1. Evaluating Consumer Loans Chapter 15
S. Scott MacDonald, Ph.D.

2. Evaluating Consumer Loans
Today, many banks target individuals as the primary source of growth in attracting new business
Consumer loans differ from commercial loans
Quality of financial data is lower
Primary source of repayment is current income

6. American Household Credit Card Debt Statistics: 2014
U.S. household consumer debt profile:
Average credit card debt: $15,611
Average mortgage debt: $155,192
Average student loan debt: $32,264

7. Credit card debt

10. Types of Consumer Loans
Installment Loans
Require the periodic payment of principal and interest
Direct
Negotiated between the bank and the ultimate user of the funds
Indirect
Funded by a bank through a separate retailer that sells merchandise to a customer

11. Credit Cards and Other Revolving Credit
Credit cards and overlines tied to checking accounts are the two most popular forms of revolving credit agreements
Over 90% of households had credit cards (average of 13 cards)
Most banks operate as franchises of MasterCard and/or Visa
Bank pays a one-time membership fee plus an annual charge determined by the number of its customers actively using the cards

12. Debit Cards, Smart Cards, and Prepaid Cards
When an individual uses the card, their balance is immediately debited
Banks prefer debit card use over checks because debit cards have lower processing costs
Smart Card
Contains a memory chip which can store information and value
Programmable such that users can store information and add or transfer value to another smart card
Only modest usage in the U.S.
Prepaid Card
A hybrid of a debit card
Customers prepay for services to be rendered and receive a card against which purchases are charged
Use of phone cards, prepaid cellular, toll tags, subway, etc. are growing rapidly

13. Credit Card Systems and Profitability
Card issuers earn income from three sources:
Cardholders’ annual fees
Interest on outstanding loan balances
Discounting the charges that merchants accept on purchases
Despite high charge-offs, credit cards are attractive because they provide higher risk-adjusted returns than do other types of loans

16. Overdraft Protection and Open Credit Lines
Overdraft Protection Against Checking Accounts
A type of revolving credit
A bank authorizes qualifying individuals to write checks in excess of actual balances held in a checking account up to a pre-specified limit
Open Credit Lines
The bank provides customers with special checks that activate a loan when presented for payment

17. Home Equity Loans
Home equity loans grew from virtually nothing in the mid-1980s to more than $600 billion by the end of in 2009, before declining after the financial crisis to $475 billion at the end of 2013.
They meet the tax deductibility requirements of the Tax Reform Act of 1986, which limits deductions for consumer loan interest paid by individuals, because they are secured by equity in an individual's home
Some allow access to credit line by using a credit card
Borrowers pay interest only on the amount borrowed, pay 1 to 2 percent of the outstanding principal each month, and can repay the remaining principal at their discretion

18. Non-Installment Loans
aka Bridge Loan
Requires a single principal and interest payment
Typically, the individual’s borrowing needs are temporary and repayment is from a well-defined future cash inflow

19. Subprime Loans One of the hottest growth areas during the early 2000s
Subprime loans are higher-risk loans labeled “B,” “C,” and “D” credits
They have been especially popular in auto, home equity, and mortgage lending
Typically have the same risk as loans originated through consumer finance companies

20. What Happens When Housing Prices Fall
During 2007–2008, banks were forced to charge-off historically high amounts of mortgage loans as delinquencies and foreclosures skyrocketed

21. Consumer Credit Regulations
Equal Credit Opportunity
Makes it illegal for lenders to discriminate on the basis of race, religion, sex, marital status, age, or national origin
Prohibited Information Requests
The applicant's marital status
Whether alimony, child support, and public assistance are included in reported income
A woman's childbearing capability and plans
Whether an applicant has a telephone
Credit Reporting
Lenders must report credit extended jointly to married couples in both spouses' names
Whenever lenders reject a loan, they must notify applicants of the credit denial within 30 days and indicate why the request was turned down

22. Truth In Lending
Regulations apply to all individual loans up to $25,000 where the borrower's primary residence does not serve as collateral
Requires that lenders disclose to potential borrowers both the total finance charge and an annual percentage rate (APR)
Historically, consumer loan rates were quoted as:
Add-On Rates
Discount Rates
Simple Interest Rates

23. Consumer Credit Regulations
Fair Credit Reporting
Enables individuals to examine their credit reports provided by credit bureaus
If any information is incorrect, the individual can have the bureau make changes and notify all lenders who obtained the inaccurate data

24. Consumer Credit Regulations
There are three credit reporting agencies
Equifax
Experian
Trans Union
Unfortunately, the credit reports that they produce are quite often wrong

25. Credit Scoring Systems
Are acceptable if they do not require prohibited information and are statistically justified
Can use information about age, sex, and marital status as long as these factors contribute positively to the applicant's creditworthiness
Credit Score
Like a bond rating for individuals
Based on several factors
Payment History
Amounts Owed
Length of Credit History
Types of Credit
New Credit

27. Consumer Bankruptcy Individuals can file for bankruptcy under:
Chapter 7
Individuals liquidate qualified assets and distribute the proceeds to creditors
Chapter 13
An individual works out a repayment plan with court supervision

28. Bankruptcy Reform
In 2005, Congress passed bankruptcy reform legislation that made it more difficult for individuals to completely avoid repaying their debts
In particular, an individual whose income exceeds the state median has to file for Chapter 13 and will repay at least a portion of his or her debts

29. Evaluation Procedures: Judgmental and Credit Scoring
Subjectively interpret the information in light of the bank’s lending guidelines and accepts or rejects the loan
Assessment can be completed shortly after receiving the loan application and visiting with the applicant
Credit Scoring
Grades the loan request according to a statistically sound model that assigns points to selected characteristics of the prospective borrower
If the total points exceeds the accept threshold, the officer approves the loan
If the total is below the reject threshold, the officer denies the loan

30. Your FICO Credit Score
Summarizes in one number an individual’s credit history
Lenders often use this number when evaluating whether to approve a consumer loan or mortgage
Many insurance companies consider the score when determining whether to offer insurance coverage and how to price the insurance
The scores range from 300 to 850 with a higher figure indicating a better credit history
The national average is 670
The higher the score is, the more likely it is a lender will see the individual as making the promised payments in a timely manner

31. An individual’s credit score is based on five broad factors:
Payment history 35%
Amounts owed 30%
Length of credit history 15%
New credit 10%
Type of credit in use 10%

34. Indirect Lending
A retailer sells merchandise and takes the credit application
Because many firms do not have the resources to carry their receivables, they sell the loans to banks or other financial institutions
These loans are collectively referred to as dealer paper
Banks aggressively compete for paper originated by well-established automobile, mobile home, and furniture dealers
Dealers negotiate finance charges directly with their customers
A bank, in turn, agrees to purchase the paper at predetermined rates that vary with the default risk assumed by the bank, the quality of the assets sold, and the maturity of the consumer loan
A dealer normally negotiates a higher rate with the car buyer than the determined rate charged by the bank
This differential varies with competitive conditions but potentially represents a significant source of dealer profit