Alternative Data Unlocks Opportunity for Auto Lenders

Delicately balancing risk and return is nothing new for automotive lenders. However, rising interest rates and delinquencies prompting financial institutions to prioritize risk mitigation more than usual.

According to the Federal Reserve’s Loan Officer Survey, the majority of banks polled expect to tighten lending standards for the remainder of 2023.

While mitigating risk protects financial institutions from economic volatility, reducing loans jeopardizes profitability and consumer loyalty. To weather the storm, financial institutions must find ways to reduce risk while maintaining loan volumes. One promising solution is to use alternative lending data to issue more loans to near-prime borrowers, an often-underserved credit segment.

Lending Enablement Solutions often use decades of proprietary data and AI-powered decision-making to look beyond FICO scores and issue more loans to reliable borrowers outside the prime category. Even in a volatile market, financial institutions using alternative data can scale up lending practices and create long-term relationships built on trust.

Scaling Back Lending Has Long-Term Implications

For many financial institutions, decreasing loan origination volume is the best way to mitigate risk in uncertain economic conditions. Many large commercial banks have stopped offering indirect automotive loans to dealership partners to simplify operations and reallocate resources.

While these decisions might protect banks in the short term, writing off potentially profitable loans and compromising consumer relationships presents long-term consequences.

Banks, captive lenders and credit unions all depend on automotive lending to generate revenue – and fewer loans issued means less money coming in. Strained consumer relationships will amplify this pocketbook pain as borrowers are more likely to return to lenders after a positive lending experience.

It’s unlikely the current economic uncertainty due to higher interest rates and inflation- will abate anytime soon. Financial institutions should reconsider scaling back loans and instead opt for alternative risk mitigation strategies that preserve profitability.

Why Near-Prime?

Near-prime borrowers are often underserved by financial institutions that rely on FICO scores or debt-to-income ratios as their sole decision-making factors. The category’s less-than-prime classification leads lenders to assume borrowers are not reliable or creditworthy, although that is often not the case.

FICO scores provide a one-dimensional view of borrowers at a single point in time and discard any nuance in their profiles. For example, near-prime borrowers are often new-to-credit consumers building a credit history and working up to a prime score. Shutting them out of automotive lending denies them the opportunity to make on-time loan payments and build credit, proving their trustworthiness for the future.

Using alternative data allows lenders to grant loans to a greater number of deserving borrowers. By looking beyond FICO scores, Lending Enablement Solutions make intelligent, risk-adjusted lending decisions that predict the probability (and severity) of default, prepayment and going to term for the loan.

There are many instances of Lending Enablement Solutions proving a borrower’s creditworthiness based on alternative data, even if a different institution rejected them. In one case, a near-prime borrower with a 627 FICO score was reevaluated with an AI-powered decision-making solution and given a more accurate score of 667. The lender was able to swiftly approve the borrower’s loan due to alternative data that provided a fair profile and risk-adjusted pricing.

Near-Prime Can Help Institutions Scale Loans and Diversify

Tighter lending standards favor prime borrowers. While prime credit scores signal reliability, the credit segment currently exhibits high delinquency rates. According to the Open Lending 2023 Lending Enablement Benchmark Study, prime borrowers are outpacing non-prime borrowers by 13 percentage points in delinquencies.

High delinquency rates among prime borrowers should not prompt financial institutions to scale back lending. Prime borrowers still represent a lucrative and reliable credit segment. Instead, lenders should pivot toward diversifying their loan portfolio with near-prime borrowers.

By using alternative data to unlock the near-prime category, financial institutions can increase their prospective borrower pool and identify more lending opportunities.

Improve Long-Term Customer Relationships

Financial institutions using alternative data can empower non-car owners with vehicle accessibility. We live in a world where vehicle ownership is necessary for accessing education, employment, healthcare and a better quality of life. By issuing risk-adjusted, equitable loans, lenders unlock the opportunities of owning a vehicle for deserving borrowers.

Matt Roe headshot 2

Matt Roe (pictured, left) is chief revenue officer at Open Lending, where he reviews sales and account management strategies and identifies opportunities to increase productivity and efficiency, and enable growth.