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:
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:
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:
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
(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:
SAMPLE LOAN POLICY TABLE OF CONTENTS
(Source: Modified from the CDFI Fund Capacity Building Initiative’s presentation on “CDFI Loan Policies and Procedures”)
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.
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.
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.
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)
Collateral (8 possible points)
Capacity (8 possible points)
Character (4 possible points)
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!)
CBA has worked to establish partnerships with several companies that can provide risk assessment tools to members. These include:
Please reach out to CBA [email protected] if you are interested in any of these services.
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:
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:
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:
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.
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.
Types of Interest:
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.
There are ways of making risky loans more secure (that are not mutually exclusive). Here are some other ideas:
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