Chapter Fifteen Consumer Loans, Credit Cards, Real Estate Lending and Managing Credit Risk

Key Topics Introduction Different Types of Loans Types of Loans to Individuals & Families Real Estate Loans Risk and Problems in Real Estate lending Home Equity Lending Unique Characteristics of Consumer Loans Credit Cards and Credit Scoring Disclosure Rules and Discrimination Consumer Loan Pricing and Refinancing

INTRODUCTION The main reason many banks are issued charters of incorporation by state and national governments is to make loans Lenders are expected to supply credit for all business and consumer financial needs and to price that credit fairly Commercial banks are the largest lenders of household loans

INTRODUCTION Loans support the growth of new businesses and jobs within the lender’s market area Loans frequently give information to the marketplace about a borrower’s credit quality The lending process requires careful monitoring at all times

INTRODUCTION p. 439 Consumer debt has become one of the fastest growing forms of borrowing money - $14 trillion in US Banks lending to households depends on their need for a source of funds – checkable and savings deposits Consumer credit is often among the most profitable services a lender can offer However, services directed at consumers can also be among the most costly and risky financial products

DIFFERENT TYPES OF LOANS Real Estate Loans – For personal homes Consumer Loans – Loans to individuals and households Commercial and Industrial Loans – business start-ups, growing a business Agriculture Loans – for farmers Miscellaneous Loans Lease Financing – renting equipment The largest category in dollar volume is real estate loans, followed by loans to individuals, and commercial and industrial (C&I) loans

Real Estate Loans p. 457-458 Banks & finance & insurance companies make real estate loans to fund the buying of property Homes, apartment complexes, shopping centers, office buildings, and land One of the most rapidly growing areas of lending over the past decade. Almost 1/3 of all bank assets.

Secured by the property. Property is the collateral itself. Real Estate Loans p. 457-458 Real estate loans can be among the riskiest forms of credit extended to customers Usually a long-term loan, typically bearing a term amortized over 15-30 years Secured by the property. Property is the collateral itself. Has a fixed interest rate or a variable (floating) interest rate Banks are the leading residential mortgage lenders today

Real Estate Mortgage Amortization Table - 20 year $200,000 loan with a 5% interest rate Year Begin Balance Principal Interest Payment End Balance 1 $200,000 5,975 9,864 15,839 194,025 2 194,025 6,280 9,559 15,839 187,795 3 187,795 6,602 9,237 15,839 181,143 4 181,143 6,939 8,900 15,839 174,204 5 174,204 7,294 8,545 15,839 166,910 6 166,910 7,668 8,171 15,839 159,292 9 30,016 14,668 1,171 15,839 15,418 10 15,410 15,418 421 15,410 0

Real Estate Loans (continued) Differences between Real Estate Loans and Other Loans The average size of a real estate loan is usually much larger than the average size of other loans Mortgage loans tend to have longer maturities versus other types of loans - 15 years to 30 years are typical for single- family homes

Risk and Problems in Real Estate Lending p. 456 The Most Risky of Home Mortgage Loans: Interest-Only and Adjustable Rate Mortgages and the Recent Mortgage Crisis (2008) When housing prices were rising during the recent housing boom, how could lenders make high priced homes affordable? More families were encouraged to sign up for adjustable-rate loans (ARMs) during a period when market interest rates were at historic lows

Risk and Problems in Real Estate Lending p. 456 Along with lenders giving Adjustable or floating rate loans two other types of lending led to the financial crisis of 2008. Predatory lending A bad practice among some lenders where lenders may require high fees Subprime Loans Granting loans to borrowers who have below-average credit scores

Real Estate Loans – Home Equity Loans p. 459-460 Home Equity Lending Homeowners can borrow the equity in their homes Equity is defined as the difference between a home’s estimated market value & the amount of the mortgage owed. For example. Your mortgage is $100,000 but you owe $50,000. You would have $50,000 in equity.

Real Estate Loans – Home Equity Loans p. 459-460 Home Equity Lending Two main types of home equity loans: Traditional Home Equity Loan (HEL) a fixed rate with installments 2. Prime Equity Loan (PEL) – interest based on rate set by the bank but based on a rate set by the FED. – .

Types of Loans to Individuals and Families p. 440 Consumer loans are known by 1. Purpose – what the borrowed funds will be used for. For example to buy a car, or other large items 2. Type – Installment Loan the borrower must repay in installments (monthly or quarterly payments) or repay in one large payment. INTEREST RATES ARE HIGHER

Characteristics of Consumer Loans (continued) Why are interest rates so high on most consumer loans? Consumer loans are among the most costly and most risky to make per dollar of loanable funds. Made to individuals and households to purchase a car, or other large items for a house.

Credit Card Loans and Revolving Credit Types of Loans Granted to Individuals and Families (continued) p. 441-442 Credit Card Loans and Revolving Credit Very popular form of credit today is credit cards. Many credit cards have variable (changing) rates of interest Card providers earn discount fees (1 to 7% of credit card sales) from merchants.

STEPS IN THE LENDING PROCESS Finding New Loan Customers Evaluating a Customer’s Character Evaluating a Customer’s Credit Record Evaluating a Customer’s Financial Condition Does the borrower have Collateral & Signing the Loan Agreement Monitoring the Loan Agreement

THE C’s OF CREDIT (Adverse Selection): Evaluating a Consumer Loan Application – WHAT MAKES FOR A GOOD LOAN? p. 445 THE C’s OF CREDIT (Adverse Selection): 1. Character – Is the customer creditworthy. They have a good credit record of paying back loans. 2. Capacity – Able to sign documents 3. Cash – Ability to pay back loan. Has the income to make payments. 4. Collateral – Assets, like a car, house to secure the loan in case of default

Evaluating a Consumer Loan Application – WHAT MAKES FOR A GOOD LOAN. p THE C’s OF CREDIT (Adverse Selection): 5. Conditions – What are the economic conditions like at the time of the loan. 6. Control – Does the loan meet all the policies and regulations?

Evaluating a Consumer Loan Application (cont) Other Important Items For Lenders Income Levels Deposit Balances Employment & Residential Stability Debt and exposure How to Qualify for a Consumer Loan Home ownership or ownership of any form of real property The most important thing to do – truthfully answer all of the loan officer’s questions

Credit Scoring Consumer Loan Application p. 450 The idea of credit scoring is that lenders are able to separate good loans from bad loans. Adverse selection. The same factors that separated good loans from bad loans in the past will separate good loans from bad ones in the future. Such an automated credit system removes personal judgment from the lending process

Credit Scoring Consumer Loan Application (continued) p. 452-453 The FICO System Most famous of all credit-scoring systems currently in use Scores range from 300 to 850 with higher values denoting less credit risk to lenders FICO score are based on five different types of information (most important to least important):

Credit Scoring Consumer Loan Application (continued) p. 452-453 1. The borrower’s payment history 2. The amount of money owed 3. The length of a borrower’s credit history 4. The new credit being requested 5. The types of credit that the borrower has already used

FICO – A SAMPLE CREDIT SCORE

EXPLANATION OF CREDIT SCORE 1.  Proportion of balances to credit limits is too high on bank / revolving credit card accounts 2.  Proportion of loan balances to loan amounts is too high   Consumers who use a high % of their available credit have a higher risk of delinquency (falling behind on payments) and charge-off (loan default) over time.

Laws and Regulations Applying to Consumer Loans (continued) p. 454 Customer Disclosure (Information) Requirements Truth-in-Lending Act – The bank or lender must provide full information about the terms and all the costs and fees of a loan to a customer. Fair Credit Reporting Act Fair Credit Billing Act Fair Debt Collection Practices Act

Laws and Regulations Applying to Consumer Loans (continued) p. 454 Making Credit Discrimination Equal Credit Opportunity Act – everyone has the right to get a loan. NO PERSON can be denied a loan based on age, sex, race, religion, rich or poor. US law requires banks tell a customer, in writing, if they are denied a loan.

Laws and Regulations Applying to Consumer Loans (continued) p. 454 Community Reinvestment Act – Banks must have offices or branches in every community, rich and poor.