In an outstanding article, Fintech Is Breaking the Credit Bureaus, Alex Johnson and Kevin Moss (former SoFi Chief Risk Officer) diagnose a couple issues that could affect the integrity of credit scores. One particular point caught my attention. In discussing secured credit card payments, the authors argue the following (emphasis mine):
The trouble is that this repayment data isn’t an accurate reflection of customers’ willingness to repay loans. The providers of credit builder cards aren’t taking actual credit risk, and, as such, the performance of their portfolios is, from an underwriting perspective, useless.
It’s a strong take: If a provider isn’t taking credit risk, what value do on-time payments really have in the consumer’s credit profile? To be valuable, the provider needs to take some credit risk, they need skin in the game.
Credit Builder Loans vs. Credit Builder Cards
Credit builder cards are designed so that every purchase with the card is fully backed by cash from the consumer. It’s a no-lose situation for providers. This is a case of having credit risk skin in the game.
But we’ve seen this before. Credit builder loans have the exact same design. The consumer is “loaned” an amount (e.g. $500), but they cannot access that amount until they pay off the installments. If the consumer fails to make the payments, the lender is made whole by reclaiming the loan amount from the locked savings account.
Credit builder loans have traditionally been the province of community banks and credit unions. And their payments have always been reported to the credit bureaus. Here is how Credit Union of Southern California describes their credit builder loan:
When you’re approved for the loan, the loan amount will be deposited into an account for you, and each month you will make payments toward pay-off of the loan. Your payments are reported to the three major credit bureaus (Experian, TransUnion and Equifax). As long as you make payments on-time you will build good credit. This will also boost your credit score.
From a lender’s point of view, the credit risk of either a secured credit card or credit builder installment loan is functionally the same. There are funds fully matching the credit that has been extended.
But there is one less obvious but important distinction. One that applies to the new crop of fintech-powered secure credit cards:
|Lender credit risk||Consumer payment|
|credit builder loan||none||requires action|
|fintech-powered secured credit card||none||happens automatically|
Perhaps the one issue with fintech-powered secured credit cards is that they really don’t require effort at all after being set up. Here’s how Chime handles payments for their innovative card, per NerdWallet:
Whenever you use the card to buy something, the total purchase amount is put on hold in your Credit Builder secured account. Once your bill is due, the on-hold money is automatically used to pay it. This keeps you from paying late and not having the money available to pay your bill in full.
No credit risk is taken, no extra effort is required by the consumer. This product is a powerful tool for consumers seeking good credit scores. But it does lack aspects that creditors would want to see in a credit account.
Of course, credit-builder loans with autopay enabled could be considered similar to these fintech cards. But even there, the credit builder loan customer has to make sure cash is in their account at the moment of payment. With Chime, the purchase only happens if there is cash in their account. That is a meaningful difference in repayment risk.
Extra Debit Card vs. Sesame Cash
On the surface, Extra’s Debit Card and Credit Sesame’s Sesame Cash Credit Builder are the same thing: debit cards that are used to build credit. They’re in-the-flow products that fit what people do everyday.
But there is a key difference between the two, shown in this chart:
Extra has skin in the game, based on two elements:
- They underwrite for risk.
- The incur credit risk because they float a loan for one day.
While taking credit risk for one day may sound trivial, it’s a legitimate risk. The Federal Reserve provides overnight funding to banks via Discount Window Lending, and those that are less sound have to utilize the secondary credit lending program which has a higher rate due to risk.
Clearly, there is a difference in approaches between Extra and Credit Sesame. Sesame Credit Builder appears to take no meaningful risk, which is smart from the provider perspective. But applying the arguments set forth by Alex Johnson and Kevin Moss, one of them has more value for predicting credit risk.
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