Chapter Eighteen

Consumer Loans, Credit Cards, and Real Estate Lending

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Key Topics
Types of Loans for Individuals and Families Unique Characteristics of Consumer Loans Evaluating a Consumer Loan Request Credit Cards and Credit Scoring Disclosure Rules and Discrimination Loan Pricing and Refinancing

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Consumer Lending
Has been among the most popular financial services offered in recent years One of the most important sources of revenues and deposits for banks and their competitors (credit unions, savings associations, and finance and insurance companies); a source of supplemental income On the other hand, presents a special challenge due to higher-than-average default rates.
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Performance and Chargeoffs by Bank Category, 12/2004

5.0% 4.5% 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% 4.01%

1.23% 0.76%

1.30%

1.66% 1.18%

1.66% 1.10%

1.35%

International Agricultural Credit Card Banks Banks Lenders

Commercial Lenders

Mortgage Lenders

Consumer Other All Other < Lenders Specialized < $1 Billion $1 Billion

All Other > $1 Billion

5.0%

4.67%

4.0%

3.0%

2.0% 0.91%

1.57%

1.0%

0.59% 0.21% 0.30% 0.12%

Mortgage Lenders Consumer Lenders Other Specialized < $1 Billion

0.31%

0.25%
All Other > $1 Billion

0.0%
International Banks Agricultural Banks Credit Card Lenders Commercial Lenders All Other < $1 Billion

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Types of Consumer Loans

Classify Consumer Loans by Purpose What the Borrowed Funds are Used For, or by Type Whether the Borrower Must Repay in Installments or in One Lump Sum Residential Mortgage Loans Nonresidential Loans Installment Loans Noninstallment Loans Credit Card Loans and Revolving Credit
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Residential Mortgage Loans

Credit to Finance the Purchase of Residential Property in the Form of Houses and Multifamily Dwellings. This is Usually a Long-Term Loan (1530 years) Which is Secured By the Property Itself. Fixed or Variable Rate of Interest
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Nonresidential Loans: Installment Loans

Short-Term to Medium-Term Loans Repayable in Two or More Consecutive Payments, Usually Monthly or Quarterly. These Are Often Used to Finance Big Ticket Purchases or Consolidate Existing Debt (automobile, furniture, appliances).
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Noninstallment Loans
Short-Term Loans By Individuals for Immediate Cash Needs and Repayable in One Lump Sum When the Borrowers Note Matures (charge accounts, medical care, auto and home repairs)

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Credit Card Loans

Credit Cards Offer Holders Access to Either Installment or Noninstallment Credit. Banks Find That the Installment Users of Credit Cards are the Most Profitable Provide Higher Risk-Adjusted Returns Than Other Types of Loans. Card issuers earn income from:
Cardholders annual fees Interest on outstanding loan balances Discounting the charges that merchants accept on purchases.
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Credit Card Regulations

U.S. Regulators of Depository Institutions -OCC, Fed, FDIC, and OTS -- in 2003, Moved to Slow the Expansion of Card Offers to Customers with Low Credit Ratings More recently, May 2009:
Strict limits on marketing to college students and other prospective cardholders under the age of 21 Preventing cardholder accounts from being charged beyond their limits Clearer disclosure of credit card interest rates and repayment estimates, using standard text sizes and styles Tougher rules related to raising interest rates on delinquent cardholders, with clear paths to rehabilitate credit card accounts.

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Debit Cards

Debit Cards Can Be Used To Pay For Goods And Services, But Not To Extend Credit. They Are A Convenient Vehicle For Making Deposits Into And Withdrawals From ATMs And They Facilitate Check Cashing.

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Outstanding Consumer Debt as a Percent of Disposable Income

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Consumer Debt Service Ratio

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Characteristics of Consumer Loans

Most Costly and Most Risky to Make Per Dollar Cyclically Sensitive Interest Inelastic

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Evaluating a Consumer Loan Application

Character and Purpose Income Levels Deposit Balances Employment and Residential Stability Pyramiding of Debt

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Credit Bureaus
Credit Reporting Agencies or Credit Bureaus Assemble and Distribute to Lenders the Credit History of Millions of Borrowers Information
Personal Identifying Data Personal Credit Histories Public Information That May Have Bearing on Loan

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Credit Scoring

Credit Scoring Systems are Based on Sophisticated Statistical Models in Which Several Variables are Joined to Establish a Numerical Score to Separate Good Loans From Bad Loans. The Most Famous of These is the FICO Scoring System Developed by Fair Isaac.
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Laws and Regulations Applying to Consumer Loans

1. Disclosure Rules
Truth in Lending Act, passed in 1968, simplified in 1981 Fair Credit Reporting Act, 1974 Fair Credit Billing Act Fair Debt Collection Practices Act Equal Credit Opportunity Act Community Reinvestment Act Home Ownership and Equity Protection Act
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2. Antidiscrimination Laws

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Ethics in Banking Box: Identity Theft

Fastest Growing Crime Against Individuals Today It Can be Difficult to Detect and Costly to Recover From Fair Credit and Accurate Credit Transactions (FACT) Act was Passed in 2003 to Counter this Growing Problem Consumers Entitled to One Free Credit Report Annually from Each of the Three Major Credit Bureaus
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Predatory Lending and Subprime Loans

An Abusive Practice Among Some Lenders That Consists of Granting Loans to Subprime Borrowers and Charging Them Excessive Interest Rates and Fees, Increasing the Risk of Default. Subprime Lending Played Important Role in the 2007 Credit Crisis.
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Real Estate Loans

Among the Riskiest Loans Banks Can Make

Average Size is Larger Than the Average Size of Other Loans Tend to Have Longer Maturities Than Other Loans

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Factors Used in Evaluating Real Estate Loans

Size of Down Payment Relative to Purchase Price of Property Should Be Evaluated in Terms of Total Relationship Need to Pay Attention to Particular Aspects of Credit Application:
Amount and Stability of Income (Gross Debt Service) Available Savings and Source of Down Payment Track Record in Maintaining Property Outlook for Real Estate Market in Local Area Outlook for Interest Rates If Variable Rate Loan

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Home Equity Lending

Home Owners Can Use the Difference in Homes Estimated Value and Remaining Mortgages as a Borrowing Base Two Types of Credit

Can Be Used for Any Legitimate Purpose The 1986 Tax Reform Act Has Helped This Type of Loan Grow in Popularity
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Closed End Credit Lines of Credit

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Interest Only Mortgages: The Most Controversial of Home Mortgage Loans

Many of these are Adjustable Rate Mortgages Home Owner Can Pay the Interest Only for an Initial Period Mortgage Payments Can be Much Higher When Principal Payments are Due Because of the Shorter Period to Repay the Loan Especially Problematic When House Prices Stop Climbing Upward During the Recent Crisis, the Fed Moved to Tighten the Rules on Mortgage Lending to Promote Greater Transparency in Loan Terms
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

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Quick Quiz
How do credit-scoring systems work? What are the principal advantages to a lending institution of using a credit-scoring system? In what ways is a real estate loan unique compared to other kinds of bank loans? What factors should a lender consider in evaluating real estate loan applications? What legal protections are available today to protect borrowers against discrimination? Against predatory lending? What forces are reshaping household lending today?
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Cost-Plus Model of Pricing Loans

Loan Rate Paid by = Consumer

Lender's Cost of Raising Funds

Risk Risk Nonfunding Premium Premium Desired + Operating + for + for Time + Profit Costs Customer to Margin Default Maturity

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Annual Percentage Rate (APR)

The APR is the Internal Rate of Return that Equates Total Payments With the Amount of the Loan. The Truth in Lending Act Requires That This Rate Be Disclosed to Consumers On All Loans
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Simple Interest
In Simple Interest the Customer Only Pays Interest On the Amount of the Principal Left. First the Declining Loan Balance is Calculated and That Reduced Balance is Used to Calculate the Amount of Interest Owed
$3,000 loan at 12% simple interest per year produces $360 in interest, or a 12 percent effective rate interest (is): = $3,000(0.12)(1)= $360

$3,360 $3,000 = (1 + is )
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Discount Rate Method

The Discount Rate Method Requires the Customer to Pay the Interest in Advance. Interest is Deducted First and the Customer Receives the Loan Amount Less Any Interest Owed
Consider a 1-year loan with a single $3,000 payment at maturity.
The borrower receives only $2,640, or the total loan minus 12% discount rate interest. The effective annual percentage rate, or APR, equals 13.64%
Interest charge = 0.12 ($3,000) = $360
Annual Percentage Rate (i n ) $2,640 =
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$3,000 (1 + in )

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Add-On Loan Rate Method

Interest Owed is Added to the Principal Amount, Then the Loan Payments are Calculated By Dividing This Sum By the Number of Loan Payments

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Rule of 78s
A Rule of Thumb to Determine Exactly How Much Interest Income a Bank is Entitled to Accrue at Any Point in Time From an Installment Loan Being Paid in Monthly

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Interest Rates on Home Mortgages

Fixed Rate Mortgage (FRM) 1930s to 1970s Most Mortgages Were Fixed-Rate Mortgages. They Had a Fixed Interest Rate That Did Not Change Over the Life of the Loan Adjustable Rate Mortgage (ARM) in the Early 1970s Adjustable Rate Mortgages Were Allowed. These Mortgages Have an Interest Rate That Changes Over the Life of the Mortgage. The Yields are More Responsive to Interest Rate Movements an Advantage for the Lender.
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Mortgage Points
This is an Additional Up Front Charge Often Required on Home Mortgages. It is a Percentage of the Loan Amount and Reduces the Amount of the Loan Available

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Quick Quiz
What options does a loan officer have in pricing consumer loans? Suppose a customer is offered a loan at a discount rate of 8% and pays $75 in interest at the beginning of the term of the loan. What net amount of credit did this customer receive? Suppose you are told that the effective rate on this loan is 12%. What is the average loan amount the customer has available during this year?
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