Will Payday Loans Affect Your Credit Rating?

We have written a couple of times recently about the potential implications for your credit status if you make use of payday loans. This is an especially important subject for those who are completing a Scottish trust deed (or debt arrangement scheme, bankruptcy or DMP) that wish to improve their credit score afterwards. On 5th January 2012 our trust deed news section discussed credit ratings and payday loans, and recently on 11th July we added a piece about whether payday loans could prevent you from getting a mortgage.

Using payday loans appears as though it is becoming increasingly risky. This is a developing story, but it would appear that there is significant potential for payday loan users to suffer a declining ability to access mainstream sources of credit in the future. Here’s why…

In October 2011 Martin Lewis (the Money Saving Expert) blogged on his website (with acknowledged assistance from Experian) that, “Repaying on time is likely to be slightly positive” but, “In the future it may be slightly negative”. The reason for the change in the future is that plans were then being made for payday loans to be put in a different section on credit reports. This would make it easier for a potential lender to differentiate between different types of credit that you have used in the past.

By 10th July 2012 Mortgage Strategy had confirmed with Experian that this separate section for payday loans on a credit record now exists. Experian also confirmed that the information had been available for some months to members of “Credit Account Information Sharing”. Experian is a commercial entity, so it can be assumed that separating payday loan information was a response to demands from their customers. Experian’s customers in this instance are the lenders who use their data to make lending decisions.

Accompanying the Mortgage Strategy story was confirmation that GE Money was to decline mortgage applications from those that had made recent use of payday loans (irrespective of whether they were repaid on time). GE Money appear to be the first to publicly announce this, but our private discussions with mortgage brokers have revealed that a number of other lenders have recently rejected otherwise “perfect” applications due to the recent use of payday loans by the applicant.

So we know that parts of the UK lending industry wanted separate access to data on payday loans, that it’s now been made available to them, and that some mortgage lenders are already using it as evidence that the potential mortgagee is too risky for their liking. Where will the story go from here?

Few subjects are quite so seriously misunderstood by the average person than credit ratings. We tend to log into our credit report (or get it posted to us), see a score, and draw our conclusions from that alone. For example, our advisers are often called by people that have recently completed a protected trust deed in Scotland and have been surprised to find that they have decent credit scores (around 800 out of 999 with Experian has been mentioned a few times). From this they conclude that they have a good chance of getting good-value credit products, but are then surprised to find that they cannot.

A “credit score” is a very arbitrary figure. It’s a way for a credit reference agency to tell you what a lender might think based upon the information that they hold on you. However, what a particular lender really thinks is based upon their own analysis of the information held by the credit reference agency. Experian may say 800 out of 999, but a lender may see a protected trust deed or a default notice (from a few years ago even) on your file and immediately reject the application outright for that reason.

What a lender really thinks is also only partly based on their analysis of the information held by the credit ratings agencies. They might hold information about you from past dealings with you, and they’ll be very interested in the content of your application for credit.

The purpose of this multi-layered approach to granting credit is straightforward, they’re using the information to make money. You might assume that this is based upon their perception of how likely you are to repay the credit, but this is also only likely to be part of the picture. Their ability to make money is partly based on how likely you are to pay, but also how you pay, and what type of product you’re applying for. So… they may conclude that there is a 25% risk of you failing to pay based on their analysis of your circumstances and past credit behaviour. Would you get a low-interest credit card? Almost certainly you’d get rejected. Might you get one of the 49% APR high-cost cards? Probably, because they’re likely to make money despite the relatively high risk of non-payment. All of which takes us back to payday loans…

Lenders analyse what types of clients pay them as expected, and which default. This helps them to amend their lending procedures in the future and therefore to maintain profitability. If a lender found that their default rates were much higher amongst clients that had previously made use of payday loans it’s easy to predict what they would do in the future. Either they’d refuse to lend to those that use payday loans, or they would only offer more expensive products to reflect the additional risk.

If you take a payday loan out it would seem that you don’t just have to worry about whether you pay your loan back on time, you also need to worry about whether others that are using payday loans will also repay their debts on time. If too many of them do not, and you’ve been lumped in the “payday loan user” demographic group with them, you can expect your access to affordable credit with some lenders to be affected.

How will this play out in the future?

Do you think that payday loans are a last resort, a sign of serious financial difficulty, or a red flag that someone does not manage their money well? If you do think any of these things, do you expect large numbers of those currently using payday loans to eventually get into a position where they cannot repay them? If you think this is likely you’ll almost certainly want to avoid using payday loans.

Do you think that payday loans are a useful way for people to tide themselves over until they are next paid (and can easily immediately clear them in full), or a convenient way to get a bit of extra cash when it’s most needed? Are they an affordable short-term financial fix used mostly by people that have taken care to ensure that they can afford to repay them (and issued by responsible lenders using effective affordability checks)? If so, you’ll probably be unconcerned that your use of payday loans will affect your credit rating and access to credit in the future.

We suspect that many people making significant use of payday loans at the current time will struggle to repay them eventually. 60% of payday loans are being used to pay for essential regular outgoings. This is a sign that most payday loans are being taken out by people that cannot currently manage their essential outgoings. Adding credit repayments to this difficult financial situation can only make things worse. That raises the prospect of significantly increasing default rates amongst payday loan users in the future. If that were to happen, even payday loan users that had been cautious and sensible might find themselves affected by the plight of others.

So will payday loans affect your credit rating and ability to get good-value credit? They already negatively affect your ability to borrow from some lenders, and it seems pretty likely that more and more lenders will form this view in the future.

Tags: credit rating, credit score, payday loans