To best set loan rates, use an analytical approach.
Last month, I shared some ideas on how to increase loan growth. Sharpening your pricing pencil was one I mentioned, but to price correctly, you must be committed to an analytical approach.
The COVID-19 pandemic has created three significant challenges for credit unions via their income statement and balance sheet. First, virtually all credit unions have experienced a flood of deposits, lowering loan-to-share ratios. For example, Ent Credit Union is $500 million over budget on member deposits for the year through April 30!
As an amateur economist, I tend to look at financial impacts “on the margin.” As an $8 billion credit union, we have a $7.5 billion balance sheet that’s doing well and generates sufficient earnings. We also have a $500 million chunk of the balance sheet that is basically deposits and investments. Investments, frankly, don’t pay enough to keep the lights on right now. Whether your credit union is $8 billion, $800 million or $80 million, you’re likely to have the same issues.
Secondly, larger credit union mortgage portfolios have re-priced dramatically, thanks to the 10-year Treasury bond yield that plummeted before the country went into the initial lockdown. The yield on our mortgage portfolio has declined over 60 basis points since March of 2020. Mortgages represent about 35% of our assets, so that 70 basis point decline represents about 22 basis points of lost ROA (35% of 60 basis points). That lost earnings power isn’t likely to come back any time soon, creating additional pressure to make money in other lending areas.
Finally, credit unions are experiencing slower loan growth in general, caused by a myriad of things—consumers paying down debts fueled by stimulus payments or refinancing non-mortgage debt, or 0% financing through the auto manufacturers. Responding to all of this, a lot of my peers have been scratching their heads for ideas to jumpstart loan growth.
How Can We Grow Loans?
It’s easy to start driving loan volume by lowering rates, but is that the right move? There are two essential questions to ask your management team when faced with the possibility of lowering loan rates to increase volume, one of which I’ll address this month, the other one I’ll explore in June.
1. Will lower rates drive higher loan volume and growth?
Talk about the $64,000 question! In normal times, it’s almost a given that lower rates will drive volume and growth. Today? I’m not so sure that lower rates mean more volume, and the answer is different based on the type of loan!
I’ve already admitted to being an amateur economist, so it won’t surprise you to read my thoughts on the elasticity of demand. I’m probably bringing back repressed memories of economics 101, but a working understanding of this concept is critical in loan pricing today. If you lower rates, will you drive member behavior and, as a result, get more business?
When it comes to consumer behavior, the answer is normally yes. Yes, if your credit union lowers rates, you will get more business. If you’re considering lower rates for personal and direct auto loans, you should see higher volumes right away. However, if you’re in the indirect lending market, is it the consumer that’s driving your volume?
The primary driver of your indirect volume is the financing offered by the manufacturer. In today’s environment with lots of 0% manufacturer financing, many consumers are likely going to the dealership with the expectation of 0%. How do you lower rates from 3% to 2.5% and compete with 0%?
You don’t, at least not across a broad spectrum of business. If you’re lowering the A+ credit, 60- to 72- month loan rate for new cars to compete with 0%, you’ll likely have the same amount of volume in that bucket of business and make less money to go along with it. That’s not your goal! However, if you’re contemplating lowering your 84-month new car rate, or your used car rates in general, you have a fighting chance of making more loans to go with it.
2. What about home equity? (It’s not an easy answer.)
Notice I haven’t talked about growth in home equity balances. For most banks and many credit unions, home equity loan portfolios really haven’t recovered after the Great Recession, even after almost 12 years. If your credit union has had success in growing balances since then, you’ve probably struggled with growth in the last 12 months as homeowners are consolidating first and second mortgages at a frenetic pace. Is it worth pursuing home equity loan growth with lower rates?
In a word, maybe! In Ent’s geographic footprint, negative margins in relation to the prime rate were commonplace before the financial crisis. Today, negative margins still haven’t come back. While the opportunity to lower rates is there, it’s critical to understand your market share and your competitors. For many credit unions, you’re already the best deal in town; lowering your rates is akin to competing with yourself.
Yet there is certainly demand for home equity; Ent has set new records in home equity funding since COVID-19 hit, as homeowners are improving their homes at a record pace. That said, we’re also experiencing record refinances and repayments. Lowering rates may or may not make sense for your credit union but increasing your marketing efforts is certainly a worthy strategy.
To succeed, home equity volume and balance growth will require very close monitoring as first mortgage rates change. If mortgage rates move even .25% up or down, it can make a world of difference to your results. The bottom line? Be ready to adjust on the fly.
What Else Do You Need to Know?
You may have a better feel for whether it’s worth lowering rates to drive more loan volume. But what about margins and, ultimately, income? Will your new loan rates generate more earnings? More volume and more income don’t necessarily go hand-in-hand. Ultimately, greater earnings is the only reason to increase loan balances.
Next month you’ll learn how to sharpen your loan pricing pencil to a level you may not have previously experienced, to ensure your credit union is making more loans with positive financial results.
Bill Vogeney is chief revenue officer and self-professed lending geek for $8 billion Ent Credit Union, Colorado Springs.