BANK LENDING

Tran Thi Minh Tram

Email: tramttm@ftu.edu.vn

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 Chapter 4: Consumer lending
CONCEPT OF CONSUMER LENDING

TYPES OF CONSUMER LENDING

FEATURES OF CONSUMER LENDING

EVALUATING CONSUMER LOAN APPLICATIONS

PRICING AND STRUCTURING OF CONSUMER LENDING

Example of consumer lending

Trends in consumer lending 2

 Learning objectives
• Explain what consumer loans are
• Outline the major types of consumer loans
• Explain how different types of consumer loan applications are
evaluated
• Explain, with the help of a specimen consumer loan
application, how the principles of lending are applied in
practice
• Enumerate the precautions to be taken in assessing consumer
loan applications
• Discuss how credit scoring and consumer loan applications is
done
• Briefly explain the laws and regulations affecting consumer
loans
• Outline the trends in consumer credit
• Explain the pricing aspect of consumer loans
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DEFINITION
• Consumer lending is the category of financing
centered on individual and household consumers.
It includes home and auto loans, as well as
personal loans extended to people who use the
funds for individual or family purposes.
(ABA – American Bankers Association)

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Consumer lending
• Among the most popular financial services offered
in recent years
• Among the most profitable services a bank can
offer
• Among the most costly and risky services
• However, profit margins are now narrowed due to
increase in competition

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TYPES OF CONSUMER LOAN
• Consumer credit is extended by banks, retailers,
and others to enable consumers to purchase goods
immediately and pay off the cost over time with
interest.
• It is broadly divided into two classifications:
instalment credit and revolving credit.
• The most popular consumer instalment loan
products are mortgages, student loans, auto loans
and personal loans.

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Types of consumer loan
• Classified by purposes:
• Loans for purchase of residential homes
• Investments properties
• Holidays
• Higher studies
• Household furniture
• Cars, boats
• Others
• Classified by the term of the loan
• Short-term loans
• Long-term loans
• Classified by the terms of repayment
• Instalment loans
• Non-instalment loans
• Classified by security
• Secured loan
• Unsecured loan/ a clean loan
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Types of consumer loans
• Classify consumer loans
– Residential mortgage loans & Nonresidential
loans
• Nonresidential loans
• Instalment loans
• Non-instalment 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 (15-30 years) which
is secured by the property itself.
• Fixed or variable (floating) rate of interest that
change periodically

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Nonresidential loans: Instalment
loans
• Often used to finance big ticket purchases or
consolidate existing debt (automobile, furniture,
appliances).
• Short-term to medium-term loans repayable in two
or more consecutive payments, usually monthly or
quarterly.
• Frequently used to cover the cost of vacations,
medical care, the purchase of home appliances,
and auto and home repairs.

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Credit card loans
• Credit cards offer holders access to either installment
or non-instalment credit.
• Actually, it is a revolving line of credit that the
customer can access whenever the need arises.
• Careful management and control of card programs is
vital due to the relatively high proportion of
delinquent borrowers and the large number of cards
that are stolen and used fraudulently.
• Card issuers earn income from:
– Cardholders’ annual fees
– Interest on outstanding loan balances
– Discount fees from merchants accepting the cards

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 18-12

Outstanding consumer debt as a

percent of disposable income

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 18-13

Consumer debt service ratio

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CHARACTERISTICS OF CONSUMER
LENDING
• Most costly and most risky to make per dollar
• Cyclically sensitive
• Interest inelastic

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Characteristics of consumer
lending
• Consumer credit use from month to month is
closely measured by economists because it is
considered an indicator of economic growth or
contraction.

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EVALUATING CONSUMER LOAN
APPLICATIONS
• General principles
• Step-by-step assessment of personal loans
• Step-by-step assessment of credit card loans

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General principles
• Like all other evaluations of loans, the assessment
of a consumer loan application follows the
fundamentals of lending
• 6Cs…

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Step-by-step assessment of
personal loans
1. Step 1: Obtaining a prescribed application form
2. Step 2: Conducting a preliminary assessment
3. Step 3: Accepting and loading applications
4. Step 4: Taking securities
5. Step 5: Determining interest, fees and charges
6. Step 6: Approving/rejecting applications
7. Step 7: Supervising the loan and following up

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Step-by-step assessment of credit
card loans
1. Step 1: obtain prescribed credit card application
form
2. Step 2: conduct credit checks
3. Step 3: if the checks are satisfactory, work out the
points and make decisions of accepting or
rejecting
4. Step 4: advise customer about the results. If
application is approved, issue the card, with
approval letter and detailed book of instructions.

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Example of a consumer loan
application

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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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EXAMPLE OF A CONSUMER LOAN
APPLICATION
• An application form for a personal loan is
downloadable from the Westpac Bank’s website
(https://www.westpac.com.au/docs/pdf/pb/Person
al_loan_application.pdf ).
• It will help to have the form handy while reading
the following discussion.

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Credit scoring consumer loan
applications
• For credit assessment, banks traditionally used
judgemental lending, which was not only subjective
but also time consuming.
• Credit scoring – a more efficient and cost-effective
systems of assessment of consumer loans - has
been developed.
• See previous chapter

Any disadvantages of credit scoring?

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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.
– If the applicant's score exceeds -a critical cutoff level, he or she is
likely to be approved for credit in the absence of other damaging
information.
– If the applicant's score falls below the cutoff level, credit is likely
to be denied in the absence of mitigating factors.
– However, all lenders do not adopt the same cutoff score for loan
approval.
• Credit scoring systems are frequently retested and revised
as more sensitive predictors are identified.

Advantages of credit scoring?

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The FICO scoring system
• The most famous of these is the FICO scoring
system developed by Fair Isaac Corporation.
• Its credit scores are based on five different types of
information arrayed from most important to least
important:
1. The borrower's payment history
2. The amount of money owed
3. The length of a prospective borrower's credit history
4. The nature of new credit being requested
5. The types of credit the borrower has already used

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Credit scoring systems

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REAL ESTATE LENDING
• Real estate lending to fund the acquisition of real
property-homes, apartment complexes, shopping
centers, office buildings, warehouses, and other
physical structures, as well as land.
• 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 home’s
estimated value and remaining mortgages as a
borrowing base
• Two types of credit
– Closed end credit
– Lines of credit
• Can be used for any legitimate purpose

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Example
Closed-end credit:
• If a home was purchased for $100,000 and has a
$70,000 mortgage loan against it today and, due to
inflation and growing demand for housing, its
market value is now $150,000
• Define the home owner’s borrowing base?

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Example
Lines of credit:
• If a home was purchased for $100,000 and has a
$70,000 mortgage loan against it today and, due to
inflation and growing demand for housing, its
market value is now $150,000
• Banks determine the credit limit on these home
equity lines by taking a -percentage of the
appraised value of the borrowing customer's
home (say, 75%) and subtracting the amount the
customer still owes on the existing loan.
• Calculate customer’s credit line?
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The Most Controversial of Home Mortgage
Loans: Interest-Only and Adjustable Mortgages
• Financial innovation: adjustable-rate loans (ARMs)
and interest-only adjustable mortgage loan
(option ARM)
• With this type of credit the home buyer is
obligated to pay only the interest on his or her
home loan for an initial period - for example, the
first 10 years. Then after that initial time interval
both principal and interest payments would have
to be made until the loan was paid off.

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The Most Controversial of Home Mortgage
Loans: Interest-Only and Adjustable Mortgages
• Many of these are adjustable rate mortgages
• 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

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PRECAUTIONS TO BE TAKEN IN
GRANTING CONSUMER LOANS
• Consumer loans are far simpler to assess and
monitor than corporate loans, but it is still
important to take adequate care to avoid problems.
• Challenges may be:
• Asymmetric information: lack, inconsistency
• Cost and difficulty of verifying information
• Legal capacity of borrowers
• …

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LAWS AND REGULATIONS
APPLYING TO CONSUMER LOANS
1. Disclosure Rules
▫ mandate telling the consumer about the cost and
other terms of a loan or lease agreement
2. Antidiscrimination Laws
▫ prevent categorizing loan customers according to their
age, sex, race, or other irrelevant factors and denying
credit to anyone solely because of membership in one
or more of these groups

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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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Ethics in banking: Identity theft

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Ethics in banking: 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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TRENDS IN CONSUMER CREDIT
• Trends in personal lending
• Trends in credit card lending
• The impact of technology

What are the trends of consumer credit in your country?

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The changing environment for
consumer and real estate lending
• Many lenders today are offering indirect loans
through dealers in autos, home appliances, and
other big-ticket items.
• The dealer prepares a credit agreement and
phones or faxes the borrowing customer's
information to the lender, seeking quick approval.
• Other lending institutions are offering preapproval
credit programs where the customer phones in or
mails credit information to the lender and gets
approval for a loan before a purchase is made.

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PRICING AND STRUCTURING OF
CONSUMER LOANS

• Loan pricing
• Loan structuring

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LOAN PRICING
• The pricing of a loan refers to the rate of interest,
fees and other terms on which bank gives a loan.
• Factors affecting loan pricing?
➢The price of a loan product typically includes the
financial cost, the administration cost, the risk premium
and the profit margin.
• Fixed interest rate vs variable rate?
• Bank fee: growing considerable criticism, sensitivity

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Pricing consumer and real estate
loans
• A financial institution prices every consumer loan
by setting an interest rate, maturity, and terms of
repayment that both lender and customer find
comfortable.
• While many consumer loans are short term,
stretching over a few weeks or months, long-term
loans to purchase auto· mobiles, home appliances,
and new homes may stretch from one or two years
all the way out to 25 or 30 years.

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Interest rate of nonresidential
consumer loans
• Many consumer loans are priced off some base or
cost rate, with a profit margin and compensation
for risk added (The cost plus model)
• Lending institutions use a wide variety of methods
to determine the actual loan rates they will offer to
their customers. Among the more familiar
methods for calculating consumer loan rates are:
– the annual percentage rate (or APR)
– simple interest
– the discount rate
– the add-on rate method

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 Cost-plus model of pricing loans

Risk Risk
Lender's
Loan Rate Nonfunding Premium Premium Desired
Cost of
Paid by = + Operating + for + for Time + Profit
Raising
Consumer Costs Customer to Margin
Funds
Default Maturity

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Annual Percentage Rate (APR)

• APR is the internal rate of return that equates total

payments with the amount of the loan.
• The Truth in lend inquires that this rate be
disclosed to consumers on all loans

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Example
• For example, suppose a consumer borrows $2,000
for a year, paying off the loan in 12 equal monthly
installments, including $200 in interest.
• Each month the borrower makes a payment of
$183.33 in principal and interest.
• Calculate monthly rate and APR?

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Example
• As loan officer, quote your customer an APR of 12
percent on a one-year loan of $1,000 to be repaid
monthly
• The customer asks, How much will I pay in finance
charges under the terms of this loan?
• What is your answer?

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Example
• suppose the customer is told he or she must pay
$260 in finance charges to get a $2,000 loan for 24
months. This means the consumer makes payments
of $94.17 (2,260/24 ).
• What APR is this customer being quoted?

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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

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Example
• $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 + i s )
i s = 12%

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Example
• Suppose the customer asks for $2,000 for a year at
a simple interest rate of 12 percent in order to
purchase some furniture.
• If none of the principal of this loan is to be paid off
until the year ends, the interest owed by the
customer is how much?

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Example
• Suppose the customer asks for $2,000 for a year at
a simple interest rate of 12 percent in order to
purchase some furniture.
• Now assume instead that the loan principal is to
be paid off in four quarterly installments of $500
each. Total payments due will be?

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 18-64

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

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 18-65

Example
• 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 …?

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Add-on loan rate method
• One of the oldest loan rate calculation methods
is the add-on 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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Example
• If the customer requests $2,000 and is offered a
12 percent add-on interest rate and a repayment
plan of 12 equal monthly installments, the total
payments due will be $2,000 in principal plus
$240 in interest, or $2,240.
• Each monthly payment will be $186.67 ($2,240 +
12), consisting of $166.67 in loan principal and
$20 in monthly interest.

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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
• The Rule of 78s arises from the fact that the sum of
the digits 1 through 12 is 78.
• To determine the borrowing customer's interest
rebate from early repayment of an installment
loan, total the digits for the months remaining on
the loan and divide that sum by 78.

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Rule of 78s - Example
• Suppose a consumer requests a one-year loan to be
repaid in 12 monthly installments, but is able to
repay the loan after only nine months.
• This customer would be entitled to receive back as
an interest rebate? The lender is entitled to keep
?% of those finance charges?

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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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Interest rates on home mortgages
• Whether a customer takes out an FRM or an ARM,
the loan officer must determine what the initial
loan rate will be and, therefore, what the monthly
payments will be.

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Example
• Principle amount of loan is $50,000, 25 year
mortgage loan, fixed rate of 12%
• Calculate the monthly payment?

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Example
• Assume that, as in the previous FRM example, the
initial loan rate for an ARM is also 12 percent.
However, after one year (i.e., 12 monthly
payments) has elapsed, the mortgage loan rate
rises to 13 percent.
• In this case, calculate the customer's monthly
payments?

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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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LOAN STRUCTURING
• Structuring refers to the repayment patterns and
other terms agreed between the bank and the
borrower.
• Two important elements:
• Security: assets and the documents establishing
ownership and payment rights
• Loan covenants: finalisation of the terms and conditions
of the loans

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DOCUMENTATION
• Documents/information generally required with an
application for personal loan:
• Monthly earnings
• Employer details
• Details of any existing loans
• Details of savings and investments
• For renters: the landlord’s name, phone number, rent
receipt…
• A list of assets and their value
• A driver’s licence number
• …
•…

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Documentation
• Documents generally required at the time of actual
disbursement of loan:
• A promissory note
• A letter of guarantee
• The bill of sale
• A loan agreement form
• …
•…

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 Documentation
• Loan agreement form usually includes the following
covenants:
• A loan agreement form usually includes the following covenants:
• Repayment amount each period (fortnight/month/quarter)
• Interest rates (variable/fixed/variant)
• Security/insurance (details of the assets to be mortgaged or
insurance policy to be assigned)
• A default clause, indicating actions to be taken in the case of
default
• A prepayment clause (facilities for prepayment, penalties for
prepayment)
• A schedule of fees and when these are payable
• Stamp duty/government charges
• …

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Documentation
• Loan documentation is obtained at different stages
of the loan.
• At approval stage
• Where guarantors are involved
•…

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Summary
• Types of loans granted to individuals and families
✓ Residential mortgage loans
✓ Nonresidential loans (Installment loans and noninstallment loans)
✓ Credit card loans and revolving credit
• Characteristics of consumer loans
• Valuating a consumer loan application
✓ Character and Purpose, Income levels, Deposit balances, Employment and
Residential stability, Pyramiding of debt
✓ Credit scoring consumer loan applications (The theory of credit scoring,
The FICO scoring system)
✓ Real estate loans (differences between real estate loans and other loans,
factors in evaluating applications for real estate loans)
• Laws and Regulations applying to consumer loans
(Disclosure rules, Antidiscrimination laws)

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Summary
• Pricing consumer and real estate loans:
Determining the rate of interest and other loan
terms
✓ The interest rate attached to nonresidential consumer loans
– The cost-plus model
– Annual Percentage Rate
– Simple interest
– The discount rate method
– The Add-on loan rate method
– Rule of 78s
✓ Interest rates on home mortgage loans
– Fixed-Rate Mortgages (FRMs)
– Adjustable-Rate Mortgages (ARMs)
• Charging the customer mortgage points

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Review questions
1. What are consumer loans?
2. What are the three major types of consumer loan?
3. How are different types of consumer loan application evaluated?
4. How are the principles of lending applied in practice?
5. What precautions need to be taken in assessing consumer loan
applications?
6. How is credit scoring of consumer loan applications undertaken?
7. What laws and regulations affect consumer loans?
8. What are the trends in consumer credit?
9. What is the pricing aspect of consumer loans?

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PREPARE FOR CHAPTER 5
1. Read documents

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