It’s 2024, and I’d like to kick off the year with a new, recurring publication focused on consumer lending. We believe the new era of helpful information is consistent, well-researched publications on current events that focuses on a specific industry. From now on, our goal will be to be the armchair experts of consumer lending, from both a business and policy perspective.
There is a lot happening in the consumer finance space this year:
CFPB’s Payday Lending Rule has been challenged and repeatedly appealed, with US Supreme Court arguments slated for early this year. The case has evolved from challenging the authority of the CFPB to enforce this rule, to challenging the constitutionality of the CFPB entirely.
CFPB is suing Curo Group for its alleged predatory lending practices. The outcomes of this case will have important effects on broader lending regulations
The auto finance industry is showing signs of weakening. Is this a brief period of decreased demand, or a warning sign for struggles to come?
The US FedNow payments rails went online in the second half of 2023, but was met with limited institutional adoption. Will 2024 see a rise in acceptance of the Fed’s attempted answer to cryptocurrency?
Will the Federal Reserve begin cutting rates in 2024? Or will the Fed need to keep rates elevated to achieve a soft landing?
We are excited to cover these topics, and explain all the jargon, this year. But for today’s post, we’d like to speak to what made us start this publication in the first place: we think consumer lending could use a public relations touch-up. There are a lot of terms and definitions out there that groups use differently between each other. It’s confusing to people new to the industry, and we want to clarify and standardize what’s important in lending.
Today’s Post…
…will do its best to be a primer for all the terms & concepts that are important when understanding the consumer finance industry. There are many types of consumer loans: mortgages, auto, student loans, credit cards. But our primary focus, at least in our first few posts, will be personal loans. Personal loans are the ones in dire need of broader understanding.
Personal loans exist in several subcategories:
There are a lot of elements mentioned in that table that are important to know:
Revolving Credit vs. Installment Loan
Secured vs. Unsecured Debt
Prime vs. Subprime
Interest Rate Cap: 36%
Reporting to Credit Bureaus
Before we dive into those elements… why would someone apply for a personal loan in the first place? Bankrate.com has a great overview on reasons why someone might benefit from one, and keep in mind that benefits differ based on the kind of loan you get. Generally, these loans exist to offer people access to additional capital when they don’t have the cash-on-hand to cover a specific expense.
1. Revolving Credit vs. Installment Loan
Think of this as “Open-ended” vs. “Closed-ended” loans. Investopedia has a great article explaining revolving credit.
Instead of receiving all the money up front, like with a mortgage, revolving credit allows you to borrow credit in bits & pieces when you actually need it. Credit cards are a type of revolving credit, where you can borrow up to a given limit, after which you must pay it down to free up space to continue to borrow. The key benefit of revolving credit is that you’re only paying interest on credit you actually use, as opposed to paying interest on a large lump sum that you may not entirely need right away.
Revolving credit is typically unsecured, like with a credit card or a personal line of credit from the bank, but some revolving credit is secured by a home or ownership stake in a business. Generally, secured revolving credit has higher limits and lower interest rates than its unsecured counterpart.
2. Secured vs. Unsecured Debt
Secured credit means that the lender has the ability to take ownership of an asset if you can’t pay back your loan. In other words, if you fail to make payments and the bank wants to simply take the loss, they have the right to take ownership of the “collateral” the loan was based on. For a mortgage, this collateral would be your house; for an auto loan, it would be your car.
There are plenty of lenders who make unsecured loans, meaning if you fail to make payments, the lender doesn’t have the right to take anything from you; they simply “charge-off” your debt. These loans typically have higher interest rates than secured loans, solely because they have no recourse if you stop making payments.
3. Prime vs. Subprime
In order to categorize borrowers more easily, the financial industry has stratified the credit score spectrum according to levels of creditworthiness. Generally, borrowers are either prime, meaning their credit scores are above 660, or subprime, below 660. Prime-rate loans are loans offered to prime borrowers, which generally have lower interest rates than their subprime counterparts. The Consumer Financial Protection Bureau (CFPB) has a great article outlining the different strata of the credit spectrum.
While thinking of things through this stratified lens, it’s important to remember that creditworthiness exists on a spectrum, and credit decisions are made based on many more factors than credit scores. Just because someone’s credit score is in the subprime range doesn’t mean they can’t get decent loan terms. And just because a loan is for subprime borrowers doesn’t mean it’s a “bad” loan.
4. Interest Rate Cap: 36%
For consumer finance, 36% is a magic number of sorts. Large, national banks in the United States aren’t allowed to charge interest rates higher than 36%. This is called a Usury Law. If you read the fine print of credit card contracts, a lot of them say their APR interest can be up to 35.99% for this exact reason.
Smaller banks and non-bank lenders are beholden to different standards, depending on the state they operate in. Some states copy the national limit of 36%, while others allow higher interest rates if you follow certain rules and limitations on fees, practices, etc. Furthermore, some lenders get around these interest rate limits by structuring loans differently. Payday loans, for instance, can charge much higher effective rates of interest because many of them are structured very differently from a standard installment loan.
“36% seems excessive. Why would a lender need to charge more than that?” It’s because interest rates are how lenders pay for their cost of operations, which includes all the people who fail to pay their loans. For businesses that exclusively lend to prime-rate customers, there aren’t many charge-offs, so the business can afford to offer very low interest rates. However, to achieve that “prime exclusivity” they turn away a lot of customers, essentially anyone who doesn’t meet high creditworthiness standards.
If a business wants to extend a loan to people lower on the credit spectrum, they would be forced to charge higher interest rates to cover their expected costs. Unfortunately, even at a relatively high 36%, that interest rate is not enough to cover the risk of lending to some people lower on the credit spectrum. So if a business wants to give as many people access to credit as possible, they would need to increase interest rates higher than some states allow.
5. Reporting to Credit Bureaus
There are three credit bureaus in the United States: Equifax, Experian, and TransUnion. These private companies collect loan & payment data across the United States and provide information on individuals, businesses, and market forces customers paying for that data.
How do they get that data? Lenders! Generally, if a lender has the ability to run credit reports on potential borrowers, the lender also reports loan & repayment data on its existing customers — this is called “data furnishing.”
Interestingly, if a lender doesn’t do a credit check in their underwriting process (yes, this happens!) then that lender isn’t required to report repayment history on its borrowers. In other words, if a lender doesn’t run a credit check on its borrowers, then its borrowers don’t improve their credit with on-time payments.
Bringing it All Together
Recall those types of personal loans we shared at the beginning of this post. Let’s apply our 5 lending elements to those loans to better understand how each product is structured.
As we unravel the layers of consumer finance in the coming posts, we will continue to reference the different categorizations & elements of financial products in this table. Our aspiration is not merely to report but to empower – to arm you with a better understanding of critical factors in lending. Stay tuned as we build upon this foundation to make consumers more financially literate, help business owners make more informed decisions, and hopefully elevate discourse around personal financial products.
I’d like to sincerely thank you for reading. I hope you find as much value out of reading about consumer finance as I do out of writing it. It’s very exciting to start something new, and seeing support from readers & subscribers helps me keep the momentum going.
-David