A study, believed to be the first of its kind in South Africa, revealed which debts consumers prioritise during times of financial stress.
Contrary to conventional wisdom, people don’t always look to safeguard home loans; rather, they look to protect their automobiles, paying vehicle loans in preference over other forms of credit.
The research‡, which observed the payment behaviour of approximately 325,000 South African consumers, looked at borrowers with at least one of each of the three primary credit products: a credit card, a vehicle loan and a housing loan. The study tracked them over time to see what happened when they were unable to meet all their credit commitments, and how they prioritised which obligations to pay above others.
This study is important in better understanding the consumer thought process and the choices they make regarding their debt obligations during times of financial stress.
Understanding the ‘payment hierarchy’
The payment hierarchy is a common term used in consumer lending and refers to the priorities that consumers place on different credit products when they are facing financial stress and don’t have enough money to pay all their obligations. It looks at which payments people prioritise and pay first, and which they place a lower priority on and pay last.
When faced with the choice of which debts to pay and which to miss between a popular set of credit products — credit cards, vehicle loans and housing loans — conventional wisdom may suggest the first product type to enter delinquency (i.e. the one consumers would miss a payment on first) would be a credit card, followed by a vehicle loan.
Further, it might be expected that only in the most dire of circumstances would consumers stop paying housing loans, prioritising those payments above all other debt types. The rationale, so the conventional wisdom goes, is that missed payments on a card do not put any important collateral at risk, automobiles are critical for efficiently getting to daily activities, and of course the home is the centre of one’s family life and the most important asset a consumer can own.
However, the study revealed that the most commonly seen hierarchy among this set of products is in fact different than conventional wisdom would suggest. Consumers generally place vehicle loan payments first, prioritising those payments ahead of home loans. Credit cards, as expected, are the product in this set that consumers prioritise last and are most likely to miss.
These study findings do not constitute a recommendation of what choices a consumer in financial distress should make, but rather are observations and insights into the decisions they do make.
Delinquency* Rates for Consumers Possessing Vehicle Loans, Home Loans and Credit Cards
*Delinquency rates (one month or more in arrears) after 12 months for consumers who possess and are current on all three credit products at the beginning of the respective performance measurement period.
It might feel counterintuitive that, for most struggling consumers, vehicle loans are prioritised over other prominent credit products such as mortgages. However, there are a number of important factors to consider. It’s not always about protecting your home; it might be the size of the payment required, access to other forms of credit and even what you feel the perceived consequences might be.
Consumers and lenders alike often have to wrestle with these problems, and our study looks to shed light on some of the difficult decisions consumers sometimes have to make.
- Cards came last
There are numerous potential reasons for this lower priority on credit cards: lesser perceived consequence (i.e. not forfeiting ownership of a car unlike with a vehicle loan), the availability of substitutes for smaller everyday spends (such as cash or digital payments if still available) or even the access to other sources of liquidity (such as personal loans or retail finance).
- Vehicle loans prioritised over home loan payments
There are a number of potential reasons why vehicle loans sit above home loan payments in the payment hierarchy. In the majority of cases, the average vehicle loan has a lower monthly payment compared to a housing loan. Missing a mortgage payment would generally give the consumer more cash flow relief and enable them to meet other obligations. As well, there are many viable rental alternatives to home ownership; in contrast, public transportation is usually not an efficient alternative to owning an automobile.
The timing of any perceived consequence might also be a factor. Consumers likely recognise that a vehicle could be repossessed relatively quickly after missing just two or three payments, whereas eviction because of default on a home can often take many more months or even years.
Finally, a vehicle may be the primary transport to work, or even looking for work, if suitable public transport options aren’t available, making continued access to a car critical to preserving a consumer’s source of income.
Payment Hierarchy Among Unsecured Products
As part of this study, we explored the payment priority among popular unsecured credit products, specifically credit cards, personal loans and retail store accounts.
Unsecured products are typically used to finance small purchases and day-to-day living expenses. When looking at roughly 375,000 consumers with this basket of popular unsecured credit products, conventional wisdom again proved wrong.
The assumption historically has been that consumers would base their payment hierarchy on the concept of future utility, prioritising credit cards over other forms of popular unsecured credit as a credit card would still be available for further use across other purchases, potentially with multiple merchants. Retail store cards would be next-again, because future utility exists (although only with a single merchant). Finally, personal loans would be last because the funds have already been received and spent, and the loan would be perceived to have no future utility.
However, the study revealed that the most common unsecured credit hierarchy saw personal loans given the highest priority amongst consumers during times of financial stress. Next came credit cards, with retail cards at the bottom of the hierarchy.
Delinquency* Rates for Consumers Possessing Personal Loans, Credit Cards and Retail Store Cards
*Delinquency rates (one month or more in arrears) after 12 months for consumers who possess and are current on all three unsecured credit products at the beginning of the respective performance measurement period.
Key findings for popular unsecured credit products:
- Personal loans prioritised over other products
This may, in-part, be due to the prevalence of debit orders for personal loans which are fixed and are often a non-negotiable condition of the loan. Thus, the consumer is less likely to ‘choose’ to pay their personal loan or not, but instead has the loan payment automatically debited, leaving them to make their payment choices among the remaining products.
- Credit cards are paid ahead of retail store cards
Here, the concept of future utility may in fact influence consumer choice, as paying their credit cards allows them more flexibility to make future purchases from a wide range of merchants compared to their retail store cards.
There are other likely reasons for the priority of personal loans in the unsecured product payment hierarchy. For example, personal loans have a fixed end date, and consumers can see a ‘light at the end of the tunnel’ in the near-term if they continue to meet their obligations, giving them relief from this one debt obligation.
This contrasts with credit cards and retail store cards, which tend to have no set end date and could potentially continue indefinitely if consumers make only minimum payments on these obligations, and then charge up the remaining available credit in the next month.
Difficult Choices During Difficult Times
This study is not about delinquency. Rather, it is about choice and the consumer thought process during times of financial stress.
When people miss a payment it is often because of significant life events – loss of a job, a relationship breakdown, illness or even other unexpected bills.
They are not choosing whether they want to pay or not, but rather are making choices to maximize the benefit of the scarce funds they have available. The choices people have to make are often difficult, and our research gives a glimpse into some of the factors that are potentially important.
Lenders need to understand the choices that consumers make across their wallets and the interaction effects between different product types in order to inform their underwriting and risk management strategies. Payment hierarchies are extraordinarily complex and dynamic, and can be impacted by external drivers such as unemployment rates, income levels and home prices.
As these drivers shift, so can the hierarchy – and the recent economic headwinds could certainly alter consumer priorities regarding their financial obligations. Lenders should always be actively evaluating, refining—and when necessary, redeveloping—their consumer mindset models, in order to anticipate and be able to quickly react when borrower or economic conditions change.
‡ About the Study
The study analysed the payment behaviours of discrete sets of consumers holding two different baskets of credit products.
The first analysis looked at cohorts of consumers with at least one of each of three products—a credit card, a vehicle loan and a housing loan—that were all in good standing (no delinquencies) at the initial observation point. We then evaluated the performance of these consumers 12 months later to measure what percentage of each cohort became delinquent, and on which products.
Delinquency was measured as one or more months in arrears at the end of 12 months. The study looked at 11 of these consumer cohorts, for each month from January – November 2016, and performance for each of these cohorts 12 months from the starting point (i.e. the last cohort was evaluated at the end of November 2017). Roughly 325,000 credit-active consumers were in the study population.
The second analysis looked at cohorts of consumers with at least one of each of three other products—a credit card, a personal loan and a retail store account—that were all in good standing (no delinquencies) at the initial observation point. The second analysis followed a similar construct over the same time periods as the first study, with roughly 375,000 credit-active consumers in the second analysis.