Inflation, central bank interest rate increases, and rising energy, food and housing costs — these elements are all working in concert to reduce consumer spending power. Almost every household is feeling the economic strain; fewer consumers are entering the lending market; and many are waiting to make large discretionary purchases.
People are prioritizing food, shelter and energy, reserving remaining funds for servicing debt obligations. When the squeeze gets tighter, credit cards are the first obligation to go unpaid. For those in the lending business, it seems like troubled times could be ahead.
I sat down with TransUnion SVP of Research & Consulting Charlie Wise — an authority on credit decisions across the customer journey — to get his perspective on economic pressures and the balancing act of finding resilient consumers while managing risk in uncertain times.
RG: A search of today’s world economic headlines describes a perfect storm of events affecting the global economy: Pandemic recovery releasing pent-up consumer demand; conflict in Europe causing rising energy prices; and the economic effects of government spending in the name of pandemic survival. These are now being felt in terms of record inflation, a forecasted drop in world GDP, and a dramatic reduction in consumer spending power.
For lenders, it’s a pretty bleak picture when faced with maintaining their levels of business. What advice would you offer as we watch developments in the markets?
CW: To say we have a perfect storm just isn’t accurate. There are ways to manage and achieve profitable growth — even amid rising inflation, reduced consumer-spending power, and challenges to new opportunities in the market..
We’ve seen times like this before, and smart businesses can weather the storm by taking a hard look within. In many markets, we’ve seen a drop in secured lending because of affordability challenges. Between purchase prices and financing costs, it's just harder for people to buy new homes and vehicles. Volume has dropped but not everywhere.
In some cases, the number of loans has fallen, but the value of the loans — in both mortgage and auto — has increased. In that regard, the top line is actually growing in terms of outstanding balances, but it's off of an increasingly smaller origination base because increasingly fewer consumers can afford to buy.
RG: What’s the impact of a smaller origination base for lenders?
CW: This illustrates a bit of a phenomena about lending: If you stop lending, or dramatically reduce new loans you write because you’re looking only for those with pristine credit, the percentage of delinquent loans will increase. When you don’t book new loans to replenish those coming off your portfolio, the good ones pay off and the bad ones go bad.
If you're not growing your portfolio, you're seeing a shrinking denominator and rising numerator — a recipe for a huge spike in delinquencies. This creates an imperative because with the ‘do nothing’ strategy (reducing or stopping lending), you pretty much guarantee a year from now your portfolio will look a lot worse than it does today. My advice is if you want to protect your portfolio, find prudent growth opportunities as opposed to shutting off lending.
RG: With fewer consumers seeking loans, what’s the trend in unsecured debt?
CW: We see quite a different story with unsecured debt (like credit cards and unsecured personal loans) where demand is growing. For example, during 2020–2021 as markets shut down for the pandemic, consumers couldn't spend like they had before, and in some cases, they were getting government support payments. Unsecured debt balances dropped because consumers didn't need to borrow as much.
Now we’re seeing a combination of those government support programs ending and prices of all types of consumer goods sharply increasing, which means consumers need access to purchasing power and are looking to borrow. Unfortunately, this is exactly when lenders start tightening their standards.
RG: What’s driving credit tightening in this environment given consumer demand?
CW: It’s clear many lenders are worried about consumers being overextended. They’re concerned about credit quality. What's going to happen in terms of affordability with people paying significantly more to fill a gas tank or grocery basket? Paychecks haven't kept up with inflation in almost every market. When push comes to shove and consumers have to make a choice in terms of their personal payment hierarchy, cards and unsecured personal loans generally lag behind auto loans and mortgages.
Lenders are understandably cautious and turn their focus to people with pristine credit scores. The problem with that, however, is there aren’t many people with pristine credit looking to borrow money — even in bad times. And unfortunately for those who do need credit, lenders are pulling back. So, how can lenders gain confidence in identifying resilient consumers who can essentially outperform what’s reflected by their credit scores? I think this is where we get into the question of ‘Is the credit score the single point of truth about a consumer?’ And in my opinion, it really should not be in many markets.
RG: That’s kind of a funny opinion for someone who delivers credit scores. Feels like there’s more to it, right?
CW: Look, there are certainly challenges. Virtually every person you know has a fixed amount of dollars, pesos or rupees for their obligations. The cost of everything is sharply on the rise, including everyday, vital necessities like gas, electricity, heating and rent. When the cost of these increases by 20% to 30%, you're almost guaranteed there will be some tightness in bottom-line budgets. This is pretty obvious, and it’s why we really recommend building an understanding of consumers and their demonstrated capacities to pay.
Consumers will be looking to borrow in this market, even with many pressures on their budgets, and that's going to cause some to get themselves into trouble. Knowing which ones are more vulnerable versus those who are more resilient is an important art, and a credit score alone isn’t always the best indicator.
That’s not to suggest credit scores aren’t useful and important elements to consider. They definitely succeed at what they were intended and built to do: rank order consumers in terms of their likelihood to default. What the score doesn't tell you is the consumer’s income or debt levels — critical aspects for determining who has capacity to pay and who doesn't.
RG: How should lenders include capacity to pay when making credit underwriting decisions?
CW: Lenders simply have to look at submitted applications more closely and make the best decisions possible for their business. In some cases, that translates to identifying and providing quality offers to consumers who aren’t as impacted by inflation or at least have a more substantial financial cushion.
The post-pandemic recovery and corresponding jobs reports also suggest people are headed back to work or beginning work for the first time. This could mean someone without a long work or credit history is looking for credit for a car, house or large purchase as they start out on their financial journey. Lenders need to make informed decisions on these consumers as they enter the workplace and credit market. New-to-credit consumers with new jobs and new incomes are an opportunity lenders can often overlook simply because they’re invisible on most common reports.
RG: Are there other tools you recommend lenders consider when evaluating applications?
CW: There are other tools you must overlay on top of credit scores to get deeper insights that enhance your ability to identify borrowers who may appear just ‘OK’ from a credit score perspective — but actually represent prudent lending decisions and smart additions to your portfolio. What we call alternative data can provide deeper consumer behavior insights that can help lenders gain a truer understanding of individual risk. With a more well-rounded view, lenders can effectively manage their portfolios and better target marketing efforts to continue growing — even in the face of multifaceted challenges.