For years, 5Cs and FICO scores have played a significant role in credit decisioning. Most lenders rely on FICO to determine whether or not to approve a business loan. It is also used to set interest rates, loan amount, and repayment terms.
In the past, FICO scores were commonly used by banks, credit unions, and other financial institutions to assess the creditworthiness of borrowers. These scores typically range from 300 to 850. The higher scores are given to business owners who’ve handled debt in the past and probably continue to do so. Business owners lose the most points for making poor financial choices in the past, missing payments, or filing bankruptcy. Just because a business has an 800 credit score, it doesn’t mean their loan application will be approved by the lender. It’s just one important factor in a bank’s lending decisions. During the pandemic, the risk management tools used by lenders proved to be sadly insufficient. While the biggest national banks continue to rely on old-school credit scoring methods, new digital and alternative lenders have started experimenting with new and innovative methods for underwriting credit risk. Besides the FICO score, these lenders also consider other important factors such as cash flow predictive data, spending behavior, and other alternative variables to make better lending decisions. Here are some important reasons why a perfect FICO score isn’t enough and why you should try an alternative to FICO. First, The 5Cs and FICO score doesn’t reveal an accurate picture of a business's financial health. Millions of aspiring and existing entrepreneurs may need extra cash for a variety of purposes in their businesses. Besides, it’s extremely difficult to determine the creditworthiness of borrowers based simply on historical data or those who have just started their new venture and don’t have a credit history yet. Lower prices, higher supplier costs, lower sales, intense competition, industry changes, government regulations, natural disasters, and the pandemic are some of the many factors that can reduce a borrowers’ ability to repay the loan amount. Since a credit score doesn’t contain items like income, expenses, cash flow, and anything about the business’ future ability to repay, historical data is not enough to make better and intelligent lending decisions. Thus, a FICO score of business owners may not be an indicator of whether they can afford to take on additional debt. Second, a FICO score won’t tell if a business is struggling with cash flow issues or seeing its revenue dip in the public-health crisis or a pandemic. FICO scores use credit bureau information, which includes items like debt payments and balance history. It doesn't contain items like a business’ revenue, income, expenses, or it won’t tell if a business is still running or has been closed. If a business has too much debt relative to income, it could be declined. Third, cash flow matters. From the last few years, lenders are realizing the benefits of cash flow predictive data in providing loans to businesses. Earlier, financial institutions were obsessed with FICO scores. If a business has a high credit score, it could borrow an almost unlimited quantity. However, FICO is mostly a measurement of whether or not a business is making payments on time. New lenders are looking increasingly at cash flow predictive data in their underwriting. A cash flow analysis of a specific period gives the lender an idea of how much debt a business can successfully handle and how much cash is left to be reinvested into the business. It helps lenders to determine a business's financial capacity to repay the loan. Simply, a positive cash flow indicates lenders that a business will be able to pay back the borrowed amount, so there’s no risk in providing capital, and vice-versa. Fourth, and finally, the risk associated with the borrower. If a borrower is looking for a business loan, their ability to make repayments on time would be a great indication of risk. However, the FICO score won’t tell this to lenders. If a business is responsible and closes credit cards that they no longer want, they can be punished by FICO. If someone has positive cash flow but a lower profit, FICO doesn’t consider this. Besides FICO scores, other signals are also more important in credit decisioning. Today, lenders can access, analyze and use the most robust, accurate, and real-time data of their borrowers to reduce credit score, determine creditworthiness and make smarter lending decisions. Some FinTechs like Codat, Validis, and ForwardAI provide financial data APIs that enable lenders to collect data from multiple sources such as accounting, cash flow, banking, eCommerce, and other financial systems. Combining these new data points with historical data, lenders can develop new credit scoring models to provide fast and easy loans to their customers. Sources: 5 Reasons New Lenders Are Ignoring FICO Credit Score | Forbes How are FICO Scores Different than Credit Scores? | myFIC
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