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Chapter 21
Consumer Lending and Borrowing
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Learning Objectives
• To see the vital role played by consumers in supplying loanable funds through savings to the money and capital markets.
• To learn about the important role consumers play as major borrowers of funds and the laws that protect their rights.
• To explore the characteristics of consumer lending institutions.
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Introduction
• Many financial analysts have referred to the period since World War II as the age of consumer finance.
- Individuals and families have become the principal source of loanable funds flowing into the financial markets today.
- They also are one of the largest borrowing groups in the entire financial system.
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Consumers as Lenders of Funds
• Consumers as a group are among the most important lenders of funds in the economy.
• Loanable funds are supplied by consumers – individuals and families (households) – when they purchase financial assets from other units in the economy.
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Financial Assets Purchased by Consumers
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Financial Assets Purchased by Consumers
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Recent Innovations inConsumer Savings Instruments
• One of the most important trends affecting consumer savings and lending today is the explosion of new financial instruments.
• Many of these new instruments offer the consumer greater financial flexibility, as well as the potential for higher rates of return.
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Recent Innovations inConsumer Savings Instruments
• Examples:- NOW accounts / share drafts- automatic transfer services (ATS)- share accounts at money market mutual funds- consumer cash management services- universal life insurance- individual and Keogh Plan retirement accounts- Roth and Education IRAs- money market and market-index CDs- variable-rate annuities and insurance plans
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Consumers as Borrowers of Funds
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Consumers as Borrowers of Funds
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Is Consumer Borrowing Excessive?
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Is Consumer Borrowing Excessive?
• The concept of a household portfolio effect argues that consumers may alter their level of spending until they once again feel comfortable with the balance between their income, financial assets, and liabilities.
• On the other hand, the wealth effect causes many individuals and families to feel comfortable with heavier debt loads, believing they could sell off their higher-valued assets if trouble appeared on the horizon.
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Categories of Consumer Borrowing
• Financial analysts frequently divide the credit extended to consumers into three broad categories. Residential mortgage credit – used to support the purchase of
homes Installment credit – used primarily for long-term nonresidential
purposes Noninstallment credit – used for short-term cash needs
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Home Equity Loans
• Like traditional home mortgages, a home equity loan is secured by a borrower’s home.
• Unlike traditional home mortgages however, many home equity loans consist of a revolving credit line that the borrower can draw on for purchases of any goods or services.
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Credit and Debit Cards
• A credit card permits the consumer to buy now and pay later, while a debit card provides a convenient way of paying now.
• Convenience users substitute credit cards for cash, while installment users maintain large outstanding credit card balances.
• A smart card is closely related to the debit card.
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The Determinants of Consumer Borrowing
• The consumer’s decision about when and how much to borrow is influenced by:
- the size of the individual or family income and accumulated household wealth
- the stage in life
- the business cycle
- price expectations
- interest rates
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Consumer Lending Institutions
• Financial intermediaries – banks, savings and loan associations, credit unions, and finance companies – account for most of the loans made to consumers in the U.S. economy.
• However, a growing share of consumer loans are being sold off the balance sheets and placed in loan pools (securitization).
• In recent years, institutions also tend to diversify their lending operations.
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Consumer Lending Institutions
Leading Consumer Lending Institutions in the United States
Source: Board of Governors of the Federal Reserve System.*2004 figures are as of first quarter.
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Consumer Lending Institutions
• Commercial banks approach the consumer by direct lending, through purchases of installment paper from merchants, and by making loans to other consumer lending institutions.
• Finance companies have a long history of active lending in the consumer installment field, both directly and indirectly.
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Consumer Lending Institutions
• Savings and loans and savings banks have long been dominant in residential mortgage lending, though they are also aggressively expanding their portfolios.
• The so-called “fringe banks” (such as “check-cashing” companies, “title loan” companies, “payday lenders,” “pawn shops,” and “rent to own” shops) lend primarily to distressed borrowers.
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Factors Considered in Making Consumer Loans
• Consumer loans usually carry greater risk than most other kinds of loans, although they also tend to be more profitable.
• Hence, most loan officers carefully consider- the ratio of household debt to gross income- the duration of employment of the borrower- the past payment record (credit integrity)- ownership of valuable properties- the number of breadwinners in the family
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Credit Scoring Techniques
• Today, credit scoring techniques are used for a wide variety of loans and other financial services.- Advanced statistical techniques are employed to assemble
information about applicants for consumer loans, analyze the information gathered, and develop a numerical score.
- Using that score, lenders can make a decision as to whether a borrower has scored high enough to qualify for a loan.
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Financial Disclosure and Consumer Credit
• Important new laws have been designed in recent years to protect consumers in their dealings with lending institutions, especially with respect to financial disclosure.
- Consumer Credit Protection Act (1968) (Truth in Lending)
- Fair Credit Reporting Act (1970)
- Fair Credit Billing Act (1974)
- Consumer Leasing Act (1976)
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Financial Disclosure and Consumer Credit
- Competitive Banking Equality Act (1987)
- Fair Credit and Charge Card Disclosure Act (1988)
- Truth in Savings Act (1991)
- Financial Services Modernization (Gramm-Leach-Bliley) Act (1999)
• The Financial Services Modernization Act was passed, in part, to create tougher laws to deal with identity theft.
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Credit Discrimination Laws
• The civil rights movement has had an impact on the granting of consumer loans.
- Equal Credit Opportunity Act (1974, amended 1976)
- Fair Housing Act (1968)
- Home Mortgage Disclosure Act (1975)
- Community Reinvestment Act (1977)
- Financial Institutions Reform, Recovery, and Enforcement Act (1989)
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Consumer Bankruptcy Laws
• The right to declare bankruptcy is designed to give individuals and businesses a fresh start, helping them to work themselves out from under a crippling burden of debt.
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Consumer Bankruptcy Laws
• Consumers filing for bankruptcy primarily use one of two methods.- Filing for bankruptcy under Chapter 7 normally completely
discharges all of a household’s unsecured debts.- A Chapter 13 bankruptcy filing usually sets in motion a new
debt repayment plan to work gradually out of the debts owed.
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Consumer Bankruptcy Laws
• In view of the soaring number of bankruptcy filings and in an effort to lower the cost of consumer credit for most borrowers, proposals have been made to make bankruptcy a more costly process and to encourage the development of more financial education courses for consumers.
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Markets on the Net
• Consumer Information Center at www.consumer.gov• Equifax Credit Bureau at www.equifax.com• Experian Credit Bureau at www.experian.com• Federal Deposit Insurance Corporation at www.fdic.gov• Federal Reserve Board at www.federalreserve.gov
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Markets on the Net
• Federal Trade Commission at www.ftc.gov• FICO Scores and Reports at www.myfico.com• Identity Theft Clearinghouse at rn.ftc.gov/dod/widtpubl$.startup?Z
-ORG-CODE=PU03
• National Endowment for Financial Education at www.nefe.org• Transunion Credit Bureau at www.transunion.com
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Chapter Review
• Introduction to Consumer Lending and Borrowing• Consumers as Lenders of Funds
- Financial Assets Purchased by Consumers- Recent Innovations in Consumer Savings Instruments
• Consumers as Borrowers of Funds- Is Consumer Borrowing Excessive?- Categories of Consumer Borrowing
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Chapter Review
• Home Equity Loans• Credit and Debit Cards• The Determinants of Consumer Borrowing• Consumer Lending Institutions
- Commercial Banks- Finance Companies- Other Consumer Lending Institutions
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Chapter Review
• Factors Considered in Making Consumer Loans• Credit Scoring Techniques• Financial Disclosure and Consumer Credit• Credit Discrimination Laws• Consumer Bankruptcy Laws
