CONSUMER LOANS, CREDIT

CARDS AND REAL ESTATE

LENDING

Chapter 3

William Chittenden edited and updated the PowerPoint slides for this edition.
Ice-breaking
 Which consumer loan products do you
know?

 Which ones do you intend to use now and

in the near future?
 18-3

Consumer lending – famous sayings

 “If you would know the value of money, go and

try to borrow some” - (Benjamin Franklin)

 “People should watch out for three things: avoid

a major addiction, don’t get so deeply into debt
that it controls your life, and don’t start a family
before you’re ready to settle down” - (James
Taylor)
 18-4

Key topics

1. Types of loans for individuals and families

2. Unique characteristics of consumer loans

3. Evaluating a consumer loan request

4. Credit cards and credit scoring

5. Disclosure rules and discrimination

6. Loan pricing and refinancing

 18-5

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.
(life cycle => how important the consumer lending is to
people’s life)
Outstanding consumer debt as a percent of 18-6

disposable income
 18-7

Consumer debt service ratio

 18-8

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
 Non-installment loans
 Credit card loans and revolving credit
 18-9

Residential mortgage loans

 Credit to finance the purchase of residential
property in the form of houses and multifamily
dwellings, usually a long-term loan (15-30 years)
which is secured by the property itself.
 Fixed or variable rate of interest.
Base rate: US Government Bond or FHLB Board’s average
home mortgage yield

 1-2% commitment fee may be charged

 18-10

Residential mortgage loans

Lenders:
 Banks
 Saving associations
 Credit union
 Finance companies
 Insurance companies
 Mortgage banking subsidiaries of FHCs
 18-11

Non-residential 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 to consolidate
existing debt (automobile, furniture, appliances).
 Direct
Negotiated between the bank and the ultimate
user of the funds
 Indirect
Funded by a bank through a separate retailer
that sells merchandise to a customer
 18-12

Non-residential loans: Non-installment loans

 Short-term loans (6 months or less) by

individuals for immediate cash needs and
repayable in one lump sum when the
borrower’s note matures
 Borrowing amount can be small ($500-$1,000)
or large ($5,000-$50,000)
 Loans are used for charge accounts, medical
care, auto and home repairs.
Non-installment loans

 Bridge loans are representative of single

payment consumer loans.
 Bridge loans often arise when an individual
borrows funds for the down payment on a new
house
 The loan is repaid when the borrower sells the
previous home
 18-14

Credit card loans

 Credit cards issued by card companies as VISA,
MasterCard, American Express, JCB, Diners Club, etc. offer
holders access to either installment or non-installment
credit.
 Most banks operate as franchises of MasterCard and/or
Visa
 Bank pays a one-time membership fee plus an annual
charge determined by the number of its customers
actively using the cards
 Holders may charge their purchase on the account
represented by the card and pay off:
 In one billing period, escaping any finance charge
 Pay gradually, incurring a monthly finance charge based on
annually interest rate (2/3 cards have variable interest rate)
 18-15

Credit card loans

 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.
 18-16

Credit card loans

 Credit cards offer convenience and revolving line of
credit that holders can access whenever they need
 Careful management and control is needed due to
relatively rate of delinquent borrowers and large number
of cards stolen and used fraudulently
 Only the greatest card operations are consistently
profitable
 Credit card program may survive because of advancing
technology giving holders access to full range of
Credit card systems and profitability

 Returns depend on the specific role the bank

plays
 A bank is called a card bank if it administers its
own credit card plan or serves as the primary
regional agent of a major credit card operation
 A non-card bank does not issue its own card
 Credit card transaction process

Individual 1 Retail Outlet

4 2
Card-Issuing Clearing Local Merchant
Bank 3 Network 3 Bank
2

Steps
1. Individual uses a credit card to purchase
merchandise from a retail outlet.
2. Retail outlet deposits the sales slip or
electronically transmits the purchase data
at its local bank.
3. Local merchant bank forwards the
transaction information to a clearing
network, which routes the data to the bank
that issued the credit card to the individual.
4. The card-issuing bank sends the individual
an itemized bill for all purchases.
Fees
1. None
2. The merchant bank discounts the sales receipt. A 3
percent discount indicates the bank gives the retailer
$97 in credit for each $100 receipt.
3. The card-issuing bank charges the merchant bank an
interchange fee equal to 1 to 1.5 percent of the
transaction amount for each item handled.
4. The card-issuing bank charges the customer interest
and an annual fee for the privilege of using the card.
A card-issuing bank also serves as a merchant bank.
 18-19

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.
 18-20

Debit cards
 Debit cards, widely available, 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.
 When an individual uses the card, their balance
is immediately debited
 They have lower processing costs to the bank
 Leading firms: First Data Corp. VISA USA Inc.,
MasterCard International Inc.
 18-21

Debit cards
 Debit card forces discipline to customers & saves
time and paper work comparing with checks
 Debit card provides banks with additional fee
income with lower losses than credit card
 18-22

Debit cards and Smart card

 Close relative of debit cards: smart card
 Smart card carries balances that can be spent
electronically in stores until the balance is fully
used up
 Contains a memory chip which can manipulate
information
 It is programmable such that users can store
information and recall this information when
effecting transactions.
 Only modest usage in the U.S.
Debit Cards and Smart Card

 Smart Card: usage will likely increase dramatically

in the U.S.:
 Firms can offer a much wider range of services
 Smart cards represent a link between the Internet
and real economic activity
 Suppliers of smart cards are standardizing the
formats so that all cards work on the same systems
Pre-paid cards

 Prepaid cards
 A hybrid of debit cards in which customers
prepay for services to be rendered and
receive a card against which purchases are
charged
 Use of phone cards, prepaid cellular, toll
tags, subway, etc. are growing rapidly
 18-25

Characteristics of consumer loans

 Profitable credits with “sticky” interest rate (priced
well above funding cost but kept unchanged in
contract regardless of market conditions)
→ significant interest rate risk
 Most costly and most risky to make per dollar
 Cyclically sensitive: rise in economic expansion
and reduce in economic downturn
 Interest inelastic: borrowers are more concern
about monthly payment than interest rate charged
 Influenced by education and income levels:
borrowing is higher in amount with educated
people and well-paid individuals.
 18-26

Performance and Chargeoffs by Bank Category, 12/2004

5.0%
4.5% 4.01%
4.0%
3.5%
3.0%
2.5%
2.0% 1.66% 1.66%
1.23% 1.30% 1.18% 1.35%
1.5% 1.10%
1.0% 0.76%
0.5%
0.0%
International Agricultural Credit Card Commercial Mortgage Consumer Other All Other < All Other >
Banks Banks Lenders Lenders Lenders Lenders Specialized < $1 Billion $1 Billion
$1 Billion

5.0% 4.67%

4.0%

3.0%

2.0%
1.57%

0.91%
1.0%
0.59%
0.21% 0.30% 0.31% 0.25%
0.12%
0.0%
International Agricultural Credit Card Commercial Mortgage Consumer Other All Other < All Other >
Banks Banks Lenders Lenders Lenders Lenders Specialized < $1 Billion $1 Billion
$1 Billion
Credit card loss rates and personal
bankruptcy filings: 1984-2004
Net Charge-Off % Personal Bankruptcy Filings $000
9% 450
Credit-Card
8% Charge-Off 400
Rates
7% 350
6%
300
5%
Personal 250
4% Bankruptcy
Filings 200
3%
2% 150

1% 100

0% 50
'84 '86 '88 '90 '92 '94 '96 '98 '00 '02 '04
 18-28

Risks of consumer loans

 Risk of consumer loan is higher or

lower compared to business loans?
 Why many banks develop products
for consumer customers?
 Retailed banking versus consumer
lending?
 18-29

Evaluating a consumer loan application

 Getting money is like digging with a needle;
spending it is like water soaking into sand -
Japanese proverb

 A bank is a place that will lend you money if

you can prove that you don't need it. ~Bob
Hope

 People are living longer than ever before, a

phenomenon undoubtedly made necessary by
the 30-year mortgage. ~Doug Larson
 18-30

Evaluating a consumer loan application

 Character and purpose

 Income levels
 Deposit balances
 Employment and residential stability
 Pyramiding of debt
 How to qualify for a consumer loan?
However, consumer loans differ so much in design
that no comprehensive analytical format applies to
all loans.
Evaluating a consumer loan application

 Can you compare 6Cs of consumer loans

and business loans?

 Remember: Creditors have better

memories than debtors.
Credit analysis

 Evaluation procedures:

 Judgmental and

 Quantitative, Credit Scoring

Credit analysis: judgmental procedures

 Judgmental

 The loan officer subjectively interprets the

information in light of the bank’s lending

guidelines and accepts or rejects the loan

Credit analysis: quantitative
 Quantitative credit scoring / Credit scoring
model
 The loan officer grades the loan request
according to a statistically sound model that
assigns points to selected characteristics of
the prospective borrower
 In both cases, judgmental and quantitative,
a lending officer collects information
regarding the borrower’s character,
capacity, and collateral
 18-35

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.
 18-36

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
 18-37

Credit bureau in Vietnam

 CIC
 PCB
An application:
for a consumer loan

 Case of Skylark application – pp. 601-604

 How does the bank analyze Skylark?

 What is the conclusion?

 Do you make the loan?

An application:
credit scoring a consumer loan

 You receive an application for a customer to

purchase a 2003 Jeep Cherokee

An Application: Credit Scoring a Consumer Loan
Example of loan application in Vietnam

 Assessment report of the individual

 Pricing assessment report of secured

items
Quick Quiz

 Comparing the assessment of loan

application btw individual and business?
 Credit scoring system, University National
Bank, applied to credit application for
purchase of a 2003 Jeep

Category Characteristics/Weights
<$10,000 $10,000-$20,000 $20,000-$40,000 $40,000-60,000 >$60,000
Annual Gross Income
5 15 30 45 60
Monthly Debt Payment >40% 30-40% 20-30% 10-20% <10%
Monthly Net Income 0 5 20 35 50
Bank Relationship None Checking Only Saving only Checking & Saving No answer
Checking/Saving 0 30 30 50 0
None 1 or more No answer
Major Credit Cards
0 30 0
Any derogatory within 7 yrs. No record Met obligated payments
Credit History
-10 0 30
< 50 yrs. >50 yrs. No answer
Applicant's Age
5 25 0
Rent Own/Buying Own outright No answer
Residence
15 40 50 15
Residence Stability < 1 yr. 1-2 yrs. 2-4 yrs. >4 yrs. No answer
0 15 35 50 0
Job Stability < 1 yr. 1-2 yrs. 2-4 yrs. >4 yrs. Unemployed Retired
5 20 50 70 5 70
NOTE: Minimum score for automatic credit approval is 200; score for judgmental evaluation, 150 to 1 95; score for
automatic credit denial is less than 150. Melanie Groome's credit score is 185.
 FICO Credit scores

National Distribution of FICO Scores

30
28%
25
20
19%
15 16%
10 12% 11%
5 8%
$% of Population1% 5%
0 Up to 499 500-549 550-599 600-649 650-699 700-749 750-799 800+
FICO Score Range

Delinquency Rates by FICO Score

100%
80% 87%
71%
60%
51%
40%
31%
20%
15% 5% 2% 1%
0%
Up to 499 500-549 550-599 600-649 650-699 700-749 750-799 800+
of Credit Delinquencies FICO Score Range
18-46
An application: indirect lending

 A retailer sells merchandise and takes the credit

application
 Because many firms do not have the resources to
carry their receivables, they sell the loans to
banks or other financial institutions
 These loans are collectively referred to as dealer
paper
 Banks aggressively compete for paper originated
by well-established automobile, mobile home,
and furniture dealers
An application: indirect lending
 Indirect lending is an attractive form of consumer
lending when a bank deals with reputable retailers
 Dealers negotiate finance charges directly with their
customers
 A bank, in turn, agrees to purchase the paper at
predetermined rates that vary with the default risk
assumed by the bank, the quality of the assets sold,
and the maturity of the consumer loan
 A dealer normally negotiates a higher rate with the
car buyer than the determined rate charged by the
bank
 This differential varies with competitive conditions
but potentially represents a significant source of
dealer profit
An application: indirect lending

 Most indirect loan arrangements provide for

dealer reserves that reduce the risk in indirect
lending
 The reserves are derived from the differential
between the normal, or contract loan rate and
the bank rate, and help protect the bank
against customer defaults and refunds
 Terms of the Dealer Agreement
Bank buys dealer paper at a 12 percent rate. Dealer charges customers a higher rate
An Application: Indirect Lending
(15 percent APR), with 25 percent of difference allocated to a reserve.
Sample Automobile Loan
Principal = $8,000
Maturity = 3 years, 36 monthly installments
Loan rate = 15% annual percentage rate (APR)
Monthly payment = $8,000/[(I/.0125) - (1/.0125(l.0125)36)] $277.32
Allocation to the Dealer Reserve
Total interest expense to customer= $1,983.52
Total interest income for bank = 1,565.72
Differential interest - $ 417.80
75% allocated to dealer: 0.75(417.80) = $313.35
25% allocated to reserve: 0.25(417.80) = $104.45
Interest Refunds on Prepayments with Add-on Rates
Loan is written on a precomputed basis, and bank accrues interest using “rule of 78s"*
Interest expense to customer = 0.15($8,000)(3) = $3,600
Interest income for bank = 0.12($8,000)(3) = 2,880
Differential interest = $ 720
75% allocated to dealer: 0.75($720) = $540
25% allocated to reserve: 0.25($720) = 180
End of Year Interest Earned* Total Bank Difference
1 54.96% $1,978.37 $1,582.70 $395.67
2 33.33 1,200.00 960.00 240.00
3 11.71 421.62 337.30 84.32
100.00% $3,600.00 $2,880.00 $720.00
*Rule of 78s factors are 366/666, 222/666, and 78/666, respectively.
 18-51

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
 18-52

Laws and regulations applying to

consumer loans
 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
 Antidiscrimination Laws
 Equal Credit Opportunity Act
 Community Reinvestment Act
 Home Ownership and Equity Protection Act
Consumer credit regulations

 Equal credit opportunity

 Makes it illegal for lenders to discriminate
 Prohibits Information Requests on:
 The applicant's marital status
 Whether alimony, child support, and public
assistance are included in reported income
 A woman's childbearing capability and plans
 Whether an applicant has a telephone
Consumer credit regulations

 Equal credit opportunity

 Credit scoring systems
 Credit scoring systems are acceptable if they do
not require prohibited information and are
statistically justified
 Credit scoring systems can use information about
age, sex, and marital status as long as these
factors contribute positively to the applicant's
creditworthiness
Consumer credit regulations

 Equal credit opportunity

 Credit scoring systems
 Credit scoring models are based on historical data
obtained from applicants who actually received
loans
 Statistical techniques assign weights to various
borrower characteristics that represent each
factor's contribution toward distinguishing between
good loans that were repaid on time and problem
loans that produced losses
Consumer credit regulations

 Equal credit opportunity

 Credit reporting
 Lenders must report credit extended jointly to
married couples in both spouses' names
 Whenever lenders reject a loan, they must notify
applicants of the credit denial within 30 days and
indicate why the request was turned down
Consumer credit regulations

 Truth In Lending
 Regulations apply to all individual loans up to
$25,000 where the borrower's primary residence
does not serve as collateral
 Requires that lenders disclose to potential
borrowers both the total finance charge and an
annual percentage rate (APR)
 The APR equals the total finance charge computed
against the loan balance as a simple annual
interest rate equivalent
Consumer credit regulations
 Fair Credit Reporting Act
 Enables individuals to examine their credit
reports provided by credit bureaus
 Ifany information is incorrect, the individual can
have the bureau make changes and notify all
lenders who obtained the inaccurate data
 There are three primary credit reporting
agencies:
 Equifax
 Experian
 Trans Union
 Unfortunately, the credit reports that they produce are
quite often wrong
Sample Credit Report
Consumer credit regulations
 Fair Credit Reporting Act
 Credit score
 Like a bond rating for individuals: based on
several factors
Facotor
Contributing to Facotor
Credit Score, Contributing to
Facotor 10% Credit Score,
Contributing to 30.00%
Credit Score,
15%

Facotor Facotor
Contributing to Contributing to
Credit Score, Credit Score,
10% 35%
Consumer credit regulations

 Community Reinvestment Act

 CRA prohibits redlining and encourages lenders to
extend credit within their immediate trade area and
the markets where they collect deposits
 FIRREA of 1989 raised the profile of the CRA by:
 Mandating public disclosure of bank lending policies
and regulatory ratings of bank compliance
 Regulators must also take lending performance into
account when evaluating a bank's request to charter
a new bank, acquire a bank, open a branch, or
merge with another institution
Consumer credit regulations
 Bankruptcy reform
 Individuals who cannot repay their debts on time
can file for bankruptcy and receive court protection
against creditors
 Individuals can file for bankruptcy under:
 Chapter 7
• Individuals liquidate qualified assets and distribute the
proceeds to creditors
 Chapter 13
• An individual works out a repayment plan with court
supervision.
 Unfortunately, individuals appear to be using
bankruptcy as a financial planning tool
 It appears the stigma of bankruptcy is largely gone
 18-63

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 financial crisis.
Subprime loans

 One of the hottest growth areas during the

1990s
 Subprime loans are higher-risk loans labeled
“B,” “C,” and “D” credits
 They have been especially popular in auto, home
equity, and mortgage lending
 Typically have the same risk as loans originated
through consumer finance companies
Subprime loans

 Subprime loans have greater risk and must be priced

consistently higher than prime-grade loans
 Example definitions:
 B: Typically scores 600+ under the Fair Isaac system; has
some 90-day past dues but is now current. Typical
delinquencies are 2%-5%; repossessions are 2.5%-6%; and
losses are 1.5%-3%
 C: Typically scores between 500 and 600 and has had write-
offs and judgments. The borrower has made subsequent
payments of some or all of the loans. Typical delinquencies
are 5%-10%; repossessions, 5%-20%; and losses 3%-10%
 D: Typically scores between 440 and 500 and has charge-offs
and judgments that have not been repaid and has not made
payments on these loans. Delinquencies are 10%-20%;
repossessions, 16%-40%; losses, 10%-20%
Subprime loans

 High LTV Loans

 High Loan-To-Value
 Many lenders upped the stakes by making “high
LTV” loans based on the equity in a borrower’s
home
 Where traditional home equity loans are capped at
75 percent of appraised value minus the
outstanding principal balance, high LTV loans
equal as much as 125% of the value of a home
 18-67

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
 18-68

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
Quick Quiz

 Why banks should pay attention to these

factors in evaluating the real estate
loans?
 18-70

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
 The 1986 Tax Reform Act has helped this type of
loan grow in popularity
 18-71

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
Pricing of consumer and real estate loans

1. Non-residential loans
 Cost-plus model
 Annual Percentage rate
 Simple interest method
 The discount rate method
 Add-on loan rate method
 Rules of 78s
 18-73

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
 18-74

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.
 18-75

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 )
is  12%
Simple Interest

 Simple Interest
 The quoted rate (APR) is adjusted to its monthly
equivalent, which is applied against the unpaid
principal balance on a loan
 The loan is repaid in 12 monthly installments
and the monthly interest rate equals 1 percent of
the outstanding principal balance at each month
 Simple interest rate

Repayment Schedule
End of Month Monthly Interest Principal Outstanding
Payment Portion Principal
Balance

January $266.55 $30.00 $236.55 $2,763.45

February 266.55 27.63 238.92 2,524.53
March 266.55 25.25 241.30 2,283.23
April 266.55 22.83 243.72 2,039.51
May 266.55 20.40 246.15 1,793.36
June 266.55 17.93 248.62 1,544.74
July 266.55 15.45 251.10 1,293.64
August 266.55 12.94 253.61 1,040.03
September 266.55 10.40 256.15 783.88
October 266.55 7.84 258.71 525.17
November 266.55 5.25 261.30 263.87
December 266.51 2.64 263.87 0.00
Total $3,198.56 $198.56 $3,000.00

Effective interest rate: Monthly rate = 1%

Annual precentage rate = 12%
12
1
Monthly payment= $3,000 
i=1 (1.01)
t
 18-78

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) =$3,000
AnnualPercentageRate (i ) $2,640 =
$360
n
(1 + in )
i  13.64%
 18-79

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
 Add-on Rates

 Example:
 Suppose that a customer borrows $3,000 for one
year at a 12 percent add-on rate with the loan to
be repaid in 12 equal monthly installments
 Total interest equals $360, monthly payment
equals $280, and the effective annual interest
cost is approximately 21.5%

[0.12($3,000)  $3,000]
Monthly Payment   $280
12
12
$280
Effective Interest Rate(i) :  t
 $3,000 i  21.46%
t=1(1 + i)
 18-81

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
Back to the indirect lending

 How to calculate the figures?

 How is the implication of indirect lending?

 18-83

2. 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.
 18-84

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
Homework

1. Explain one specific pricing policy for

consumer loans of one commercial bank
in Vietnam. Pros and cons of that policy.

2. Assess the prospects and risks of real

estate loans in Vietnam.
 Questions & Problems
1. How do credit-scoring systems work? What are the
principal advantages & disadvantages to a lending
institution of using a credit-scoring system?
2. What factors should a lender consider in evaluating real
estate loan applications?
3. What options does a loan officer have in pricing consumer
loans?
4. What is home equity lending, and what are its advantages
and disadvantages for banks and other consumer lending
institutions?
5. Problem 2, 7, 9 and 13 (page 627-9)
 Answers
1. How do credit-scoring systems work?

Credit-scoring systems use statistical techniques

(usually multiple discriminant analysis) to classify
borrowers based on selected characteristics of each
borrower as to whether they are likely or unlikely to repay
the loan they have requested.
 Answers
1. How do credit-scoring systems work?

Credit-scoring systems are usually based on discriminant

models or related techniques, such as logit or probit
analysis or neural networks, in which several variables are
used jointly to establish a numerical score for each credit
applicant. 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.
 Answers
1. What are the principal advantages & disadvantages to a
lending institution of using a credit-scoring system?
Adv: The credit scoring method has the advantage of being
objective, requiring less loan officer judgment, possibly
lowering loan losses, and lowering operating costs when a
large volume of consumer loans is processed.

Diadv: Credit scoring systems do not take into account

motivational factors or individual differences and may
become outdated unless frequently retested for statistical
accuracy.
 Answers
2. What factors should a lender consider in evaluating real
estate loan applications?

a. What is the borrower's monthly income and monthly debt

repayments? The bank must be assured there is adequate
cushion to comfortably absorb the home loan repayments.
b. Does the borrower have good prospects for continued
employment? Because the loan is long term the bank
must have reasonable assurance the borrower can service
a long-term loan.
c. Is the current market value of the home to be purchased
sufficiently larger than the amount of the loan to give the
bank adequate cushion if local real estate values decline?
 Answers
1. How do credit-scoring systems work? What are the
principal advantages & disadvantages to a lending
institution of using a credit-scoring system?
2. What factors should a lender consider in evaluating real
estate loan applications?
3. What options does a loan officer have in pricing consumer
loans?
4. What is home equity lending, and what are its advantages
and disadvantages for banks and other consumer lending
institutions?
5. Problem 2, 7, 9 and 13 (page 627-9)
 Answers
3. What options does a loan officer have in pricing consumer
loans?

Most consumer loans, like most business loans, are

priced off some base or cost rate, with a profit margin and
compensation for risk added on. The rate on a consumer
loan may be figured from the cost-plus model or the base-
rate model. Most installments and lump-sum payment
loans are made with fixed interest rates. However, due to
the volatility of interest rates in the 1970’s and 1980's, a
greater number of floating rate consumer loans have
appeared.
 Answers
4. What is home equity lending, and what are its advantages
and disadvantages for banks and other consumer lending
institutions?
Home-equity loans use the residual market value of a home
(over and above the amount of any outstanding liens against
the home) as a borrowing base. Financial institutions often
lend a fraction of this residual value, which subjects them to
the risk that the market value of a home will fall, significantly
eroding the cushion of protection for a loan of this type. If the
customer fails to make any promised loan payments, the
bank or other lender could foreclose and take over the home
to sell it and recover at least a portion of loaned funds.
 Answers
5. Problem 2 (page 627)
The maximum credit line available is:

$110,000 x 0.70 - $60,000 = $77,000 - $60,000 = $17,000.

This would clearly not result in a large enough borrowing

base to cover the $24,000 loan requested. Many banks
make adjustments in the permissible loan amount if the
customer has an above-average level of income, other
assets to pledge, relatively low mortgage debt obligations,
and an excellent credit rating. Thus, the Nappers may be
able to qualify for an additional $17,000 in loanable funds
(perhaps by pledging other collateral) to make up the
$24,000 they need.
 Answers
5. Problem 7 (page 628)
The total loss to the bank from delinquent customers is
$47.523 million or 7,665 customers * $6,200. On the other
hand, paying credit-card customers (amounting to 3,066
customers) averaged a score of 40 points or less, but
successfully generated about $1,000 a piece in revenues,
resulting in aggregate revenues of $3.066 million or $1,000
* 3,066 customers. By adopting a decision rule to grant
credit-card privileges only to customers scoring more than
40 points (and assuming about the same average
revenues and losses) the bank will save about $44.457
million.
 Answers
5. Problem 9 (page 628-9)
The credit scoring system considers the following factors:
Length of employment: > 1 year –6 points
Length of time at current address: 1-2 years – 4 points
Current home situation: rents home – 4 points
Credit bureau report: excellent – 8 points
Credit cards currently active: 2 cards – 4 points
Deposit accounts with bank: Yes – 5 points
Total 31 points

The Mulvaney family has a point total of 31. San Carlos Bank
and Trust has a cutoff score of 30 points so the Mulvaneys
are likely to receive their loan.
 Answers
5. Problem 13 (page 629)
Interest paid = Loan principal * Loan rate
= $8,000 * 0.0575 = $460
What is the amount of each required monthly payment?

Amount of monthly payment = ($8,000 + $ 460) / 12 =

$705

What is the effective loan rate in this case?

Effective loan rate = Interest owned/Average loan amount

= 460 / (8,000 / 2) = 11.5%/year
 CONSUMER LOANS, CREDIT
CARDS AND REAL ESTATE
LENDING

Chapter 3

William Chittenden edited and updated the PowerPoint slides for this edition.