Products-in-a-Box: Loan Design

Nonprofit lenders aim to improve the quality of life for individuals with limited access to safe and affordable credit. The million-dollar question is, “How does an organization fulfill this mission at a reasonable and sustainable cost to the organization AND to the borrower?” Determining what is reasonable and sustainable is an important part of the loan design process. In an ideal world, each loan would be high impact to the borrower and profitable (or at least sustainable) for the organization, but in reality, this often involves a give and take. Some loans may be time and resource efficient, while others may require more intensive resources. To balance out variation, it is important for organizations to develop a “big-picture” risk management plan, and design specific loan features based on that plan. For example, a nonprofit lender may stipulate guidelines for the composition of its loan portfolio such as:

  • Limits on funds to any single borrower
  • Percentage of secured vs. unsecured loans
  • Size and term of loans
  • Risk level of individual borrowers

Figuring out what feels “healthy” for your organization, yet allows you to be responsive to community needs will take time and the adaptation of policies and procedures. It is important to have the right people in the room thinking about your PROFIT organizational and target population needs from the beginning and then on an ongoing basis. This includes internal leadership, board members, lending staff, community partners, and members of the population you plan to serve. It could also include representatives from local government, funders, and members of the mainstream financial industry.

On a federal level, the Consumer Financial Protection Bureau (CFPB), an independent bureau within the Federal Reserve System established under the Consumer Financial Protection Act of 2010, regulates much consumer lending and financial products. Becoming familiar with key federal regulations that impact small dollar lenders (described in Appendix B: Federal Legislation That Impacts Small Dollar Loans) is a good first step. Staying informed of developing or newly enacted legislation is also key. The CFPB provides tools and resources for consumers and practitioners, enables consumers to submit complaints about bad lending practices, develops new rules to protect consumers and has up-to-date guidance on adhering to federal policy. In addition, each state has different lending laws and governing bodies. For instance, in Oregon, the Department of Consumer and Business Services oversees the regulation of small dollar loans, whereas in Minnesota, the Department of Commerce fills that role, and in West Virginia, it is the Division of Banking. Appendix B: Consumer Installment Loan Regulations has a list of states, their governing bodies for small dollar loans, and links to pertinent legislation (note that legislation may have changed or may change in the future and this list reflects what exists at a snapshot in time). State regulations can have serious implications for loan design and roll out in the following ways:

  • Product and service delivery design (i.e. there may be a cap on the interest rates and types of fees you can charge) See the box entitled "All About Interest" in the Interest and Fees section for more information on APRs.
  • Loan documents, including loan applications, disclosures, and loan agreements
  • Loan servicing
  • Reporting and loan management systems
  • Licensing/permitting costs
  • Legal fees
  • Bonding/insurance requirements

A preliminary step for new nonprofit lenders is to determine if they need a lending license. In some states, small dollar lenders are exempt from needing a license under certain circumstances, such as if they offer 0% interest loans. Whereas for other states, going through the process of getting a license is necessary. This can be a challenge if you operate in multiple locations, which encompass different states. Regardless of whether you need a license, it is important to be aware of the requirements around small dollar lending in any state in which you offer loans. You may want to cultivate a relationship with your state’s regulatory agency. Below are some potential sources for help with regulatory compliance issues:

  • National Association of Consumer Credit Administrators (NACCA), an association of state consumer credit regulators, has a Financial Services Regulator Directory with the contact information for each state agency.
  • Money Transmission: Money Transmitter Regulators Association (MTRA), a national nonprofit organization dedicated to the efficient and effective regulation of the money transmission industry, has links to state and federal consumer lending regulatory agencies.
  • The National Consumer Law Center (NCLC), works with nonprofit and legal services organizations, private attorneys, policymakers, and federal and state governments and courts across the nation to stop exploitative practices, help financially stressed families build and retain wealth, and advance economic fairness. NCLC often has up-to-date information on consumer law.
  • Legal Aid, State Bar Associations, and law schools can often provide pro-bono legal advice for nonprofits.
  • Bank or financial institution partners may also be able to provide guidance on regulatory compliance.

The policies and procedures are the go-to guide for your loan. They address the minutiae of your loan product—describing loan features, borrower requirements, the application process, and servicing and collection procedures, including (near and dear to CBA’s heart) credit bureau data furnishing. Creating policies and procedures are essential for helping your organization anticipate situations that may arise throughout the lending process, and come up with policies to address them. However thorough you were in creating your policies and procedures, unanticipated situations will always surface that necessitate additions or revisions. Having a plan for how you will regularly review and amend your policies and procedures may be just as important as creating them! Policies and procedures need not be rigid and inflexible. While some policies must be definitive, others are best examined on a case-by-case basis. A leader at the Pennsylvania Assistive Technology Foundation emphasized, “It is important when you are creating policy that you allow your procedures to be flexible…life is unpredictable!” While being flexible (within the limits of fair lending) can help staff to better meet the unpredictable needs of borrowers, standardized procedures can help minimize biases that may crop up when staff are making a series of individual decisions. It often takes time for organizations to find their own balance between being responsive to borrower needs and adhering to standardized practices. However, even the best intentioned nonprofit lenders may open themselves up to complaints against them and inadvertent Equal Credit Opportunity Act (see more about this law in Appendix B) lawsuits if they are inconsistent in the way they apply this flexibility.

TWELVE ELEMENTS OF A GOOD LOAN POLICY

  1. Clear mission
  2. Specify lending authority (i.e. clear structure of who approves loans)
  3. Delineate responsibilities for reporting loan information
  4. Describe origination, underwriting criteria and process
  5. Documentation for complete application and complete credit file
  6. State who maintains credit files
  7. Collateral guidelines
  8. Loan rating and loss reserves
  9. How interest rates and fees are set
  10. Preferred upper limit for total loans outstanding/concentrations
  11. Describe trade area
  12. How to detect, analyze, and work out problem loans

(Source: CDFI Fund Capacity Building Initiative’s presentation on “CDFI Loan Policies and Procedures”)

The development of policies and procedures is a good time to involve program stakeholders including staff, community members (particularly those from your target population), the board, and individuals with legal expertise. Appendix C has a sample policies and procedures that can be used as a good starting point for your own. The CDFI Fund’s “Twelve Elements of a Good Loan Policy,” and the "Sample Loan Policy Table of Contents" boxes provide guidance on determining key loan features and elements that may also be considered within your policies and procedures. When developing your policies and procedures think about the following:

  • How often will you revisit and review your policies and procedures? (Many nonprofit lenders review their policies and procedures annually at a minimum.)
  • How will you assess if the policies are too lenient, stringent, outdated or vague?
  • What is your process for making changes to and updating the policies and procedures?
  • How will your organization learn from its own experience to improve its policies and procedures?

SAMPLE LOAN POLICY TABLE OF CONTENTS

  1. Introduction
  2. Mission Statement
  3. Scope of Services
  4. Definitions
  5. Loan Limits
  6. Interest Rates and Fees
  7. Loan Approval Authority
  8. Application Procedures and Underwriting Standards
  9. Loan Origination Procedures and Standards1
  10. Loan Servicing & Collections
  11. Modifications and Extensions
  12. Credit and Security Standards
  13. Borrower Credit Reporting
  14. Exception of Lending Policy

Attachments:

  • Loan Application
  • Loan Agreement
  • Truth in Lending Act (TILA) for some public assistance beneficiaries with disabilities to save without affecting the strict asset limits.

(Source: Modified from the CDFI Fund Capacity Building Initiative’s presentation on “CDFI Loan Policies and Procedures”)

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At the heart of a responsible loan is responsible underwriting. It helps to ensure that people receiving loans are well positioned to pay them back and that loans meant to solve a challenge do not instead make it worse. Strong underwriting is also essential to the health of the loan fund by reducing risk and potential for losses. Lending to low-income communities has historically been considered risky, yet there are ways to assess, manage and plan for risk while still being inclusive of these communities. Although most nonprofit lenders emphasize a distinction in striving for sustainability rather than profitability, few are interested in losing loans or clients to charge-offs. This means that nonprofit lenders must work to develop alternative criteria to assess an applicant’s potential risk. Traditional consumer lenders typically rely on the Five C’s of Credit (see diagram below). Above all, nonprofit lenders typically care most about the capacity and willingness to repay. Mission-driven lenders often want to help as many people as possible. While the desire to say “yes” may be noble, giving someone a loan they cannot afford to repay is not helpful in the long-term for either the borrower or the lender. Some lenders develop underwriting rubrics in order to weight and score different underwriting criteria (see the Justine PETERSEN example below), while others look at the application as a whole with no set “value” for their underwriting criteria. The recommendations below provide ideas for fair and sound underwriting for high-risk populations that may supplement and in some cases replace one or more of the traditional Five Cs.

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PROGRAM EXAMPLE

Juntos Avansamos, a network of credit unions seeking to better serve Hispanic communities, guides members to accept a variety of ID forms including: Passports, Matricular consular, Documento personal de identification (DPI), Voter IDs, Municipal IDs. And, if one form of ID is expired, allowing the applicant to use the expired ID along with other identifying documents (birth certificates, utility or phone bills, etc.) can suffice.

WHEN TO REQUIRE THIRD PARTY VERIFICATION?

Many CBA members were unsure of when to require third party verification for applicant information versus when to just take applicants at their word. For example, should an organization require bank statement to assist in creating a budget, or simply allow clients to create the budget from memory? The more third party verification you require, the more hassle the application process may be for the applicant. However, receiving accurate information may allow for a more realistic risk assessment of the loan application.

PROGRAM EXAMPLE

Justine PETERSEN, a St. Louis, Missouri based CDFI nonprofit loan fund and one of the nation’s leaders in nonprofit credit building, developed a rubric for underwriting. Each item in the rubric is associated with a certain number of points and the applicant’s total score tells the loan officer whether the applicant is low, moderate, or high risk. The rubric uses four of the Five C’s of Credit taking into account:

Credit (10 possible points)

  • Credit score
  • Civil judgments, state/federal tax liens, or bankruptcies
  • Late payments in the past year
  • Phone or utilities with disconnection notices

Collateral (8 possible points)

  • Deeds of trust with 20% equity or more
  • 100% collateral
  • W2 that shows three years at the same job
  • Co-signer with verified income

Capacity (8 possible points)

  • Positive balance in checking or savings account for past three months
  • Budget that shows sufficient discretionary income to cover loan payment amount
  • 5 years or more at the same address
  • Long-term job history (over 3 years at same job)
  • Debt-to-income ratio under 50% (including proposed loan payment)
  • Business-related indicators (for business loans)—positive income, experience in the field, education

Character (4 possible points)

  • Former JP borrower with no late payments over 60 days in the last year of the loans
  • JP client with a positive character reference from a JP employee who has known them for at least a year
  • Attended financial education classes
  • Senior underwriter bonus point (this is a discretionary factor based on the underwriter’s instinct and experience with the borrower)

In this model, credit is weighted most heavily out of the four categories, and character is weighted the least. This underwriting information is not only used to make a determination for underwriting the loan; additionally, JP uses risk-based pricing, so this data helps determine the borrower’s interest rate. (See more on risk-based pricing in the interest and fees section!)

ACCESS TO ADDITIONAL UNDERWRITING TOOLS THROUGH CBA

CBA has worked to establish partnerships with several companies that can provide risk assessment tools to members. These include:

  • LexisNexis® RiskView™ solutions (made available to CBA members in December 2017) leverages non-tradeline alternative credit data, such as public records information, to provide a more holistic view of consumers. This innovative approach allows lenders to better predict the creditworthiness of a consumer, allowing them to increase the number of accounts booked while reducing losses.
  • ChexSystems reports (to be added in early 2018) examine data submitted by banks in the past five years. A report may describe banking irregularities such as check overdrafts, unsettled balances, depositing fraudulent checks, or suspicious account handling. Banks may refuse to open a new deposit account for a consumer that has a negative item reported.

Please reach out to CBA membership@creditbuildersalliance.org if you are interested in any of these services.

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There is no magic equation for pricing a loan. Determining how much to charge for the loan is a balancing act of covering the cost of the loan and keeping the loan affordable to borrowers. Traditionally, there are three main strategies for pricing loans:

  • Market-based: loan pricing is based on the pricing of other similar products in the market
  • Risk-based: loan pricing is based on an individual borrower’s probability of default determined during underwriting
  • Cost-based: loan pricing is based on the cost of providing the loans

Perhaps a fourth “strategy” that nonprofit lenders should keep in mind, is mission-based pricing: what pricing is fair and affordable to borrowers? None of these strategies are mutually exclusive and pricing a loan will look different for every lender. As a mission-driven organization, you must decide what type of margins with which you are comfortable. This likely depends on your business model. Organizations whose primary business is lending may strive to cover more of their program costs through loan pricing than organizations that offer multiple services, and have added a loan product as another way of meeting specific community needs. Many nonprofit lenders operate at a loss, acknowledging that they will always need outside funding to cover program costs. Others seek to scale their program and create efficiencies to reduce lending costs, or cross-subsidize loans through other services/products. Most nonprofit lenders are happy to be able to cover their lending costs and nothing beyond that. Here are some key considerations and factors to keep in mind for each strategy:

1. MARKET-BASED PRICING:

What do similar lenders charge? Similar can mean lenders that provide the same type of loans, or lenders that provide loans of similar amounts. The interest rate of surveyed CBA members ranges from 0 percent to 21 percent with an average of 7 percent. Data from the Opportunity Finance Network found that the microenterprise industry average is an 8 percent interest rate, with interest rates increasing for lenders who provide smaller sized loans. However, when looking at other lenders’ rates, it is important to make sure that you are actually comparing apples to apples. For example, a lender that provides similar loans may do so at a completely different volume, which will have different cost implications. For more information on other CBA members who are small dollar consumer lenders and their rates see Appendix B.

2. RISK-BASED PRICING:

Risk-based pricing involves charging higher interest rates to borrowers who are deemed at higher risk of default. Rather than looking at the overall risk of the average borrower to determine a flat rate, risk-based interest takes into account each individual’s risk of default. Often, interest rates are tiered to different levels of risk. Mainstream financial institutions typically rely on credit scores to determine an individual’s interest rate. Other factors to consider include:

  • Whether the loan is secured with collateral and/or a co-signer
  • Stability of income and employment
  • History of paying other bills/debts on-time
  • Debt-to-income ratio

See the example on Justine PETERSEN’s underwriting model (see the section on Underwriting) for examples of other criteria to take into account in risk-based pricing. Keep in mind that risk-based pricing runs the risk of “penalizing” those who are in worse-off financial situations by charging them more in interest. It can also be more administratively complex to implement. On the plus side, risk-based pricing can be used to incentivize loan repayment. For example, lenders could reduce the interest rate after borrowers have made a certain number of on-time payments. Under the FCRA, if you use risk-based pricing, you are required to notify consumers who do not receive the most favorable terms due to their credit score (or other consumer report information that went into the decision). See the box on Data Furnisher Requirements below.

3. COST-BASED PRICING

Cost-based pricing is perhaps the least straightforward of the pricing strategies because of the multitude of direct and indirect costs involved in operating a loan program. Here are some examples of costs that a lender might include:

  • Staff time. This will likely be the largest cost to your loans. And the time staff spend on each loan may vary depending on the borrower’s situation, the size and planned use of the loan. Tracking staff time and averaging the amount spent on different procedures can be helpful. If you have not started lending yet, this may be hard to determine but is a good habit to create out of the gate. You can start by estimating and then adjust once you are able to track the amount of time spent (see pie chart above on how one staff member from Innovative Changes spends her time as an example of one lender’s experience).
  • Overhead costs. This includes a fraction of your organization’s overhead costs such as rent, bills, supplies, software and licensing fees, credit reporting costs, etc. Typically, organizations factor between 10 percent to 15 percent for this cost.
  • Cost of funds. If any of your loan capital is borrowed, the cost of funds is the interest rate at which you will need to repay the funds. If different funds cost different amounts, use the average rate.
  • Loan loss rate. Rather than pricing each loan depending on a complex algorithm of each borrower’s risk, the loan loss rate is an overall indicator of risk. If you are just starting to lend, you can look to the loan loss rate of those providing similar loans. Among a broader group of CBA members surveyed, the average charge-off rate was 4 percent (see section on “Protecting Your Loan Fund” for more information on charge-off rates).
  • Other factors that may impact the cost of loans:
    • Time spent on other services that benefit the borrower such as financial education
    • The costs of a credit report pull
    • Inflation/depreciation of loan funds
    • Availability of funds (or leverage ratio)
    • Number of secured loans
    • The loan terms (the shorter the loan, the less likely it is that your organization will recoup costs because similar amounts of effort and resources go into making a shorter loan compared to a longer one. Also, the shorter the loan, the less interest you earn).

4. MISSION-BASED PRICING:

On top of all the costs to your organization, it is important to weigh the needs and capacities of your borrowers.

  • How much can your target population afford to pay for the loan?
  • What types of payments would serve as a barrier to taking out the loan (for example, is an upfront application fee prohibitive at any amount)?
  • How will the fees and interest that you charge be perceived by the community, including key stakeholders such as partners and funders?
  • And, perhaps less easily answered, what costs does your organization and community feel are fair?

5. LEGAL CONSIDERATIONS:

Regulations imposed by state and federal regulators limit the interest rates and fees that a lender can charge. These vary by state. See section on “Adhering to State and Federal Lending Regulations” for guidance on how to stay up-to-date on regulations that impact your organization. Keep in mind that the fees you plan to charge that are directly tied to the loan (such as the origination fee) become a part of the Annual Percentage Rate (APR) calculation. It is important to ensure that your APR does not exceed (or come close to exceeding) the usury cap or the caps for the specific loan (i.e. small dollar installment loans) in the states in which you lend (if it has a cap). Once you have taken your costs, borrower risk, market pricing, borrower needs, mission, lending regulations, and anything else necessary into account, you can start determining your interest and fees. Below are common types of fees and considerations for each one.

ALL ABOUT INTEREST

Types of Interest:

  • Simple interest: a rate calculated based on the original amount of loan principle (commonly used by nonprofit lenders).
  • Compound interest: a rate calculated on the principle and accumulated interest over a set period of time (not commonly used by nonprofit lenders).
  • Annual Percentage Rate (APR): simple annual interest PLUS certain non-interest charges and fees related to obtaining the loan (like the origination fee). The calculation is not a simple formula but there are powerful tools that exist to calculate it.
  • Flat interest rate: one interest rate that applies to all borrowers across the board.
  • Risk-based interest rate: an interest rate that depends on an individual borrower’s risk of default.

What Is the Deal with Annual Percentage Rate (APR)?

It is important to note that an effective “APR” is not always synonymous with “annualized interest rate.” Instead, an effective APR calculation includes some— though not all—of the fees and charges associated with a loan, as well as the interest to be earned over the term of a loan. The APR has been used as the yardstick for the cost of credit in the United States for almost half a century. Although there are many who argue that the use of APR as the yardstick is flawed, it is the most commonly touted tool by which consumers are encouraged to compare loans. Determining whether and what, if any, effective APR cap exists in a given state often requires careful reading of the statutes.

What Are the Pros and Cons of Risk-Based Pricing?

Risk-based pricing could run the risk of “penalizing” those who are in worse-off financial situations by charging them more in interest. It can also be more administratively complex to implement. On the plus side, risk-based pricing can be used to incentivize loan repayment. For example, lenders could reduce the interest rate after borrowers have made a certain number of on-time payments, therefore serving as an incentive. Under the FCRA, if you use risk-based pricing, you are required to notify consumers who do not receive the most favorable terms due to their credit score (or other consumer report information that went into the decision). See the box on Data Furnisher Requirements below.

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Securing loans

There are ways of making risky loans more secure (that are not mutually exclusive). Here are some other ideas:

  • Collateral: To minimize risk, you can choose to take collateral on a loan to guarantee repayment. This means that if the borrower stops making loan payments, your organization can seize the collateral as an attempt to recoup the loan capital. Taking collateral is not a clear-cut route for immigration loans, nor is it typical of CBA members that provide loans under $1000. This option could work if borrowers have substantial assets such as a home or car. However, these type of assets are disproportionately larger than a typical small dollar loan, thus the consequence of loosing a large asset over failure to repay may be antithetical to the lender’s mission and/or not worth a lender’s time.
  • Forced savings. Rather than take collateral on a borrower’s purchase, you can withhold a percentage of the loan as “forced savings” that is returned to the borrower once they pay off the loan. For example, Innovative Changes puts five percent of each loan into an escrow account. Keep in mind, that since the borrower does not receive these funds upfront, this may trigger the need for larger loans.
  • Collecting references at time of application. Having the contacts of a few family, friends, or co-workers who can help you get in touch with the borrower if they stop making payments, can be helpful for locating someone who seems to have “fallen off the map.”
  • Requiring or encouraging a co-signer. Requiring a co-signer means that two people are legally responsible for paying back the loan. This can be a good approach for younger borrowers with involved parents. It is important that the parents realize how this commitment could negatively affect their credit history, if their child stops paying back the loan or pays late.


Loan Loss Reserve

  • In addition to minimizing the risk of individual loans, most organizations maintain a loan loss reserve (LLR) of funds to cover potential charge-offs. A LLR should resemble (or be a rate just over) your charge-off rate. However, you may not know what your charge-off rate is yet. Here are some considerations for determining your loan loss reserve amount:
  • Do your funders have provisions around loan loss reserves? What rate do similar lenders set aside? (see table above)
  • How often will you revisit your loan loss reserve? A study of CDFIs found that many were overly conservative about their loan loss reserves, which unnecessarily limited their amount of available loan funds (or leverage).55 For example, Northwest Access Fund’s board recently decided to reduce its LLR from 10- percent to 5 percent when they realized that the organization’s losses were lower than originally projected.
  • How diversified are your loans (small, large, high risk, low risk, etc.)? And, how much would one or two charged-off loans impact your portfolio? If you are a low volume lender, a few charge-offs may make a big difference, so your loan loss reserve may be closer to covering the amount you lend. For a more diversified portfolio, the LLR may be lower.

55 Swack, M., Northrup, J., & Hangen, E., (2012) CDFI Industry Analysis: Summary Report. Carsey Institute. Retrieved from https://www.cdfifund.gov/Documents/Carsey%20Report%20PR%20042512.pdf