Consumers and lenders alike are becoming increasingly aware of the importance of credit referencing, but what are the limits of this process, and how will they affect the motor finance sector? Chris Farnell writes.
Credit scores are widely used in the motor finance industry to assess the credit risks of both customers and companies.
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They are a vital resource for lenders to ensure that customers are not getting into financial stress or levels of debt that they cannot afford. The process by which this score comes about, which can often seem opaque to those outside the industry, involves a complex amalgamation and cross-referencing of information.
“Credit agencies use a variety of information sources to gather data for credit scores – financial institutions, public records, the electoral roll,” explains Justin Basini, chief executive officer and co-founder at fintech business ClearScore.
“The most important data points, however, come from financial institutions, which report the accounts you have had with them in the last six years. Credit scoring is incredibly complex, and so many factors are taken into consideration, including information fed to the credit reference agency [CRAs] from banks and lenders.”
Perhaps the best known of these agencies is Experian, which aggregates information on over 1 billion people and businesses. The credit agency’s head of automotive, James Syron, points out: “CRAs enable banks, lenders and other providers to exchange information about the payment behaviour of their customers, to support responsible and profitable lending decisions. The CRAs add in other relevant information, such as the electoral register, court judgments and insolvencies, to build up factual credit reports on most UK adults.”
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By GlobalDataA customer’s credit score is, as Basini describes, “a snapshot reflecting how you have handled debt and credit accounts in the past”. Very simply, people who have handled debt well, never defaulting or missing payments, will have good scores; however, those who have had trouble paying off debts will have lower scores.
As technology develops, credit agencies have improved their processes for registering and refreshing data, ensuring that their reports adapt quickly to reflect recent events.
“For example, providers of payday loans can register new customer loans with the agencies in real time,” Syron tells Motor Finance (MF). “Annual paper electoral registers that had to be checked and keyed in manually have been replaced by monthly electronic updates from local councils that can be matched, checked and updated by machines.”
By using new technologies and techniques, credit scores are able to better predict future behaviour by comparing new and past customers customers with similar profiles, using credit scorecards.
“While the basic approach has not changed, improvements have been achieved through more sophisticated modelling – for example, looking at data trends rather than one-off snapshots,” Syron says.
“Advances are also being made in improving decisioning about people who traditionally had little or no credit history. One example is adding rental payments to tenants’ credit reports – for example, through Experian’s partnership with Big Issue Invest.”
Cars and Customers
The main purpose of a credit score is to predict whether money lent is likely to be repaid as agreed, and this applies as much to motor finance as any other lender. And as in any financial decision, the more information to which a lender has access, the better.
Giulia Fabritius, car finance specialist at ClearScore, explains: “Ultimately, for the borrower, a higher credit score translates to two main benefits: getting approved for a higher amount, and getting a lower interest rate. The score itself does not provide any additional information – it is, instead, the summary of all the information. But lenders always look at the credit report together with the score.”
By looking at the credit report, lenders can gain an insight into the customer’s financial life – the types and amounts of borrowing they have had in the past, the total debt they owe at the moment, whether their debt is increasing or decreasing, and their monthly required payments. The knock-on effect for this should be twofold: providing customers with better deals, and car finance companies with better returns.
“Car finance deals should become cheaper as a direct result of the implications of improved credit risk based on a rising credit score,” Fabritius points out; unfortunately, however, it does not always work that way. “A recent paper by the Financial Conduct Authority (FCA) looked specifically at the car finance broker commission models, where firms are effectively incentivised to set higher customer interest rates, thus earning higher commissions. Due to increased scrutiny, over time we should see this change to reflect the link that we should see between the two, much like we do when looking at loans.”
Credit data is an essential component in understanding how likely a customer is to repay a loan, but it is also used to determine affordability.
As well as helping customers assess whether a financial product will be affordable for the lifetime of the loan, some credit agencies are partnering with the motor finance sector to take into account another vital element in lending decisions: the vehicle itself.
“The vehicle is another key factor in lending decisions,” Syron says. “Experian has partnered with an industry-leading valuation partner, Cazana, to assist lenders in understanding the value of a vehicle both now and in the future. If a car depreciates quickly, then this key insight requires feeding into a lending decision, as it is a greater risk.”
These relationships are becoming more common. As Tim Smith, head of motor finance at Black Horse, explains, the lender routinely interacts with credit agencies when making decisions. He tells MF: “As a bank, we share data with CRAs regularly. This ensures that financial institutions have a full view and are able to fairly assess a customer’s level of indebtedness for any new lending.”
Self-Aware Customers
While the motor finance industry is working increasingly closely with credit scoring agencies, and establishing ever-more detailed and granular methods to build up a picture of their customers, customers themselves are also becoming more aware of their credit score and the impact it has on their lives.
“When it comes to car finance, the better your score, the better your deal,” Fabritius says. “If a person knows that they want to purchase a car in the future, they can start working to improve their credit score in the hope of securing a better deal.”
Smith agrees that customers are now becoming more interested in their personal credit ratings, and this is evident from the growth in online options in this space.
“It is an important development, as consumer acceptance here signposts that risk-based pricing approaches may become more viable in the future for car buyers,” he notes. “This has positive benefits, because it can increase availability of credit and consistency of pricing.”
Pre-eligibility checks are an important development in this space that will help improve the customer experience, and online tools embedded on websites are expected to increase in popularity; ClearScore is one such tool. It obtains data from Equifax, one of the UK’s three CRAs, providing consumers with free access to their credit scores and reports for life. By taking a commission from partners when a customer buys a product through ClearScore, it is able to offer this service free of charge.
“The growth of ClearScore is proof of customers’ growing awareness of the importance of credit reports and scores in all finance decisions,” Basini says. “Our users know that by using us to finance their vehicle, they can apply with confidence, as we tell them the likelihood that they will be accepted for finance.”
Experian has also noticed that awareness and engagement with credit reports and scores has been growing for many years. Experian’s 2019 Credit Awareness Week survey revealed that more than a quarter of adults know their current credit score, or at least a guide score from a credit reference agency – no one has a single credit score. This undoubtedly affects how people approach and manage credit.
“For example, more and more people are using eligibility services to see whether they are likely to get the credit they would like before they apply,” Syron explains. “In February 2019, 77% of credit card searches were soft searches, compared to less than a third (29%) four years previously – a rise of 48%. These soft searches, which allow consumers to check their eligibility, have no effect on the individual’s credit score.”
Experian has responded to this trend by expanding its eligibility services to better include the motor finance sector. Consumers can compare a range of finance options for used cars, and see their likelihood of being accepted.
“Such services are important, as we found that nearly two-thirds (60%) of Brits admitted they do not know the difference between HP, PCP and a typical car loan – even though these options are how cars are now commonly purchased,” Syron says.
Credit Limits
While the benefits of credit referencing are manifold, it has its limits – even with the vastly increased volumes of data to which agencies now have access.
The challenges take various forms. Firstly, there are regulatory considerations. Credit reference agencies are authorised and supervised by the FCA, and must meet its conduct rules and principles.
Credit reporting also falls under the watch of the Information Commissioner’s Office, which ensures compliance with the Data Protection Act.
“It has been well publicised that General Data Protection Regulation [GDPR] is now in force in the UK, and has raised the bar in terms of consumer privacy and transparency, requiring a number of changes to the way CRAs operate,” Syron tells MF. “One simple example is that people can now check their own credit reports for free.”
The credit-scoring process is continually reviewed to ensure that it is as accurate as possible. Lenders and CRAs are finding ways to incorporate the latest technical developments, such as machine learning and big data analysis, into their scores.
Credit scores are likely to continue to play a very significant role when deciding if a customer will be eligible for finance in the future, but there remain limits, which the industry is working to overcome.
“At the moment, the biggest limit of credit scores is that they are heavily based on a user’s past borrowing behaviour,” Basini says. “Those who are new to credit are stuck in a chicken-and-egg loop: you cannot get a credit score until you borrow, but you can’t borrow until you get a credit score.”
Syron adds: “It is essential that credit reporting keeps track with changing consumer behaviour to stay fit for purpose. For example, the advent of Generation Rent has underlined the value and importance of bringing rental data into credit reporting. As more people are renting and sharing rather than owning their home, the CRAs must respond by taking steps to keep credit reports and scores up to date and relevant.”
Basini explains that credit agencies and fintechs are exploring alternative ways to assess borrowers – from measuring rent payments to analysing spending, both of which are increasingly important sources of data in a market where mortgages and home ownership are on the decline.
“These solutions are in the nascent stages, however, and it will be a while before we see one reach market penetration,” Basini says. “In the meantime, ClearScore offers users with no or recent credit score access to alternative products that can help them build the history they lack.”
Even if a potential customer has a long credit history, if borrowing is spread between different countries, not all the relevant data may be visible to the CRA.
“It is very dependent on past borrowing behaviour specifically within the country in which said borrowing took place,” Basini says. “As a result, some individuals who move countries have insufficient information to build up a truly representative credit score, even when they should otherwise be considered a low credit risk.”
The aggregation and analysis of data is now easier than ever – a trend that is only set to continue, even with the advent of GDPR regulations. Using that information wisely is the next challenge.
Regulation
In light of the changes and challenges to the credit scoring market, the FCA has launched a market study to examine how the market works and its impact on consumers.
There may be inefficiency in the sector, some of which the regulator has detected, and with the advent of technological innovation come new market players that will add information about where these market efficiencies lie, further increasing the interest of the regulator.
There also remain questions of privacy and consent for technology business consumers that are monitoring social media firms as a basis for credit scoring.
The FCA says the market study will focus on three themes: the purpose, quality and accessibility of credit information; market structure, business models and competition; and consumer engagement and understanding of credit information, and how it impacts their behaviour. It adds that in exploring these themes, the study will assess how the sector is working now, and how it may develop in the future. It will also look at how the markets for credit information work in some other countries, and what the UK market might learn from them.
The FCA says it will report on its preliminary conclusions on these themes in the spring of 2020, including, if appropriate, a discussion of potential remedies.
