Chapter 15
Evaluating Consumer Loans
Chapter Objectives
1. Describe the characteristics of different consumer loans.
2. Evaluate the competitive environment in the credit card business.
3. Explain why sub-prime loans are popular at many lending institutions.
4. Discuss various consumer credit regulations and their impact.
5. Introduce fundamental issues when analyzing a consumer loan request.
6. Describe the standard features of credit scoring models. Explain why the use of credit scoring is
now widespread and, how, on occasion, it is abused.
7. Describe the features of indirect consumer lending.
8. Describe the features and impact of the 2005 Bankruptcy Reform legislation.
Key Concepts
1. Consumer loans are generally classified as either installment loans, credit card/revolving
credit lines, or non-installment loans. Installment loans have fixed maturities and require
periodic principal and interest payments. Credit cards and revolving credit lines are
commitments to consumers for any expenditure, and require monthly payments with no
fixed maturity. Non-installment loans are used for virtually any purpose and are typically
repaid in a single payment.
2. Credit card lending has been extremely profitable for banks with large portfolio. Card
issuers get revenue from annual fees, charges against merchants who accept the cards, and
interest paid on outstanding consumer credit card balances. Since the early 1990s,
charge-off rates on credit card loans have been far higher than charge-off rates on other
types of loans. Similarly, personal bankruptcy /lings have generally increased. Exhibit 15.1
documents profitability measures for banks by asset concentration. Credit card lenders
reported the highest ROAs, on average, and the highest net interest margins.
3. Many lenders have increased their exposure to “subprime” borrowers. As the label suggests,
these borrowers are high risk compared to traditional bank borrowers. often, the loans are
labeled “B,” “C,” and “D” paper. Not surprisingly, lenders charge high interest rates and high
fees on such loans because the borrowers have limited alternatives. Many subprime lenders
experienced high defaults and ultimately closed operations. Not surprisingly, credit card
lenders experienced the highest loan charge-offs as a fraction of outstanding loans in 2008.
4. The federal government has authorized a broad range of regulations to protect individuals
when obtaining or requesting credit. These include:
a. Equal Credit Opportunity Act: prohibits discrimination and requires proper reporting.
b. Truth in Lending: requires lenders to disclose finance charges on loans in a standardized
format so borrowers can compare credit terms across lenders.
c. Fair Credit Reporting: enables individuals to examine credit reports /led on themselves.
d. Community Reinvestment Act: prohibits lenders from selectively not extending credit
within specific geographic markets.
5. Credit scoring models use information supplied by prospective borrowers to quantitatively
determine whether a bank should accept or reject a loan. The basic framework involves
identifying the key characteristics of borrowers who regularly repay their loans as promised
and the key characteristics of borrowers who systematically default. These factors are
weighted by statistical models and used to assign a score to a potential loan application. If
the score exceeds some threshold value, the loan is accepted. If the score falls below
another threshold value, the loan is rejected. If the score fall between these threshold
values, the loan is subjectively evaluated. The presumed benefit of credit scoring include
lower costs, objectivity, and nondiscriminatory lending because the factors are structured to
eliminate biases.
6. In recent years, non-lenders have started using credit scoring models and their results in
making financial decisions. For example, insurance companies often use an individual’s credit
score to help assess the likelihood that he or she will /le a claim. This usage has created
widespread debate as to whether a credit score should be used to set insurance premiums
and/or to make accept/reject insurance decisions.
7. Indirect consumer lending involves a bank buying loans or dealer paper from a retailer.
8. The U.S. Congress passed new bankruptcy reform legislation in April 2005 that increases the
consequences of /ling for bankruptcy. specifically, it is now more diBcult for borrowers who
default to avoid making any payments on outstanding debts. Credit counseling is required
and debtors need to provide documentation on their spending habits.
Teaching Suggestions
Differentiate between consumer and commercial lending by comparing basic features of two
general categories of loans. The average size of consumer loans is smaller, the maturity is longer,
and the number of payments to be processed is larger. Thus, it costs a bank proportionately
more to handle consumer loans. Have students compare the relative profitability of consumer
and commercial loans by examining the spread between different consumer loan rates and the
national prime rate. Discuss why consumer loan rates do not change as quickly as commercial
loan rates and money market rates.
Credit scoring is extremely popular with widespread use among lenders. Students need to know
how lenders and insurance companies use credit scores, as well as what information is contained
in a credit score. Spend time with students on this issue. Refer them to the many internet
sources that provide credit scoring information. For example, refer them to www.fairisaac.com
and www.myvesta.com, which contain current data and useful information regarding the
construct of a credit score. Spend time going through the data in Exhibits 15.9 – 15.12.
Credit reports are now available online. Have students request and analyze their personal credit
score and the underlying diagnostics. Be sure to help them acquire the reports without paying
any fees.
Have students discuss personal bankruptcy /lings. The data in Exhibit 15.3 are disconcerting
given the relatively strong U.S. economy over most of the time period examined. What has
caused the increases in charge-off rates for credit cards and the increase in bankruptcy /lings?
Discuss reputation effects and apparent loss of any adverse stigma, the ease of /ling for
bankruptcy and the resulting costs. Are lenders at least partially responsible for the increase in
bankruptcies given the mass mailings of credit cards and perceptions that many customers are
pushed or induced into borrowing.