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

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Presentation on theme: "Evaluating Consumer Loans Chapter 15 S. Scott MacDonald, Ph.D."— Presentation transcript:

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

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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

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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 Debit 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

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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 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

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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 Judgmental 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%

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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

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