Credit affordability in practice and its perspectives

3.6.1 Credit affordability and rational lending

In the UK, the Task Force, mentioned in section 3.4.1 has conducted a survey on credit affordability from which they found the evidence of irrational lending. More than 20 % of the population was granted credit that they could not afford to refund and to pay (Consumer Affairs Directorate, 2005).

However, irresponsible lending and irresponsible borrowing are two sides of the same coin.

They found clear evidence of borrowers acting irresponsibly and following patterns of irrational borrowing:

• Borrowing money when already in financial difficulty to pay off other credit or to pay off arrears on bills and other commitments

• Taking on credit agreements, despite knowing that they will struggle to repay the money

• And impulsive shopping and credit use by consumers who buy things on the spur of the moment, knowing that they will not be able to repay or do not consider whether they will be able to do so (Consumer Affairs Directorate, 2005).

The Task Force agreed that many consumers take out a loan without giving detailed consideration to key factors such as:

• Can I afford this loan?

• How much will it cost me?

• How can I get the best deal?

• Will I still be able to afford it if my circumstances change? (Consumer Affairs Directorate, 2005) Thus, the assessment of credit affordability and control can limit irrational lending and borrowing.

However, many lenders work on different levels of profitability (Finlay, 2009), therefore, they might have different approaches in assessing credit affordability. Income is still an important factor, but there will be differences in what level of income is acceptable when granting a loan.

Therefore, some institutions borrow to a customer who is already heavily indebted, resulting in over-indebtedness, while other institutions may reject this customer. The so-called “stretched”

affordability was seen in the past, also through the use of interest-only and the extending of mortgage terms. This is also the evidence of irrational lending (Financial Service Authorities, 2010).

However, according to Hansen et al. (2009), the chances of irrational mortgage lending are lower.

Because of bigger debt, underlying risks and time for re-payment, it will be expected that banks will be more careful in mortgage lending, but, on the contrary, I have shown that we experienced irrational mortgage lending, driven by high expectations in future housing prices, high investment return opportunities and under-estimation of underlying risks.

61 3.6.2 Credit affordability and financial stability

Lunde (2008b) analysed how the owner-occupier sector, as an important part of the Danish economy is linked to financial fragility via increased indebtedness.

The following ratios reflect important economic housing conditions for owner-occupiers sector, which are also important to financial stability:

• Household debt/ GDP ratio

• Household debt/ disposable income ratio

• Total liability / net wealth ratio

• Mortgage debt/ net non-financial wealth

• Housing wealth/ income ratio

• Net liability/ income ratio

• Net liability/ housing wealth ratio

• Net interest expenditure/ income ratio

The same ratios can be used to assess credit affordability. For example, the fall in the net interest expenditure to income ratio from 20 per cent in 1987 to fewer than 10 per cent in 2005 among 30- 39-years-of-age group (a proxy for first-time buyers) indicated improved affordability of owner occupation in Denmark (Lunde, 2008b, p.59) ¹⁵. Please note, if a household has interest payments of 20 per cent of the income disposable in our days, it will get a status of “over- indebted household”

(Consumer Affairs Directorate, 2005). Part of the movement is related to the shift between fixed rate mortgages to adjustable-rate mortgages. However, the improvements over later years are weak, when the reduced tax rebate is taken into consideration (Lunde, 2008b).

The ratios are important risk indicators for lenders, who use properties as collateral, for financial and monetary authorities and for national economic policies. As they can be used for predicting default risk and send “early warnings” on a coming financial instability (Lunde, 2008b).

The ratios can be applied at the family level as well as on the aggregate level.

However, the analysis on the macro level might be misleading. For example, an increase in net liability-to-income ratios (a measure of leverage) amongst low-income groups, for example, is likely to introduce a far greater risk to financial stability than an increase in the same ratio amongst high income groups (Lunde, 2009; Girouard et al., 2006b).

15 Those are pre- tax estimates. The increased affordability could be barely explained if including “after- tax” interest expenditure. There were reductions in interest expenditure deductions from taxable income from a maximum of 78 per cent to 33 per cent through three tax reform in Denmark (in 1987, 1994, 1999) (Lunde, 2008b)

62 Thus, the analysis of credit affordability on the aggregate level is necessary for financial stability assessments, because it represents the risk of default and over-indebtedness.

3.6.3 Credit granting decision and counseling

Credit affordability analyses should be incorporated into credit granting (borrowing) decision.

It determines the level of debt a household can tolerate in relation to its income and outgoings.

In practice, the bank Nordea in Finland affordability”) employs the housing affordability index as a relationship between housing prices and monthly loan servicing cost. Thus, the current low interest rates on housing loans enhance the housing affordability, and trigger a rise of the housing prices.

However, I discussed that if only financial costs are included, the housing affordability will be over-estimated. Not only debt cost, but also cost of maintenance and repair should influence the housing buying decision. If these cost items are ignored in credit granting decisions, there will be much flexibility in measuring the credit affordability, resulting in increased indebtedness.

When banks do not include housing-related costs into the credit affordability measure, they are willing to grant loans that are significantly higher than allowed by the rule-of-thumb.

What banks’ concern should be is, of cause, credit affordability dependent on both income and expenditure. However, housing affordability- the ability to sustain a house including all housing- related costs should also influence the credit granting decision. This would limit credit access in boom times, a main trigger for housing boom (Muellbauer, 2008; Kindleberger, 2005).

3.6.4 Regulation

Improved housing affordability can happen via improved credit affordability. For example, prior to the 1970s, in New Zealand, in order to expand homeownership, the state support maintained low mortgage interest rates and enlarged the supply of housing. It improved housing affordability through cheap credits to new home-owners together with subsidies to the building industry, all of which caused a massive expansion in home ownership rates from 50,5 % in 1936 to 68 % in 1971 (Broom, 2009). However, after the 70’s, state support for expanding home ownership weakened, resulting in a decrease in lending activities by 38 % from 1978 till 1990. As a result, the low income class was locked out of the property market because of worsened credit affordability (Broome, 2009).

Thus, control of credit affordability via decreasing interest rate can lead to improved housing affordability for low income groups.

63 To sum up, the perspectives on credit affordability demonstrated that the credit affordability concept is significant. The analyses of credit affordability can be valuable in assessing the degree of over- indebtedness and irrational lending, financial stability and financial decision making. But more importantly, the changes in credit affordability result in changes in the housing prices equilibrium in the long- run. I shall now discuss these issues from an empirical perspective.