Earlier this month, I had the opportunity to moderate Taktile’s second installment of our Expert Talks series, featuring speakers:

The discussion touched on the rise in popularity of credit builder products in recent years and the novel approaches some fintech companies have taken. We also discussed opinions on what makes a “good” vs. a “bad” credit builder, how lenders may treat this data, and risks to be aware of.

If you weren’t able to attend the session, you can watch it on demand or read on for our key takeaways.

The idea of a credit product designed to help consumers establish or repair their credit history isn’t new. Secured credit cards, which require users to collateralize the credit line by holding cash in escrow, date to the late 1970s. As credit history and credit score have become increasingly intertwined with everyday life, impacting everything from qualifying for an apartment rental to employment applications and insurance rates, credit builders have grown in popularity. Unsurprisingly, the primary reason consumers choose to use such products is a desire to qualify for traditional credit products, like auto loans or mortgages, Self’s Chris LaConte says.

While “classic” secured cards can be an effective way to begin building a credit history, for consumers, they historically have come with a number of drawbacks. The requirement to pay an upfront deposit, typically at least several hundred dollars, is a common stumbling block for users. Low credit limits have meant that typical secured cards are not very attractive for issuers from a revenue and profitability standpoint, leading many companies that offer typical secured cards to charge high fees; though, the CARD Act, passed in 2009, implemented caps on the fees issuers could charge. And even though issuers are indemnified from a borrower’s default by the security deposit, interest rates on secured cards tend to be high, which can drive significant finance charges, should users choose to revolve on their cards.

Credit-building loans are another long-running example of products consumers can use to establish or rebuild their credit. Like secured cards, the dollar amount of credit builder loans tends to be low – often $500 or $1,000. With a credit-builder loan, rather than the loan proceeds being disbursed to the borrower, they are held in a separate escrow-type account; this protects the lender against the risk of the borrower defaulting. After the borrower makes payments for the term of the loan, most commonly 12 months, they receive the proceeds that have been held on their behalf. Credit-builder loans may carry an upfront fee and an interest rate, as, even though the risk of default is theoretically zero, such products aren’t free for lenders to offer.

Although both secured cards and credit-builder loans can be effective ways for consumers to build their credit, most versions of both products have drawbacks that may make them less appealing to many consumers: both typically come with costs, require work, and take time to make an impact on users’ credit history and score. Fintech Take’s Alex Johnson points out that many consumers who are new to credit lack the upfront money to pay a deposit, limiting the market for traditional secured cards.

Fintech firms have certainly taken notice of some of the less user-friendly features of classic credit builders and have iterated on product structures in an attempt to address these shortcomings.

The most popular structure is what some refer to as a “crebit” structure, also known as an “open secured” card. In this model, while the specifics vary from issuer to issuer, the idea is to give users an experience that looks largely like the checking account/debit card structure they are accustomed to, but while reporting tradeline data to the major credit bureaus. Fintechs may achieve this by enabling users to pre-fund a separate credit builder account alongside their regular checking account. Other fintechs may not require pre-funding a discrete account, but use a sort of “pay as you go” approach, by automatically setting aside funds from a linked checking account as a user makes payments with their credit building card and, at the end of the month, using the funds that have been set aside to pay the statement balance in full. 

But rather than allowing users to revolve and assessing interest charges, most fintechs that offer such “crebit” or open secured accounts do so as a charge card, meaning they require users to pay their balance in full each month, while prohibiting users from spending more than they have pre-funded or hold in linked checking accounts. Structuring the product this way reduces or eliminates the kinds of fees and interest expenses tied to classic secured cards, but also functionally puts up guardrails around a borrower becoming delinquent or charging off, which generally reduces the predictiveness of this tradeline data. An ancillary benefit for fintechs that offer such credit builders as secured cards is that transactions on such cards generate significantly higher rates of interchange income than debit cards.

Ideally, credit building products go beyond simply trying to increase a user’s credit score, Mission Lane’s Jason Capehart says, but incorporate features that educate users and encourage them to improve their financial health. Alex Johnson emphasizes that credit builders shouldn’t be an “easy button” for consumers looking for a quick fix in order to qualify for a loan.

Johnson echoes the sentiment that quality credit builder products should be designed to help consumers build healthy financial habits, particularly because the credit system in the U.S. isn’t intuitive. Self, a fintech focused on offering credit-building tools, offers a great example: Self’s credit card, which users can qualify for after making sufficient progress on the credit builder loan the company offers, warns users as they approach 30% utilization on their line, as this metric has significant weight in common credit scoring models. Another innovative feature Self has developed, the company’s strategy chief Chris LaConte says, is the ability to save over time towards the deposit required for a secured card, instead of requiring users to come up with the entire amount upfront, as has historically been the case.

There is a tradeoff, Johnson explains, between making credit building “easy and frictionless” for users vs. generating a good signal that other lenders can use to make credit decisions.

There are two primary areas of risk for firms that want to offer their users credit-building features. The Fair Credit Reporting Act (FCRA) and its implementing rule, Regulation V, is designed to protect the privacy and accuracy of consumer reports, popularly known as credit reports. FCRA requires companies that furnish data to consumer reporting agencies to furnish information that is complete and accurate. Data furnishers must maintain written policies and procedures governing the accuracy of information they furnish. But furnishing data isn’t always black and white, Troutman Pepper counsel Jesse Silverman says. The system and the regulations that govern it are dated, and there are numerous barriers to accurate reporting, according to Silverman.

If a consumer disputes information in their credit report, a furnisher is obligated to conduct a reasonable investigation, review information provided by the consumer, report results to the consumer (generally within 30 days), and notify each credit reporting agency if it determines the information was inaccurate.

Many fintechs that offer credit-building products or features lean heavily into marketing them, which touches on the second key area of risk: the Consumer Financial Protection Act’s prohibition on unfair, deceptive, or abusive acts and practices, commonly known as UDAAP. In the context of credit builders, much of the risk turns on if a firm has validated the claims it is making. For example, marketing to users that a product helps build their “credit history” is a distinctly different claim than telling users a product will improve their “credit score” or increase the likelihood that they will qualify for any specific product or service. Troutman Pepper’s Silverman warns that there are so many factors that go into a credit score and methodologies for popular scores like FICO and Vantage are non-public, making it risky to make marketing claims about boosting a user’s score or improving their odds of qualifying for a loan.

If it isn’t clear by now, not all credit builders are created equally. The predictive value of data from a classic secured card or credit-building loan is unlikely to be the same as that furnished from an open secured charge card, where a user is pre-paying or collateralizing the line and is prohibited from revolving. The predictive value of other kinds of “alternative data” like rent, utility, and subscription reporting can also be highly variable. Whether or not someone is paying their rent consistently on time each month, for example, is likely to have more predictive value than if they are paying their Netflix or Spotify subscription.

Indeed, the major credit bureaus, TransUnion, Equifax, and Experian, are still working through exactly how to treat and categorize emerging kinds of tradeline data, like fintechs’ newer takes on secured cards and various kinds of alternative data, Mission Lane’s Capehart says. Firms that produce credit scores, like FICO or Vantage, offer numerous variations of their scoring models, tailored for specific use cases, and different versions. Newer iterations of these scoring models are beginning to incorporate emerging categories of tradeline data and even cashflow data, to the extent they are predictive of the likelihood of delinquency or default. In addition to these “off the shelf” scores, many lenders develop their own customized models, Capehart says, including by tailoring data sources and underwriting methodology based on the product and customer segment they are serving.

Fintech’s newer iterations on credit building products are but one example of new types and sources of data that can be used to assess credit risk. The major U.S. credit bureaus have made strides in incorporating other emerging sources of underwriting data, including rent, utility, and other recurring payments. Taking advantage of emerging sources of data requires the agility to accurately balance risk vs. reward: being capable of identifying, ingesting, and evaluating the usefulness of such data for your specific use cases.

Disclaimer
This information provided in this article does not, and is not intended to constitute professional advice; instead, all information, content, and material are for general informational and educational purposes only. Accordingly, before taking any actions based upon such information, we encourage you to consult with the appropriate professionals.