Summary:
Affordability checks help ensure loans are safe, responsible and manageable for borrowers
Loan applications are subject to several assessments to verify that the requested borrowing meets the provider’s eligibility criteria, complies with regulatory obligations to protect consumers’ interests, and is affordable for the individual.
Creditworthiness checks, however, are not the same as affordability evaluations, with the former focused primarily on the credit scores and histories compiled by the UK’s credit referencing agencies.
Affordability assessments focus on safeguarding borrowers from taking on more credit than they can manage to repay and ensuring lenders deliver services responsibly, fairly, and ethically, but many consumers may not be aware that the two types of checks aren’t the same or how the processes lenders use can differ.
What UK Lending Rules Say About Affordability Assessments
Part of the reason affordability assessments vary between lenders is that the regulations overseen by the Financial Conduct Authority (FCA) don’t dictate the specifics around how loan providers determine whether a loan application is deemed affordable.
Instead, lenders are expected to verify consumers’ incomes, review their regular income and commitments, and confirm that the debt will be sustainable without putting the applicant in financial distress.
The regulator expects all loan providers to check creditworthiness and affordability, but leaves the mechanisms by which they do so up to each organisation. This can be based on the amount of credit being applied for, the type of product, such as a loan, credit card or mortgage, and the individual’s circumstances.
Lenders may, to some extent, rely on consumers to be honest and accurate in the incomes they declare. However, they may also ask for evidence of income, such as payslips and tax returns, to verify that the reported income is correct.
Loan providers should also ask consumers to submit information about their outgoings to arrive at a disposable income figure. That includes financial commitments such as existing loan and credit card repayments, child maintenance costs, and mortgage or rent obligations, as well as essential spending such as utilities and groceries.
Some providers apply specific calculations, such as debt-to-income ratios, which show how much of a consumer’s monthly income is allocated to paying current debt. Organisations may have their own criteria about the maximum ratio they consider acceptable.
The challenge for some borrowers is that, while lenders must conduct the above checks, many primarily rely on credit scoring as the deciding factor in whether they approve or reject a loan application. Credit scores show how a consumer has managed debt in the past, but don’t necessarily provide a complete picture of the individual’s financial circumstances now.
How Credit Scoring and Affordability Assessments Differ
There are countless scenarios in which credit scores may not accurately reflect how affordable a loan could be. One of the most common examples is where a consumer has never taken out any debt before.
A lack of credit history can mean a lender automatically rejects a loan applicant, regardless of their income, the reason for the loan, or their ability to comfortably repay the debt.
Similarly, a borrower could have a low credit score due to defaults within the last six years, even if they have since brought their finances back into good order, have never defaulted on a debt before, and now have a substantially higher income.
A loan applicant should never be offered credit based only on their credit score if there is no evidence that the debt will be affordable. A high credit rating is based on past events and borrowing activity, and credit reports alone cannot provide an up-to-date financial profile.
Despite this, research by one of the UK’s credit referencing agencies shows that 24% of lending organisations rely on consumers’ declarations to assess their outgoings, 19% depend on credit bureaus as their main source of information, and 16% use average data about living costs from the Office for National Statistics (ONS).
ONS data is useful, but the same study found that the essential spending estimates cited by the organisation were 25% higher than the figures calculated using Open Banking data, suggesting that even official calculations may not be as accurate as in-depth affordability assessments.
Loan Evaluation Approaches Adopted by Responsible Direct Lenders
Best practice is to use both mandatory credit checks and detailed affordability evaluations, and to recognise that self-declarations from prospective borrowers may need to be verified before a lender commits to a loan.
This is especially vital while consumer prices remain high, because compliance with the FCA’s Consumer Duty rules means lenders may be asked to demonstrate how they have confirmed loan affordability and ensured they aren’t offering irresponsible borrowing if the Financial Ombudsman Service (FOS) requests this.
Private short-term loans lenders such as Cashfloat are advocating for this approach, noting that credit checks, while necessary, are no more relevant than affordability, and that affordability checks ensure lending decisions are applied fairly, without being unreasonably influenced by credit scores alone.
Assessing affordability on a case-by-case basis, rather than relying on averages or credit reports, means that lenders aren’t missing key pieces of information or approving a loan without having an audit trail that shows how they have arrived at a decision.
Outcomes include supporting consumers who cannot afford the borrowing they are applying for, redirecting individuals in financial difficulty to debt management charities, and ensuring consumers understand the impacts that repayments may have on their day-to-day finances.
Applicants who are approved for a loan also have the assurance that they know what their repayments will be, have created a list of income and outgoings to check they’ll be able to afford the debt, and are unlikely to find themselves struggling to keep up with repayments.
Resources like online affordability checkers are also available, giving consumers access to free, impartial information about whether their requested borrowing is likely to be approved and showing how monthly repayments and total interest costs will change depending on the loan term.
