Tackling the Affordability Challenge with a Data-Driven Approach

Lenders challenged by an economic landscape shaped by high inflation, rising interest rates, and multiple employment trends find themselves in murky waters when qualifying and approving borrowers. Lenders' success relies on expanding their portfolios, but the current environment may prompt them to be cautious in opening themselves up to riskier prospects.

Today, lenders must take loan affordability into account, a consideration greatly influenced by a borrower's debt-to-income (DTI) ratio. Each lender and loan type will have different requirements for DTI, of course, but a benchmark utilized by some lenders is a DTI of 36 percent or less. This number is widely accepted to mean that a borrower's debt is at a manageable level compared to their income, and the borrower most likely has enough income left after paying their existing bills to manage future monthly payments for the life of the new loan.

Properly assessing DTI, and therefore loan viability, requires lenders to gather and assess a great deal of information. The collection of this information is not only time-consuming but can result in manual errors, particularly when lenders must rely on paper-based information supplied by the applicant. Additionally, the use of paper-based information can open lenders up to fraudulent documents. The use of instant verifications of income and employment using employer-provided data can help alleviate any errors that may come from an applicant over or under-stated income. Lenders who adopt a data-driven approach to income verifications not only help improve accuracy and streamline how they obtain applicant information but unleash a powerful tool for understanding risk exposure.

Debt-to-income ratio: A moving target

Historically, DTI was a straightforward calculation. That is no longer the case amidst the shifts in inflation, the job market, and the overall economic landscape. In recent years of heavy volumes at low-rate refinances, many borrowers had a healthy DTI and qualified for the new loans easily. In today’s market of extremely strong property values, 20-year high-interest rates, student loan payment resumption, and bloating credit card balances, every dollar of income is important to qualify a borrower for the loan. It is more important than ever to understand the overall income per category and source for each borrower and co-borrower.

Total household debt has increased by over $2.5 trillion since 2020, up in nearly every category. A recent study from the Consumer Financial Protection Bureau (CFPB) reveals that almost 37 percent of households report an inability to cover expenses for more than a month, even when tapping into savings, borrowing, or seeking assistance from various channels. And consumer spending is unsurprisingly taking a hit as well. The beginning of 2023 showed promise, but consumer spending hasn't broken one percent in months, coming in at just 0.7 percent in December.

All of this indicates a significant financial strain on American households, resulting from wages and salaries not increasing at rates capable of competing with inflation. In short, households are tightening their financial belts and preparing for more rockiness ahead.

Consumer financial challenges continue

A borrower’s DTI may also be adversely affected by the recommencement of student loan repayments that began in October 2023. In addition to a near-instant increase in their DTI, according to the CFPB, around 20 percent of student loan borrowers have additional risk factors that indicate student loan repayments may cause problems with their ability to meet their monthly minimum payments.

Additionally, year-end holidays typically prompt a spike in consumer spending. According to the National Retail Federation, holiday spending reached record levels in 2023. With finances already tight, many will turn to increased use of already over-utilized credit cards and pay-later financing, which can lead to elevated debt levels. Inflation, the end of pandemic-era student loan forbearances, and a holiday spending spike create an environment where lenders need visibility to all of a borrower’s income information to accurately determine a borrower's DTI.

Although loan volumes are currently low, speed is still important to borrowers and lenders. The faster a lender can approve and lock in a borrower, the more likely they are to convert that loan. At the same time, with loan origination costs at record highs, the faster a lender can determine a lack of ability to pay based on DTI, the more they can save in lost cycles and hours spent on loans that will not convert.

Lenders navigate complexities as affordability becomes the hinge of decision-making

Shifting economic trends have brought affordability to the center stage of loan decision-making, and measuring affordability depends on income data. Interpreting income data accurately can present a complex challenge, prompting some lenders to settle for directionally accurate income and employment data. Some lenders may use bank transaction data, consumer-permissioned data from third-party aggregators, or consumer-provided documents, such as pay stubs and W-2s, to gather crucial affordability information, all of which have variables that may result in errors in reporting and forecasting.

Yet, relying on these income verification methods involves risk. The intricate nature of income data, compounded by variations in reporting, opens up lenders to potential pitfalls. For example, an Equifax study reveals a trend that is reason for concern – up to 52 percent of loan applications misrepresent income by 20 percent or more. Such false reporting, driven by a desire to boost approval chances, underscores lenders' difficulty in ensuring income assessments are accurate.

DTI should be considered alongside other factors

When lenders adopt a data-driven approach to assess borrowers, however, the picture becomes more precise and holistic. While essential, DTI alone may be given too much weight in the loan underwriting process, especially given economic instabilities. In addition to research indicating that many loan applicants misrepresent their income, several other factors contribute to a person’s ability to repay a loan and overall credit history. The Five Cs of Creditworthiness provides a far more comprehensive view of a person’s ability to repay a loan. In addition to a simple DTI calculation, lenders are encouraged to consider broader aspects of a loan applicant’s capacity. By leaning into using a data tool, lenders can more efficiently uncover this information.

Lenders also can apply customer-centric loan pricing optimization policies to mitigate the potential risks of lending to borrowers with high DTI ratios. FICO recommends that lenders should consider the entire loan offer, including detailed customer value predictions, behavior analysis, and customer attitudes and choices. They also indicate that higher-priced lenders win business and maintain competitiveness by making loan products available to a broader range of customers.

Author: Joel Rickman is the Senior Vice President of Verification Services at Equifax, where he serves as General Manager for a $1 billion line of business for the company. Joel's leadership extends beyond routine management; he plays an instrumental role in shaping the future of The Work Number^®, an industry-leading income and employment solution for Verifiers. Joel is responsible for The Work Number relationship and growth across all lines of banking and lending - Mortgage, Auto, Consumer Finance, Fintech, Card, and Student Loans.