(Photo by Tierra Mallorca on Unsplash)
For over 5,000 years, long before we had money, people borrowed from each other to satisfy their needs.
Contrary to popular belief, bartering was not the only way our agrarian ancestors financed their work. They made contractual agreements with each other with the same kinds of covenants we routinely use today. The difference between then and now is how we evaluate the likelihood of repayment.
It wasn’t until the 1950s, with the advent of the Diner’s Club credit card, that we began to score prospective borrowers using formulas, which over the last 70 years have morphed into complex and secretive algorithms. Credit is simply a proxy for trust, and in the past, we used to price the degree to which we believed someone would pay us back by taking the time to know that person.
A quaint concept, you say?
Our attention spans have become so short that we only have 30 seconds to make our point. We don’t have conversations now. We make “fast pitches.” Our society requires immediate gratification. But interestingly, the models built on instant decisions prove inadequate to the task when the economic sands are shifting beneath us quickly.
Decisions based on credit scores use inductive reasoning — there is no time for further inquiry, so we assume that the past predicts the future by relying solely on these indices. But credit is a lagging indicator — it can be months old. Less than 20% of subprime lenders even take the time to verify income, and we know how that ends. (Remember the subprime mortgage crisis?)
The pandemic is a humanitarian crisis. And with all crises, there is an opportunity for real systemic change.
Subprime lenders price their loans high because they have a high expectation of default. Consumers with weak or non-existent credit are deemed risky, and the loss rates with these loans suggest this is a reasonable approach. What happens if we shift this paradigm? What happens when we have a low expectation of default, despite what a credit score indicates? Americans have $1.2 trillion in open auto loan balances in 2020, with approximately 40% of all originations made to less than prime consumers. Most of these loans are securitized with investor returns of 1 – 3% (per S&P data on securitized pools). Expected cumulative loss rates within these portfolios exceed 30%. If we take a different approach, what we refer to as a borrower equity-focused loan, using character-based underwriting that provides a low expectation of default, we can charge subprime consumers 50 – 60% lower interest rates, driving payments down by about 20% over the conventional subprime lending approach.
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To illustrate, a borrower with a 525-credit score would be considered deep subprime by traditional lenders who would view this loan as very risky with a high probability of default. This borrower would pay an interest rate somewhere between 18 and 22%. If they financed a car for $15,000 with a five-year term at 20% interest, their payment would be $397. If we took just a little bit more time to learn enough about the borrower to understand their risk profile better and viewed them as about a 50/50 chance of default, we might be willing to make that same loan for half the rate. Under the same scenario at 9.75%, their payment drops to $316, a 20% reduction. Over the five-year loan period, the savings on interest alone is about $5,000.
The loan is only part of the story. Since a car is a significant purchase for a working family, making sure they avoid buying the wrong car is equally important. We pair a favorable loan with vehicle selection assistance. We can aid further purchasing power by ensuring the vehicle is reliable, under warranty, easy to maintain, inexpensive to fuel, and holds its value. One of the primary reasons for default is purchasing a bad vehicle, especially one that is not under warranty. When the average American cannot put their hands on $400 in the event of an emergency, how do they manage a $2,000 transmission repair and continue to make their car payments? Focusing their car purchase on needs versus wants is easier with a vehicle purchase coach, creating an extraordinary difference in outcomes. In some cases, the financial benefit can approach as much as $20,000 over the term.
Finally, a borrower-first loan servicing strategy is important. Traditional lending, where banks have no knowledge of their borrower’s circumstances, uses automatic repossession triggers based on predetermined delinquencies. If we assume there will be a low degree of default and we work with our borrowers to that end, without automatically repossessing their means to reach their jobs, the opportunity to build credit and avoid the devastating impact of losing a car is possible. It can put low-income consumers on an upward economic trajectory instead of one that leads to credit deterioration, job loss and even potential homelessness. What traditional lenders will find is that this approach builds tremendous loyalty with their customers who will redouble their efforts to get caught up on their payments with just a little bit of grace.
We know this approach works. We have created this model inside a loan fund seeded by impact investors. The fund is designated as a Community Development Finance Institution by the US Treasury (making it easy for banks to partner). Because this is a private ESG impact investing fund (our cars are 35% better for the environment in terms of greenhouse gas emissions and fuel consumption), there is greater latitude to make loans unconventionally. The investors who have funded these loans receive the same market-rate returns of 1 – 3% that the securitization investors receive, but the loss rate is three times better. Under this model, the capital stewardship is much more robust, and the adverse impact on families is minimized.
Now is the time for creative approaches. As the devastation from COVID becomes fully realized, there will be a massive wave of nonperforming loan exposure. Lenders know this is coming, but what they may not fully grasp is that they have the ability to avoid it. It would take courage for traditional lenders to change the way they have always done things, but refinancing these loans for credit-challenged low-income consumers to a more humane lending model for existing borrowers could change the outcome:
- Consider reducing the interest rate, cut it in half if you are bold enough.
- Hire a coach, instead of a collector, to talk with your borrowers about what they need during this time. Offer to defer a payment or two, tacking them onto the end of the term, and reduce your provision for loan loss.
- Make financial education available for your borrowers and launch a massive PR campaign, encouraging them to take the reduction in payment cost and put it in a savings account.”
This approach will astonish their customers and buy them tremendous goodwill with the public. Their default rate would likely decrease by 90%, with no impact to their investor returns, but a tremendously positive impact for the millions of American families trying to get to the other side of the crisis.-30-
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