Use of debt, and especially consumer credit debt, is frequently described in negative terms. But from an economic perspective, such debt plays a crucial role in allowing people to manage temporary cash-flow shortfalls and spread the cost of making large purchases.
One of the explanations for why debt has such a bad reputation could be its association with financial distress. But what is financial distress? What proportion of people with debt experience financial distress and what are their socio-economic characteristics? Most importantly, is it possible to predict the consumers who are at high risk of suffering financial distress in the future, or does financial distress just follow from unpredictable life events like losing your job? Our analysis published today explores these important questions.
In order to reliably explore these questions it is crucial to carry out analysis using data that can show which individuals are suffering from financial distress. Our analysis uses the nationally-representative Wealth and Assets Survey produced by the Office for National Statistics (ONS) which contains very detailed information on individuals. Importantly, this survey interviews the same people over several years, allowing us to examine how financial distress relates to changing individual circumstances.
People suffer financial distress when they face financial and non-financial difficulties from repaying their outstanding debts. Financial distress may mean that individuals file for bankruptcy or increase working hours, take on additional jobs, or reduce spending in order to meet repayments. Financial distress may also have wider non-financial effects, such as stress, along with other forms of mental and physical distress or social stigma. Through missing repayments or persistently maintaining debt financial distress may also impede a person’s future ability to access credit.
But how do we measure financial distress?
One approach is to use objective measures, such as whether someone has missed two or more credit payments. But this is a narrow measure of financial distress as it does not include people who are keeping up with credit repayments but may be falling behind on other repayments or reducing spending to meet repayments. An alternative is to use subjective measures, which capture someone’s self-reported views on their ability to manage their finances (e.g. whether they regard repayments of their debts as a financial burden). Our research uses both of these approaches.
Using one method which combines objective and subjective measures of financial distress, we find that 17% of people with outstanding consumer credit debts are in moderate to severe financial distress. As many people hold a consumer credit product but do not have debt on it, most commonly in the case of credit cards, this 17% is equivalent to 7% of everyone in Great Britain who has at least one consumer credit product.
What are the characteristics of people in financial distress? These people are typically younger, with lower incomes, less likely to be employed and have higher debt-to-income ratios. They are also more likely to hold higher-cost credit products. When we examine the well-being of people in financial distress we find them, perhaps unsurprisingly, to report being significantly less satisfied with their life and more anxious than other borrowers. Consumers in financial distress are suffering. What can we do?
People may become financially distressed for a variety of reasons, all of which have different implications for consumer protection regulation. It may be that they take on an unaffordable amount of debt relative to their ability to repay it, or it could be because they experience ‘life events’, such as losing their job, leading to unexpected difficulties in repaying their debts. If financial distress is predictable, it suggests that before firms grant credit they should consider whether doing so would be expected to lead to the consumer suffering financial distress. The particularly ground-breaking part of our analysis is the examination of whether financial distress can be predicted.
Our research finds some financial distress is unpredictable. Therefore there appears to be a role for interventions, such as debt management plans and insolvency arrangements, to deal with financial distress which may follow from unpredictable shocks to individual circumstances. These shocks may be individual ‘life events’ or changes in the national or regional economy which means firms cannot predict the particular individual who will suffer financial distress in the future.
While firms cannot predict which exact individual will suffer financial distress in the future, our research shows it appears possible to consider, on average, whether cohorts of individuals with a set of characteristics are especially vulnerable to future financial distress, and therefore whether lending to them may be predictably unaffordable and harmful.
We explore a broad range of factors which could potentially predict financial distress, including income levels, the number of debt products held and their total value. We find the ratio of consumer credit debt relative to income, known as the debt to income (DTI) ratio, has a strong relationship with financial distress. People with higher debt relative to income experience greater financial distress.
A person’s current DTI ratio is a strong predictor of whether individuals are likely to experience financial distress approximately two years in the future. This finding holds even when we account for ‘life events’, which also have an important role in explaining why some people become financial distressed.
We also find that the 10% of people with the highest DTI ratios are much more likely to suffer financial distress in the future than those with lower DTI ratios. The type of debts a person holds also appear to be important – individuals with the majority of their debt in higher cost products are much more likely to experience financial distress than individuals who have the majority of their debts in other forms. Given that a higher risk of financial distress can be predicted, based on the product individuals apply for and their existing circumstances, this suggests a role for affordability policies that take these factors into account.
In sum, while unpredictable ‘life events’ is a common explanation for individuals entering financial distress, and these do have a role, it appears DTI ratios can be important predictors of financial distress, helping to highlight which individuals are most at risk of financial distress.
Our thanks go to John Gathergood, Associate Professor of Economics at the University of Nottingham, for co-authoring this article.