuable lessons and providing valuable information to investors. Alternative lenders now have additional data they can draw on to determine which clients are most likely to default and which are most likely to make their payments on time.
Among the metrics alternative lenders use to weed out bad clients and identify good ones are mobile phone bills, payday loans and rent payment history. That only makes sense, since even these so-called thin file borrowers, clients with little to no credit history, are likely to rent an apartment or carry a cell phone.
Alternative lenders can also use more traditional metrics to assess the creditworthiness of the clients they evaluate, including personal loans and the payment history associated with them. Previous interactions with banks and other lending institutions are always valuable when evaluating a client’s creditworthiness and that is just as true with a thin-file client as it is for one with a long credit history.
Which Data is Most Reliable?
A history of on-time payments for personal loans, credit cards and other traditional borrowings is predicative of future behavior. It is always helpful when that kind of history exists, and many alternative lenders use it to their advantage.
Of course not all clients who turn to alternative lenders will have that kind of history with traditional banks. That is why it is so important for alternative lenders to explore other metrics that can predict future behavior.
By examining patterns of purchases, educational achievements and job history, alternative lenders can gain real insight into the clients they are evaluating and make educated decisions about which ones to lend their money to.
There are a number of additional metrics alternative lenders can use to evaluate clients and make smart decisions. Information about the client’s social circle can be very revealing, as can inferences about their character and even their spelling. Poor spelling could be an indication of a substandard education, which in turn could reveal problems about future employability and the ability to repay loans.
How Can Lenders Protect Themselves from the Risk of Default?
The world of alterative lending has been growing rapidly, and that means there is now much more data available than there was when the industry was still in its infancy. The data collected so far can provide valuable information going forward, allowing new lenders to reduce the risk of default and maximize their earning potential.
Researching clients carefully and employing a variety of financial metrics and other criteria is perhaps the best way for alternative lenders to reduce the risk of default. While there are no guarantees in either traditional lending or its alternative counterpart, there are always things lenders can do to reduce their risks and attract the best clients.
Thoroughly evaluating every client that requests a loan is a great place to start. Many newcomers to the world of alternative lending try to do too much too fast. In the rush to improve the return on their money they often lose sight of the importance of the return of their money. This is a common mistake, but it is also one that is easy to avoid. Vetting potential lending clients carefully, and employing all of the metrics outlined above, is the best way to avoid these problems. Whether you are new to the world of alternative lending or just trying to improve your returns, the more you know about your clients the more successful you can be.
There are a number of reasons individuals and business owners turn to alternative lending to get the money they need. In many cases the clients are small business owners who have not yet established the credit history they need to get the attention (and the money) of the big banks. These firms are solvent enough to make good on their loans. They have sufficient cash flow to meet their obligations and build their businesses. What they lack is a credit history, and alternative lenders can benefit from this oversight in the financial world.
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