The history of underwriting and its present problems

The basics of underwriting

The word underwriting came from the simple act of writing your name under the amount agreed you wanted to borrow. Today, it has evolved into a complicated process of credit checks and income verifications, one that few people understand.

Modern underwriting determines if a loan applicant is creditworthy and deserving of approval. They are usually done by investment banks, insurance companies, or other third-party financial institutions. These entities review the application, either manually or with an automated system, and make the final judgment call on whether to approve the applicant for the loan.

The process:

The borrower submits a loan application which triggers a credit review by the underwriter. A credit review usually consists of a credit check from one of the three large credit bureaus —Experian, TransUnion or Equifax. These bureaus track and report your FICO score to inquirers.

Then, the underwriter will analyze your debt-to-income ratio to make sure you haven’t taken on too much debt. This is followed by an income verification (such as an official pay stub) to corroborate your self-reported earnings. Finally, once the underwriter has reviewed all the information, they will make and deliver an approval or denial.

What is a FICO score?

The FICO score was created by the Fair Isaac Corporation. It’s a single number between 200 and 850 that indicates your credit risk; ie how likely you are to pay back a loan. The score combines a variety of information—including payment history, accounts owed, length of credit history, new credit, and credit mix—to create your score.

The problems with traditional underwriting

Changing credit behaviors have outpaced innovation in traditional underwriting processes, making them extremely outdated. Lenders still rely primarily on FICO, but the way in which people spend, save, and borrow is dramatically different. By only basing loan approvals on one number, underwriters are missing the opportunity to combine modern technology and crucial data that could affect the decision and, ultimately, a person’s life.

Below are a few of the most pressing problems with traditional underwriting:

1.     Millennials don’t use traditional credit

Using the FICO score to base the majority of credit applications presents problems for younger consumers because fewer of them are following the credit-building habits typical of previous generations. Two-thirds of millennials don’t have a credit card—one of the earliest ways people have historically started to build up a credit profile. Millennials have also delayed purchasing cars and homes which also can contribute to credit-worthiness. Because of this avoidance, twenty-six million people are credit-invisible and lack a credit history substantial enough to be underwritten—even if they have a solid financial foundation. These consumers who have avoided credit in the past are finding it impossible to get credit now that they want it.

2.     One mistake can determine your credit destiny

Traditional underwriters are risk-averse using a pre-set list of limited criteria to make an approval decision including a substantial ding for late payments. Just one late payment can stay on your credit report for seven years, even if you follow it with perfect repayment. When a borrower is late on a payment it usually means they don’t have the money. When a credit company slaps a substantial late fee on top of the payment they owe, this only compounds the problem leading to a vicious cycle of missing payments. One late payment can doom you for decades. Moreover, some credit companies design their products to be confusing to take advantage of customers and rake in billions of dollars in late fees.

3.     FICO doesn’t use appropriate data for modern loans

The FICO score uses the same data points when approving for a 30-year mortgage and a credit card applicant. Payment history and credit history are the primary inputs into the FICO score, making up 50 percent of the total. While these may be good indicators for an applicant’s ability to repay a loan over an extended period, like a mortgage, it doesn’t always give useful information about loan repayment over a shorter period, like for a credit card.

These loans are fundamentally different and should look at different data sources. Over 30 years, jobs can change, incomes shift, and cash flow varies. It makes sense to understand a borrower’s relationship with credit over an extended period. For loans that are repaid over six or 12 months—where these significant life changes are much less likely—a narrower data assessment will give the underwriter a more accurate risk evaluation.

4. Underwriting hasn’t improved

While underwriters use models that are complex, those models haven’t changed in decades. By operating within the same format without any evolution, their ability to approve or deny appropriately is frozen to when those models were created.

By implementing machine learning—the process of using artificial intelligence to analyze an algorithm—underwriting will evolve for the better. With this model, decisions and processes aren’t set in stone; they’re always changing and improving. By approving a small number of applicants who might be denied using traditional underwriting, modern underwriters can balance risk with learning. The ideal customer profile is continually updated to be as precise as possible at detecting a qualified applicant. And of course, we need to be aware of any inherent bias in these algorithms and work to combat them.

Why it matters for retailers

Credit and spending habits have evolved rapidly, but traditional underwriting remains decades old. For retailers, this means it’s much harder for many deserving people to access credit and make needed purchases–even those they could reasonably and responsibly afford.

It’s time for underwriting to catch up to the 21st century. Your retail business will gain the best outcomes by working with an underwriter that takes a more holistic approach to approvals, instead of relying on a single outdated number. By looking at relevant data and evolving how risk is assessed, modern underwriters can approve a higher number of qualified shoppers than a traditional FICO underwriter—which will lead to more happy customers for you.

About the Author

Jesse Klein

Jesse is a graduate from the University of Michigan with a degree in neuroscience and a passion for writing. She uses both skills to tackle financial technology. Jesse was born and bred in the Bay Area and has watched as technology companies came to flourish in San Francisco. She is excited to be part of one that focuses on helping people make better financial choices.

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