opinion
Over-indebtedness occurs when someone borrows beyond their means, or finds themselves in a position where they do not have sufficient funds to cover their debt repayments. Whose responsibility is overindebtedness? If it arises from a change of circumstances, such as illness or being made redundant, then arguably no one's - it's just one of those unforeseen events that are outside of anyone's control, and it is estimated that in the US about 90 percent of bankruptcy can be attributed to such events (The American Bar Association 2006, p.201). If it occurs because someone has run up more debt than they can afford, then one view is that the responsibility is entirely the borrower's. They should know what their income and outgoings are, and how to manage their budget. It is their responsibility to know how much debt they can afford and not to borrow beyond this level. The other side of the argument is that it's all the lender's fault. Credit is supplied indiscriminately by companies who have no concern for people's financial circumstances. They will lend to people who do not know or fully understand the terms under which they borrow, and they don't care if they are borrowing beyond their means, just so long as they can make a profit from them. If they end up with financial difficulties then so much the better because of the extra fees that can be charged.
Both sides of this argument have some merit. Perhaps a pragmatic approach is to accept that both the lender and borrower have some shared level of responsibility to ensure that any credit-debt relationship entered into is affordable. A borrower should think about what they can afford and be honest in their dealings with the lender. A lender should not advance credit if they have good reason to believe a customer is likely to find it difficult meeting the repayment schedule.
To what lengths should a lender go to help prevent someone becoming over-indebted? The main problem lenders face is that while indebtedness is a simple concept in principle, in practice there is no widely accepted definition that lenders, governments or other interested parties have agreed upon (Consumer Affairs Directorate 2001, 2003). One reason why this situation exists is because it is difficult to come to a consensus as to what constitutes disposable income. Is it income remaining after the bare essentials of food/clothing/shelter have been met, or should it include expenditure on pensions, holidays, eating out and so on? Is a car an essential item of expenditure? If so, then what type of car? A second reason is the relationships between individual and household finances. If an individual applies for credit, should the income and outgoings of other household members be included or excluded in any assessment of their ability to pay?
Even if a precise definition of indebtedness can be arrived at, establishing the affordability of debt is not straightforward in a practical lending environment. First, many lenders do ask some simple questions about income and expenditure in order to try to establish the affordability of new debt, but individuals may simply lie about their true income/expenditure in order to obtain credit, particularly if they are desperate to obtain new funds. Second, asking individuals detailed questions about income and expenditure can act as a barrier towards selling products and services, leading people to apply for credit elsewhere. Therefore, there is little incentive to seek a lot of information about expenditure unless it can be assured that the competition are taking a similar line. Third, credit granting is a business in which many customers shop around for credit and make extensive use of balance transfer and debt consolidation services. In some circumstances this will actually help to reduce indebtedness if the new debt is at a better price than the old one. If someone with a high level of debt on a credit card applies for a new card with a lower interest rate, and has the intention of using the new credit to pay off the existing debt, it is not necessarily the best policy to decline them. However, there is no way of ensuring that they won't transfer the debt and then continue to run up new debt on their old card.
To tackle these issues, a pragmatic approach taken by the UK Government Taskforce on Over-indebtedness (which included industry as well as government representation) was to define the conditions for which individuals have a high likelihood of being over-indebted, and by implication, should not be advanced further credit without good reason. A household was defined as having a high risk of being overindebted if any one of the following conditions were met:
- Having four or more credit commitments (this excludes mortgage and utility payments, and debt on credit and store cards that is paid in full each month).
- Spending more than 25 percent of gross income on credit, excluding mortgages.
- Spending more than 50 percent of gross income on credit, including mortgages.
This is a very simple set of conditions that will not identify everyone that is over-indebted. Conversely, some people will match these conditions and not be over-indebted. However, it is simple, easy for the general public to understand, and is something that most lenders could implement easily within their systems. It is also the case that in many countries the information required to establish if these conditions are satisfied can be obtained from a credit reference agency. Very little information needs to be obtained directly from the individual. The taskforce reported that 7 percent of UK households satisfied one or more of these conditions and would be classified as over-indebted (Consumer Affairs Directorate 2003, p.12).
It should also be remembered that we live in the real world - things need to work, money needs to be made and spent. To achieve a perfectly ethical lending environment is probably impossible. However, an admirable goal is to always be working towards the ideal, not away from it. Whenever a decision is made about how credit is marketed, sold and managed it is worthwhile considering how this impacts on the parties involved and whether or not the overall benefit to the lender, borrower and society justifies the decision made.
© Steven Finlay, Consumer Credit Fundamentals 2nd Edition, 2009, Palgrave Macmillan. Reproduced with permission of Palgrave Macmillan.
Steve Finlay is one of the UK's leading credit risk professionals and a research fellow at Lancaster University. Steve has developed Jaywing's new programme of training courses for the credit industry, including "Credit Scoring Fundamentals" (1/9/09), "Managing Fraud within Consumer Credit Portfolios" (2/9/09), "An Introduction to Basel II and Capital Requirements for Consumer Credit Portfolios" (7/9/09) and "Compliance and Credit Risk Management"(8/9/09). Courses will be held at the East Midlands Conference Centre, University of Nottingham. To find out more click here.
