What is Affordability and Creditworthiness?
In recent years Affordability and Creditworthiness have become buzz words for lenders in all types of lending. This is never more true than in the world of Payday Loans, but what do they really mean and why are they so important.
The concept of carrying out these 2 important checks is not a new one. It was around in the days that the Office of Fair Trading (OFT) regulated lenders and was a big part of the 2010 European Consumer Credit Directive too, however it really gained momentum when the Financial Conduct Authority (FCA) took over regulation in 2014.
In the late 2000’s much of payday lending was about getting as much money out there as possible and then using a firm hand to get it back in again. Concepts such as raiding peoples bank accounts to snatch back amounts as low as £1.00, making up fictitious debt collection companies and lawyers letters were among the tactics used.
The big move that the FCA enforced was to lend responsibly and therefore there shouldn’t be any need to forcibly extract the repayments. This, coupled with bans on multiple and varied collection attempts on the debit card also pressured lenders into this new way of thinking.
Part of responsible lending is to employ a calculated approach before you release the loan to maximise the chances that it will be repaid.
There are basically 2 types of debtor in existence. These are affectionately known to lenders as the ‘can’t pays’ and the ‘won’t pays’. By using creditworthiness and affordability checks, the idea is to identify, and therefore not lend to either of these groups.
Let’s look at these 2 types of check and how they can be used to identify these groups of debtor.
The affordability check, as the name suggests, is about whether you can afford the payments that become due on the loan. Quite simply, if you subtract your monthly outgoings from your monthly income, is what is left enough to cover the loan repayments. Of course, while this check is good for identifying the ‘can’t pays’, it is less effective for the ‘won’t pays’ who may have sufficient funds, but just are not prepared to use them.
It is not quite as simple as the calculation detailed above as lenders will want to put in their own ‘buffers’ and allowances. To start with, many lenders will compare the income and expenses declared by the applicant with their credit file. If the applicant declares £400 of credit outgoings each month and the credit file shows £700, this extra must be allowed for. Additionally, they will not want to leave the borrower with a spare income of zero, as this means 1 extra bill or expense will take them over the top. Each lender will decide how much should be left over, after all current and new borrowing is accounted for.
A final consideration is that the assessment should ensure that the loan is affordable over the entire duration, not just the 1st payment. With instalment loans this should include, as much as is reasonably possible, all of the payments that are likely to come due.
The creditworthiness check is principle about reviewing how the applicant has, or is, managing their credit. For the ‘can’t pays’ missed credit payments may be an indication that they cannot afford their current credit commitments, whereas for a ‘won’t pay’ this is a good indicator that they are simply avoiding their debts, even though they may have the ability to pay if they chose to.
Let’s look at some example of credit files to see what they may tell us about the applicant.
Applicant A has got a payday instalment loan, credit card and a small bank loan which they have had for 2 years. These were all showing really good repayments up to 3 months ago. 2 months ago the credit card and payday instalment loan started to miss payments and last month the bank loan went into arrears.
The earlier history shows that this borrower knows what is required of them and is genuinely wanting to repay their debts. The more recent events would suggest that the borrower has either had a change in circumstances (maybe lost their job or had a pay cut) or has increased their other monthly outgoings (maybe had a baby and the weekly shopping bill has increased). This is a classic ‘won’t pay’ and should not have their credit burden increased further.
Applicant 2 has taken payday loans one 3 years ago and one last year and a credit card, they are 34 years of age. The payday loans show that they immediately went into arrears, whereas the credit card showed 1 payment made and then went straight into default. This is a classic ‘won’t pay’. Their age shows that they were not a ‘typical student’ getting into debt at college/university, and that they simply do not pay any debt that they incur. They were bad 3 years ago and still bad now. These are a definite ‘no lend’.
Our final Applicant 3 is 24 years old. They had 2 credit card when they were 18 and these both were paid for a number of years and then went into default. Another payday loan was taken when they were 22 and that also went into default. A further payday loan was taken out 6 months ago and paid in full as per schedule. This is most likely an applicant that knows how to repay loans, but clearly got in a mess while they were at university or just starting a career. Since becoming settled they have shown that they can borrow and pay back a loan. This would be a good case to lend, but only when full affordability checks are passed.
I hope in this article I have demystified Creditworthiness and Affordability and also shown some of the ways in which lender use these to protect both their own resources and the borrow.
Warning: Late repayment can cause you serious money problems - For help, go to moneyadviceservice.org.uk
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Author: Internal Marketing Department