Affordability is now a central tenet for all lenders in their dealings with consumers. Thus far we have explored the rationale for the FCAs decision to demand lenders take affordability into consideration within the context of creditworthiness; and discussed whether neglecting affordability, and focusing only on the credit risk angle, led directly to the collapse of Wonga.
Affordability checks within the context of a loan application remains far from straight-forward. Credit risk, the aspect of the loan that describes what the risks are to the lender not being repaid can be simply calculated. However projecting forward to assess what the applicant’s circumstances may be in the future, whether there may be extenuating circumstances that may impact on their feasibility for the loan, such as mental health, is not at all easy.
Within the confines of this article we will seek to answer how lenders can assess affordability, primarily through the use of credit reference agencies.
UK Debt Challenges
The FCA has been very clear in its mandate on affordability. The part played by credit and loans given to those who could not afford them was, at least in part, the impetus for the great financial crash. Over the last ten years the FCA and other institutions have worked to legislate against anything of the nature of 2008 occurring again. Besides the wellbeing of the economy, the FCA also wishes to protect consumers from taking out loans that are not affordable and thereby impacting upon their own financial health.
The FCA are right to have concerns on the health of the UK economy. Household debt has recently matched the figure it was in 2008, and consecutive studies have illustrated too few households are saving money month-on-month.
The Money Charity has documented a number of these statistics, including:
- £2,238 Average credit card debt per household in July 2020
- £60,403 Average total debt per UK household in July 2020
- £3,947 Total unsecured debt per UK adult in July 2020
- 12.8 million Number of households with either no, or less than £1,500, in savings
Affordability and Risk Assessment
These numbers –some of them astronomical – illustrate some of the challenges Government and Government bodies have in trying to ensure that where credit is proposed, it is done so for those that understand the potential risks, understand how consumer credit operates, and the lender is confident the applicant can repay the money without undue financial hardship.
The challenge for creditors is to not just look at an applicant’s retrospective credit history in isolation, but also to use this information, and other available data, to decide if there is any risk both to the lender and the applicant.
Credit Reference Agencies
In the UK there are three principal credit reference agencies, of which lenders may turn to just one, two, or all three depending on their risk appetite. Experian, CallCredit and Equifax all build pictures UK adults based on their financial history, whether you have loans or credit cards, utilities, mobile phones or car loans and mortgages.
Based on your past history CRAs can establish a credit score which can be used by creditors to determine whether credit can be offered (and at what rate). The credit reference agencies themselves play no part in deciding whether approval should be granted or not, but pass on available information to the lender.
Responsible lending means that lenders only sell products that are affordable and suitable for the borrowers’ circumstances. Credit reference agencies (CRAs) help ensure this by sharing personal data about potential borrowers, their financial associates where applicable, and their financial history.
To help them offer the right information to creditors, the CRAs have built a suite of tools that can help to determine applicant’s affordability for credit.
As an example, CallCredit has an “affordability suite” that offers flags on those with unsecured loans over 5% of salary; flags on those with secured loans taking up more than 80% of income and; an “over-indebtedness score” illustrating the probability of a customer becoming over-indebted to the point of defaulting. Similarly, Experian’s traditional affordability checks offer income verification, income estimation, debt-to-income ratios, and monthly disposable income.
In this manner, CRAs are moving away from their traditional business model of only providing backwards facing information towards offering lenders a more comprehensive view of customers.
The role and manner of their credit scoring is not however, always appreciated. Critics of credit reference agencies state that they were designed for a time when virtually every person worked in a stable 9-5 job. In today’s world of the gig economy and zero hours contracts, it can be difficult for some people to be accepted for credit. This is particularly true for young people, those who have never made a credit application, those who do not appear on the electoral roll, and those not working in salaried job roles.
A report written by Responsible Finance and the Centre for Business in Society (CBiS) Coventry University, concluded that CRAs were no longer fit for purpose and penalised too many people in society. They concluded in their report:
Lenders do not always have the information they need to make informed lending decisions, leaving people locked out of credit, with little choice of credit provider or paying more to access credit. The annual cost of having a poor credit score per household is estimated at £1,770 extra for basic, everyday goods and services.
They have argued for a more holistic approach to the setting of credit scores to ensure credit parity across the board – including for those not in stable work positions, renters and the young.
The Financial Conduct Authority has been vocal in its demands for lenders to consider the wellbeing of the customer as well as considering their own financial credit risk. To that end it is right lenders should take in all available information regarding consumers when making credit decisions. Some of this information can be gleaned from consumers, and credit agencies can supply supplementary information.
Credit reference agencies have been extending their reach for some time and, with additional information on income, are well placed to offer information and analytics around affordability. They are most well known for having a detailed and multi-faceted approach to financial information, gathering and being able to provide a credit score, as well as specific information on who we bank with, and what loans and credit cards we have applied for. This information can all be used to help build a picture of customer’s affordability rating.
For lenders, the limitations of CRAs should also be considered. If the individual has never applied for credit before, is it possible to assess their affordability based entirely on their credit score?
The raw information and analytics offered by a reference agency are valuable for a lender looking to decide on an application. A holistic approach is however required in order to understand the applicant’s financial history, make a comprehensive decision, and understand the possible ramifications of offering credit.