Lending Club issued $258 million in loans in 2011. Last year, that number was $4.4 billion.
Alternative lending platforms like Lending Club, Prosper, and OnDeck Capital are experiencing astronomical growth right now. This growth has been greeted with enthusiasm by venture capital firms (which have poured billions of dollars into alternative lending start-ups) and the market at large (as reflected in Lending Club’s initial public valuation of nearly $9 billion). Given their growth rates and the somewhat pejorative label “alternative lending,” it is natural to assume that the success of these companies is due, at least in part, to borrowers with subprime credit histories. After all, how could these new companies be growing this fast if they weren’t tapping into customer segments that traditional financial institutions traditionally ignored?
FICO Score Needed
Well, it turns out that the vast majority of alternative lending platforms have explicitly chosen to avoid working with subprime customers and they are surprisingly transparent about it. The Lending Club website states, in order to apply for a loan, one must have a FICO score of at least 660. Prosper’s minimum score is 640. These score cutoffs put Lending Club and Prosper’s customers squarely in line with traditional lenders’ definition of prime credit customers. In fact, both companies’ loan portfolios have actually gotten more conservative, from a risk standpoint, as they have grown over the last 10 years.
When I was putting together my latest research report, The Disruptive Potential of Marketplace Lending in the U.S. Consumer Credit Market, I discovered that there are a couple of very good reasons why these platforms focus on potential borrowers with high credit scores.
- With the exception of a few alternative lenders that are explicitly focused on subprime borrowers (such as LendUp), the business models of most alternative lenders aren’t compatible with the risks associated with subprime lending. For example, the business model employed by both Lending Club and Prosper is called “marketplace lending” or “peer-to-peer lending,” a model that uses a platform that funds borrowers’ loans by connecting the borrowers with investors willing to fund those loans in exchange for a risk-adjusted return. In order to grow their businesses, Lending Club and Prosper must balance the interest rates they charge borrowers against the risk levels their investors are willing to accept. If they move too far down the creditworthiness spectrum, they risk scaring off investors.
- Most alternative lenders have built their own proprietary credit decisioning systems that they claim are much more sophisticated than the systems used by traditional lenders (banks). They argue that this sophistication enables them to make more accurate determinations of a consumer’s true creditworthiness than a bank that is simply using the FICO score. However, it’s important to remember that while alternative lenders claim to have built analytic models and algorithms that perform better than the FICO score, they still rely on the FICO score as a baseline requirement for borrowers. This means that not only do these lenders reject consumers with poor credit scores, but they also reject consumers who don’t have credit scores.
What This Means
Alternative lenders’ focus on prime customers and their reliance on the FICO score have two very interesting implications for mainstream financial institutions.
- If alternative lenders—most of which are based in Silicon Valley and think of themselves as technology companies first—haven’t figured out how to evaluate the creditworthiness of underbanked consumers like students and new immigrants, then maybe it’s not a technology problem. Accurately assessing the credit risk of consumers who don’t have credit files is a challenge that banks, vendors, consumer advocacy groups, and government regulators have been focused on for years. This isn’t a challenge that will be overcome quickly or without a great deal of cooperation among the aforementioned groups. Consequently, this is probably not an area that alternative lenders will meaningfully disrupt in the near future.
- Banks, on the other hand, should be asking themselves why prime credit customers are going out of their way to work with these alternative lenders in the first place. Remember, the growth that these platforms are seeing is coming from the same consumer segments on which traditional financial institutions focus. Why would a fully “banked” consumer choose to get credit from someone other than the bank? In my research, I found that the answer is less a matter of pricing (as many assume) and more about providing the fast, digital-centric borrowing experiences that today’s consumers want.