Data and knowing your members’ loan ‘stories’ can help you find the right balance.
A top strategic initiative for credit unions is to improve the quality and volume of member financial education they offer. As a movement we can only read so many headlines like “the average American doesn’t have $1,000 in emergency savings” before we decide to get serious about helping members make better financial decisions—and save more.
While we are teaching members to save and make better financial decisions, many of us are also trying to serve more members by making more B-, C- and D-paper loans that carry higher rates of return for our credit unions.
Do these two goals ever clash? They certainly can, and likely will, unless you’re committed to making loans that make sense for both the borrower and the credit union—what I like to think of as “responsible lending.”
I was actively collecting loans at a nationwide consumer finance company every day for the first five years of my career, so I’ve heard all of the excuses why people can’t pay their bills. The root causes are excessive debts and/or the lack of an emergency savings account.
While we can’t always tell whether a borrower has any emergency funds saved, we can tell with a high degree of certainty whether a borrower is over-obligated. We’re likely to give prime borrowers the benefit of the doubt if they seem to have too many debts. Should we do the same for non-prime or sub-prime borrowers? I’d argue that if you’re promoting financial education and you turn a blind eye to ability to repay, you’re lost in the woods.
It helps to have a healthy grasp on your credit union’s data. Besides your borrower being over-obligated, you might turn down non-prime borrowers for other reasons. Perhaps they want to borrow more than your policy maximum. Or they don’t have a sufficient down payment for that new or used car purchase. They may also want to finance their cars for a longer term than your guidelines allow.
I have enough data to know the risk in lending 110% of book value compared to 100% of book value. I also know the risk of going out to 84 months as opposed to 72. Those risks are fairly predictable and manageable. The magnitude of my loss if I have to repossess a car on an 84-month loan is about 25% higher than on a 72-month loan. I may also have a slightly higher repossession rate—more cars per 1,000 loans—because of the likelihood the borrower will have significant negative equity. Yet I think I can manage those risks if the borrower can afford the loan.
Here’s the problem: I also have enough data to know that a non-prime borrower whose debt-to-income ratio exceeds our typical guideline may be as much as four times more likely to cause a loss! Sure, we have risk-based pricing to cover losses, but how do you price four times the risk? How can you charge an extra 10-12% if the borrower has a higher debt-to-income ratio? In reality, you may not be able to without adding fuel to the fire, so to speak, and make it that much more difficult for the borrower to afford the loan. You’re likely to lose big bucks on a book of business like this.
So, what’s a credit union to do if it wants to make loans and be a responsible lender, promoting sound financial decisions?
- Ask your borrower tough questions if you think they’re over-obligated. You aren’t doing your members any favors if they can’t afford the payment. If your members want to borrow money to buy a new car, and their payment is going up $150, how are they going to make that higher payment? Have they been saving $150 a month? Perhaps with the lower fuel costs on a more efficient car and reduced repair costs compared to their old clunker, they really can afford the lower payment. Do your homework and insist that borrowers do theirs.
- Look hard at your guidelines to see if your loan amounts are too conservative. Would you rather approve a $15,000 loan on an older used vehicle to a borrower with questionable stability and an excessive debt to income, or a $40,000 new car loan for 84 months to a different borrower with the same FICO score and the ability to repay? Our data shows that focusing on smaller loans doesn’t necessarily translate to lower loan losses for auto loans. Older cars produce higher losses as a percentage of the original loan amount.
- Don’t be afraid to negotiate the finer points of the loan. Our research shows that members looking to buy a new car will go elsewhere if we try to approve the loan for less than what they want. Used car buyers are more likely to work with you. If borrowers are looking for maybe $5,000 more than you’re comfortable lending, ask for a reasonable additional down payment like $1,000. A good faith effort. Maybe they’d accept a 78-month term instead of 84 months if you’re trying to manage the risk of a 110% LTV loan?
- Make sure you understand the merits of a story loan and pursue the opportunity to learn more about your borrower when the opportunity presents. The concept of a story loan is one that was long promoted by the now-retired Rex Johnson, lending consultant and former CEO of Baxter Credit Union. In today’s lending world, when so many credit applications are taken electronically, it’s hard to get the borrower’s story. In the last example, if that $40,000 request was from a longtime member who went through a difficult time with an illness in the family, wouldn’t you be more likely to approve the loan? Making loans that make sense sometimes requires your staff to recognize when a loan application doesn’t make sense, like when a longtime member with good income and a stable job has less-than-stellar credit. Dig deep enough, and you’ll probably find out they had a significant life event that impacted their ability to repay—and you might want to make the loan.
Making loans to serve your members and providing sound financial advice don’t have to be mutually exclusive initiatives. Neither is necessarily easy to accomplish, though, so you have to be willing to make the tough decisions and put in the time and effort. That being said, it’s worth it.
CUES member Bill Vogeney is chief revenue officer and self-professed lending geek for $6.1 billion Ent Credit Union, Colorado Springs.