Dynamic affordability assessment: predicting an applicant’s ability to repay over the life of the loan

Katarzyna Bijak, Lyn C. Thomas and Christophe Mues

Abstract

ABSTRACT

In the credit decision-making process, both an applicant's creditworthiness and their affordability should be assessed. While credit scoring focuses on creditworthiness, affordability is often checked on the basis of current income and estimated current consumption as well as existing debts stated in a credit report. Contrary to that static approach, a theoretical framework for dynamic affordability assessment is proposed in this paper. In this approach, both income and consumption are allowed to vary over time and their changes are described with random effects models for panel data. The models are derived from the economic literature, including the Euler equation of consumption. A simulation is run on their basis and predicted time series are generated for a given applicant. For each pair of the predicted income and consumption time series, the applicant's ability to repay is checked over the life of the loan, for all possible installment amounts. As a result, a probability of default is assigned to each amount, which can help find the maximum affordable installment. This is illustrated with an example based on artificial data. Assessing affordability over the loan repayment period as well as taking into account variability of income and expenditure over time are in line with recommendations of the UK Office of Fair Trading and the Financial Services Authority. In practice, the suggested approach could contribute to responsible lending.