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Can we predict which consumer credit users will suffer financial distress?
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Context
Financial Conduct Authority (FCA) rules require consumer credit lenders to assess the creditworthiness of loan applicants. This paper is intended to inform discussion about how consumer credit lenders should evaluate whether lending to an individual is likely to lead to financial distress (i.e. is “unaffordable”).
The study
The research, commissioned by the FCA, analyses data from four waves of the Wealth and Assets Survey (WAS), produced by the Office for National Statistics (ONS). WAS is a nationally representative longitudinal (panel) survey of households in Great Britain which began in July 2006. Wave 1 comprised interviews with 53,300 adult respondents (aged 16 or over) across 30,500 British households. Wave 4 (the most recent) covers the period July 2012-June 2014.
This research:
- describes the distribution of consumer credit debts in Great Britain;
- estimates financial distress in Great Britain;
- analyses the relationship between financial distress and well-being; and
- examines whether financial distress can be predicted.
Key findings
- The majority (61%) of individuals in Great Britain have at least one consumer credit product and, at any time, roughly one in four people hold outstanding debt.
- Ordering individuals by their consumer credit debt-to-income (DTI) ratio, the top 10% of individuals hold roughly one-third of the total debt and have debt levels in excess of two-and-a-half months of household income (before tax), with an average consumer credit debt of £10,300.
- Using a narrow definition of financial distress based on arrears, 2% of individuals with outstanding consumer credit debt are in financial distress. Using a broader measure, 17% of individuals with outstanding consumer credit debt, or 7% of those holding a consumer credit product, face moderate or severe financial distress.
- Compared to other individuals, those in financial distress are typically younger, with lower income and higher DTI ratios.
- There is strong, though non-causal, evidence that individuals in moderate or severe financial distress have on average 14% lower of life satisfaction and 37% higher of anxiety. These individuals are typically younger, less likely to be employed are also more likely to hold higher-cost credit items.
- DTI ratio is a strong predictor of future financial distress, even after controlling for ‘life events’ that may cause financial distress.
- The top 10% of individuals by DTI ratio are much more likely to suffer financial distress than other individuals.
- Those who hold the majority of their debts in higher-cost products are substantially more likely to experience financial distress than holders of other forms of credit, such as personal loans. Findings support the use of DTI ratio over other measures in affordability assessments, especially for higher-cost products.
Points to consider
- a full explanation is provided for the rationale for WAS as the data source, the WAS methodology itself and the methods adopted for the analysis for this paper. WAS is a robust national survey.
- the estimates using combined objective and subjective measures of financial distress are calculated from survey data and the exact figure should be treated with caution; attempting to causally identify the impact of financial distress on consumer welfare is not possible from this survey - instead, the research carries out descriptive and detailed econometric analysis to inform the interaction between financial distress and well-being.