Loan decisioning in a cost-of-living crisis

The cost-of-living crisis is hitting borrowers across all income groups. Consequently, responsible lenders need to adjust their approach when assessing loan applications.

According to the Resolution Foundation, the typical working-age household faces an income fall of 4% or £1,100 in 2022-23. However, the poorest quarter of households will see income fall by 6%. This is because low-income households spend more than average on energy and food. As a result, an extra 1.3 million people may fall into poverty in 2023.

Nevertheless, credit scores in the first five months of 2022 are 5% higher compared to 2021. Furthermore, the proportion of credit union borrowers who are over their credit card limits fell slightly over the same period.

These counter-intuitive findings may be the result of a delay between facing increased expenses and the impact of these being shown in credit data. Consequently it is more important than ever to spot these issues early on.

Regulatory requirements

FCA rules on credit worthiness bring the cost of living crisis into sharp focus. There are two elements to credit worthiness; credit risk and affordability. Both assessments are required for an applicant to be considered for a loan.

Credit risk represents the likelihood that a loan will not be repaid on time.  This is a risk to the lender, because they will lose money lent out and not repaid.

On the other hand, affordability risk is the risk that a borrower cannot afford the loan. Consequently, they may miss payments to both the lender and other creditors, including essential bills. Therefore, affordability is a risk to the borrower. Consequently, FCA guidance on conduct risk and good consumer outcomes are especially important.

 

Low-income households already struggle

Of course, low-income borrowers are already struggling to make ends meet. NestEgg uses opening banking data to display a spending overview according to the 50/30/20 rule.

Households split their income into three different categories: essentials (needs: 50%). Flexible spending (wants: 30%). And financial goals (commitments: 20%). Housekeeping, bills and transport fall into the first category. General shopping, restaurants, hotels and holidays are not essential. They’re classified as ‘wants’. Finally, 20% is spent on financial goals. Paying down debt, saving for the future.

For those with a monthly income of up to £1,400 per month already spend two-thirds of their income on essential expenditure. And the proportion spent on essentials is now rising.

 

A guide to assessing applications

Credit risk

A falling credit score is an obvious sign of recent difficulty. Credit score encompasses a range of risk indicators triggered by cost-of-living problems. Credit score will fall if there are recent credit searches. This can indicate that an applicant is looking to borrow to cover gaps in income and expenditure.

Missed payments reduce credit score, especially recent ones. Additionally when missed payments move from early delinquency (up to two months missed payments) to sustained delinquency (3 or more missed payments) credit score falls faster.

Missed payments and early delinquency are the most useful early warning sign for financial difficulty.

Legal action including CCJs and insolvencies would send a credit score tumbling. But new CCJs are likely to be a result of earlier problems. Difficulty, for example paying bills and, as a result, credit, would take a few months to manifest as CCJs. Furthermore, it is reasonable to expect some pressure on gas and electricity suppliers, to maintain a light touch to enforcement.

Affordability

Debt ratios are critical. The monthly debt ratio relates to the ratio of monthly payments on active accounts to monthly income. If the monthly debt ratio rises it could be a combination of falling income and rising credit spending. Importantly, gas and electricity bills are credit accounts and will contribute to this ratio.

For example, Alice earns £1,500 each month, spending £500 on repaying credit. This is a ratio of 33% (£500 / £1,500). That’s probably too high.

The Revolving Credit utilisation ratio relates to the proportion of credit card and overdraft limits that have been utilised.

For example, Alice has a credit card balance of £9,000; 2 cards with limits of £10,000.  This is a ratio of 90% (£9,000 / £10,000). That’s high and a possible sign that Alice is using a credit card to fund day to day living expenses.

Open banking provides additional indicators. This might include falling income, and rising spending. Bounced direct debits are an early indication of difficulty and can quickly manifest as missed payments Debt collectors may appear more frequently and Buy Now Pay Later (BNPL) missed payment fees also feature. BNPL will appear on credit reports from July 2022.

Next steps

NestEgg’s decision engine can take all the above into account and much more. Contact us to fix a strategy call to see how we can help you continue to grow your loan book during the cost-of-living crisis.

About Adrian Davies

Adrian is a co-founder at NestEgg. He is an alternative finance and credit union expert with extensive experience of start-ups, business development, IT, Target Operating Models and regulatory compliance. Adrian has 20 years’ experience in the responsible lending sector, supporting credit unions with innovative ideas so they can grow and meet service user needs.