In the current economic climate, borrowers and lenders alike are afflicted by rising inflation, elevated interest rates and changing employment patterns. Just as borrowers need to adapt to unpredictable circumstances, lenders must continue to assess risk prudently and tailor their offerings to meet the evolving needs of borrowers.
As of November 2023, 62% of Americans lived paycheck to paycheck. This means that one missed paycheck would put an individual or family at risk of not being able to afford essential living expenses, including housing, utilities, groceries and transportation. Potentially surprising is that 40% of these consumers also report having super-prime (720 or above) credit scores.
Is Prime Really Still Prime?
While prime borrowers are generally considered lower risk by lenders, the designation of “prime” should not imply immunity to economic fluctuations or financial challenges. Credit scores are an important indicator of creditworthiness and financial responsibility, but they don’t necessarily reflect an individual’s overall financial health or their ability to manage day-to-day expenses.
With many people living paycheck to paycheck,there exists a higher likelihood of financial instability and difficulty in meeting financial obligations. This increased financial vulnerability poses a greater risk for lenders, especially if borrowers face unexpected expenses or income disruptions that could impact their ability to repay their mortgage loans.
In February 2024, the total U.S. consumer debt reached $17.37 trillion, marking a 2.8% increase over the previous year. This rising debt burden adds another layer of concern for both borrowers and lenders, underscoring the importance of prudent risk assessment and tailored lending practices. Additionally, higher levels of paycheck-to-paycheck living may lead to an uptick in delinquencies and defaults, particularly among borrowers with thinner financial cushions, resulting in more losses for lenders.
Lenders may respond to the heightened risk by tightening their lending standards, particularly for borrowers with less-than-perfect credit or smaller down payments. This could make it more difficult for prime borrowers, or those who are on the cusp, to qualify for mortgages. It could also result in higher interest rates or additional fees for borrowers who are considered higher risk.
Loan Affordability is Essential for Long-Term Viability
As lenders assess a borrower’s ability to obtain and maintain loans responsibly, loan affordability emerges as a crucial aspect to preserving homeownership and promoting financial well-being. Measuring loan affordability provides insight into whether borrowers have sufficient income to cover their debt obligations comfortably, and ultimately achieve financial stability and avoid delinquency or default.
Lenders using loan affordability assessments, such as debt-to-income (DTI) ratios, are better equipped to evaluate the level of risk associated with extending credit to near-prime borrowers. Determining the DTI ratio involves comparing a borrower’s total debt to their gross income (pre-tax). Lenders’ preferred DTI ratios can vary. For example, FNMA’s maximum DTI ratio ranges from 36% to 50%.
For borrowers on the verge of prime qualification, a favorable DTI ratio can increase their chances of accessing credit, since they are considered lower risk because they have more disposable income to cover their debt payments. As a result, lenders may be more willing to extend credit to borrowers with manageable DTI ratios, even if they have slightly less-than-perfect credit histories. This can broaden the pool of eligible borrowers and provide opportunities for individuals who are financially responsible but may not meet traditional prime lending criteria.
Data-Driven Strategies For Loan Affordability
Considering fluctuating trends in wages and inflation, as well as tepid job market conditions, it has become increasingly challenging to predict whether a borrower’s DTI ratio will remain constant throughout the loan process. To combat this, lenders must adopt a data-driven approach for verifying income and employment to assess loan affordability accurately. This approach provides a clearer picture of borrowers’ financial health and improves risk assessment, while also simplifying how lenders measure DTI ratios.
At the root of DTI calculations lies income data, which lenders may derive from various sources. Some may rely on bank transaction data, third-party consumer-permissioned data, or consumer-provided documents (e.g., pay stubs or W-2s). However, these methods come with risks and data security/privacy concerns. Additionally, they introduce extra steps in the process for the consumer, such as setting up a separate account with a data provider or needing to manually print and provide documentation.
Not all consumer-permissioned data sources are created equal. When linking to many bank transaction data sources, third-party aggregators may be allowed continued access to consumer data until the consumer manually disconnects the third party from their account, posing additional risks for lenders due to the storage and security of financial data.
Additionally, the consumer-credentialed processes used in some mortgages today have not been tested during a downturn in the economy. Should defaults occur with loans that relied upon consumer-credentialed data, investors may apply additional quality control measures that could result in unexpected financial liability for lenders.
As such, lenders should carefully choose their data sources, and consider utilizing automated income and employment verification data from trusted sources to help determine loan terms while minimizing risk and providing for a seamless applicant experience.
In response to affordability issues, some borrowers are using additional income sources beyond base pay, like bonuses and commissions, to qualify for loans. Verifying all income sources is crucial to avoid surprises during underwriting. Income and employment verification data is not the only type of alternative data that can help lenders better understand their potential borrowers and improve loan portfolio risk. Information about a consumer’s utility payment history–which may demonstrate commitment to paying bills consistently and on time–and even education history information can aid lenders’ decision-making and potentially expand their loan portfolio.
Embracing data-driven strategies can help lenders better assess loan affordability, even in uncertain economic times. By offering tailored lending solutions and considering broader financial indicators, lenders can tap into this segment of borrowers and facilitate their transition to prime status.
Chris Mock is vice president of mortgage verification services at Equifax Workforce Solutions.