Two months ago, Ben Bernanke, the former Chairman of the Federal Reserve, revealed that he had been shot down by lenders for a mortgage refinancing.
The farcical circumstance made big headlines, mostly about the ridiculous tightness of credit markets.
So it's no surprise that when several of the largest US mortgage lenders recently announced plans to ease standards for borrowers according to new guidelines from Fannie Mae and Freddie Mac, Bernanke's story was the first thing that came to mind.
Bernanke himself admitted that credit conditions "may have gone a little bit too far." But the fundamental roadblock he faced in our modern financial system has more to do with credit evaluations than credit conditions.
Today's banks consistently misunderstand — or at best, willfully ignore — an applicant's full history, whether it's for a mortgage refinance, a credit card or a car, as evaluations are based on limited inputs that are an inaccurate survey of someone's actual credit worthiness.
While relaxing lending standards may allow hundreds of thousands more people to receive mortgages, it doesn't mean these lending decisions will be any smarter.
We need to evolve our standards, not lower them, in order to ensure a stable financial future.
Let's redefine credit
All the bank saw when Bernanke walked in was a FICO score and outdated income metrics, and he's not a rare case. In the modern world of machine learning and big data, the choice to base credit evaluations on such limited information translates to lost business and lost trust.
In fact, this outdated system is turning off an entire generation. A recent study found that big banks are among the least-liked brands by Millennials — a wariness that extends to the financial system at large. In the wake of a financial crisis and unprecedented student loan debt, young people are increasingly averse to borrowing and risk. Studies show that 63% of 18-29 year olds don't own a credit card, compared to only 35% of those over 30, and 74% are unwilling to make above-average or substantial risk investments.
But these traits of the Millennial generation also contribute to an often overlooked positive: financial responsibility. From reviewing applications for merit-based loans at my company, Earnest, I've found that Millennials have significantly less credit card debt, smarter spending habits and fewer delinquencies than their parents' or older siblings' generations. Unfortunately, without following the conventional path to establish a credit score, recognition of this financial responsibility can be near impossible.
In five years, Millennials will comprise nearly 50% of the workforce in America. It's time to engage responsible borrowers in this generation and not only redefine credit worthiness, but create a thriving financial future in our country.
More than a score
We need smarter ways to evaluate and give "credit" where credit's due. Today, everything from job offers to insurance policies to housing rentals to loans rely on credit scores, when these decisions could be based on a much more accurate collection of data.
Contributing to your 401(k), regularly investing in a safety net fund, and spending less than you earn are key indicators of financial responsibility. Your educational career, your past income growth, and your projected earning trajectory are important predictors of stability. Instead of a brief snapshot on payment history like a FICO score, we can use data science and gather a comprehensive understanding of consumer spending to evaluate an individual's long-term financial values.
But is it feasible to collect all of this personal data on consumers? Absolutely. Many consumers already provide in-depth access to tech startups that aim to make their financial lives easier — from better budgeting with Mint to easy investing with Acorns to seamless payments with Square or Venmo. At Earnest, I've seen that consumers are more than willing to provide access to their financial, educational and career histories if it helps us understand that their financial responsibility and, therefore, results in a better rate.
Consider a friend who decides to go back to school for nursing, about to embark on a promising career but unable to front a big cross-country move. Or a neighbor living off hard-earned savings to stay at home with a new baby. Or a talented engineer who recently moved to the US. In the current system, each would likely be penalized when applying for a loan, a new apartment or a new job, thanks to their current job status and lack of credit history. But after a more comprehensive data analysis, these individuals could pass a financial responsibility check with flying colors.
Bringing back 'personal' finance
By prohibiting responsible people from investing in their future and failing to reward them for smart finances, the current system is losing profit and loyalty from a large population of prospective life-long customers. The use of data-driven decisions can put the "personal" element back into personal finance, allowing startups and institutions alike to re-engage a generation wary of today's financial institutions.
Using big data to determine lower, personalized rates on credit cards and loans will benefit financially responsible people in a way the current system does not, allowing reliable borrowers to pay less and get out of debt faster. And building a customer base of financially aware people will benefit banks — reducing the risks of fraud, as well as default, and saving institutions money in the long run. Investing in the future of stable individuals equally invests in the future of a stable financial industry and national economy.
It's time for the financial system to embrace a larger scope of indicators to determine financial responsibility; simply put, the old ways of evaluation cannot keep up with new ways of living and working. This starts with gathering a better understanding of consumers to create financial plans that fit their individual needs.
Armed with powerful software and sophisticated data science, the future of the financial industry rests on our ability to bring informed personal finance into the modern era.
Louis Beryl is the founder and CEO of Earnest, a merit-based loan provider, and believes we can fix the financial system with elegant software, smarter data, and thoughtful design. Prior to Earnest, Beryl was a partner at the venture capital firm Andreessen Horowitz.
