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The Credit Services Association (CSA)
Blog: Debt-to-income ratio and financial distress – what the debt collection sector can do
Leigh Berkley is President of the Credit Services Association (CSA) and Director of External Affairs & Development at Arrow Global.
In August, I attended the launch of the Financial Conduct Authority’s (FCA) latest Occasional Paper which asks the question: ‘Can we predict which consumer credit users will suffer financial distress?’ This has been published as part of the FCA’s investigations into approaches to assessing creditworthiness in the consumer credit market with a view to amending current guidance.
As debt collection sector professionals, we often deal with those that are in financial difficulty as a result of being unable to repay their outstanding debts. We therefore do our best to treat all customers sensitively. But, using data from the Wealth and Assets Survey, the Paper found that if we define financial distress just according to arrears, only 2% of individuals with outstanding consumer credit debt are suffering from it and this underestimates the problem. There are forms of financial distress which do not actually result in inability to make repayments but still have a negative impact on the person’s life and well-being with 16% of people saying debt is a heavy burden whether they have fallen behind on repayments or not because of subjective measures such as regularly running out of money or having to significantly cut back spending. We all need to work together to ensure that customers are being properly evaluated throughout their consumer credit journey.
Financial distress and well-being
The Wealth and Assets Survey (WAS) data analysed shows that those in financial distress (which, using broader subjective measures equates to 17% of people with outstanding consumer credit debt) have lower levels of life satisfaction and higher levels of anxiety, both of which have an impact on overall well-being and mental health. Financial distress may or may not affect the customer’s ability to repay outstanding debts.
Financial distress and borrowing/lending
The Paper acknowledges that use of consumer credit is by no means always an indicator of financial difficulty but can in fact be an indication of high income growth amongst young people who are borrowing now for future gain. It also acknowledges that it is not in creditors’ interests to lend to those who cannot afford to make the repayments and that means of assessing a customers’ creditworthiness are already robust and points out that only ‘high cost short term lenders’ such as pay day loans companies lend to those in high likelihood of default.
However, consumer credit lenders need more insight into which consumer credit users are most likely to suffer from financial distress before they can fully evaluate the impact upon them. Although use of consumer credit is widespread, the top 2.5% of those using it hold one third of the total debt and those with much of this debt in higher cost products are much more likely to suffer financial distress. The Paper gives us a greater understanding of the wider causes and implications of financial distress which could help both lenders and the debt collection sector assess customers’ circumstances more thoroughly.
Financial distress and ‘life events’
Losing your job or getting divorced, which lenders can’t predict at the time of selling a consumer credit product, are life events that could typically lead to financial distress. However, the report found that life events such as these happen equally amongst those who are in financial distress and those who are not.
The Paper identified debt-to-income ratio (the proportion of a consumer’s gross income that is used to pay off debts including taxes, credit etc) as a much stronger indicator of someone’s potential for future financial distress. Those with the top 10% highest debt-to-income ratio hold a third of total consumer credit debt, have debt levels of more than two and a half month’s household income, tend to be younger on lower incomes, and are the most likely to suffer financial distress.
Although debt-to-income ratio can’t solely be used to determine an individual’s likelihood of experiencing financial distress, it does give us greater insight into what may make consumers more vulnerable to it which can inform how we deal with them to alleviate any unnecessary stress or anxiety.
Improving affordability assessments
The Paper’s findings indicate that debt-to-income ratio should be considered as part of affordability assessments for consumer credit products, particularly for younger individuals. This more in-depth look at customers’ personal circumstances is more reliable in predicting and preventing financial distress than looking at the individual’s overall levels of debt and number of credit products.
At the UK Credit & Collections Conference in September 2016, we held a fascinating panel discussion on vulnerability, mental health and debt which included Helen Barnard of the Joseph Rowntree Foundation who pointed out that we do not do enough to identify and support those on low incomes as vulnerable customers. This is something that we as an industry will be looking at addressing over the next 12 months.