Chapter Eighteen

Consumer Loans, Credit Cards, and

Real Estate Lending
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Key Topics
Types of Loans for Individuals and Families
Unique Characteristics of Consumer Loans
Dodd-Frank, the Consumer Protection Bureau,
and CARD
Evaluating a Consumer Loan Request
Credit Cards and Credit Scoring
Disclosure Rules and Discrimination
Consumer Loan Pricing and Refinancing
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Introduction
Consumer debt has become one of the fastest growing
forms of borrowing money
Nearly $14 trillion in volume (including both mortgage and
nonmortgage consumer debt) in the U.S.
The modern dominance of banks in lending to
households stems from their growing reliance on
individuals and families for their chief source of funds
checkable and savings deposits
Consumer credit is often among the most profitable
services a lender can offer
However, services directed at consumers can also be among
the most costly and risky financial products
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Types of Loans Granted to Individuals and
Families
Consumer loans are classified by
Purpose what the borrowed funds will be used for
Type whether the borrower must repay in installments or
repay in one lump sum
Residential Loans
Credit to finance the purchase of a home or fund
improvements on a private residence
Usually a long-term loan, typically bearing a term of 15 to
30 years
Secured by the property itself
May carry either a fixed interest rate or a variable
(floating) interest rate
Banks are the leading residential mortgage lenders today
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Types of Loans Granted to Individuals and
Families (continued)
Nonresidential Loans
Installment Loans
Short-term to medium-term loans, repayable in two or more
consecutive payments (usually monthly or quarterly)
Used to buy big-ticket items (e.g., automobiles, furniture, and
home appliances) or to consolidate existing household debts
Noninstallment Loans
Short-term loans individuals and families draw upon for
immediate cash needs that are repayable in a lump sum
May be for relatively small amounts and include charge
accounts that often require payment in 30 days or less
May also be made for a short period (usually six months or
less) to wealthier individuals and can be quite large
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Types of Loans Granted to Individuals and
Families (continued)
Credit Card Loans and Revolving Credit
One of the most popular forms of consumer credit today is
accessed via credit cards
Credit cards offer their holders access to either installment
or noninstallment credit
Approximately two-thirds of all credit cards have variable
rates of interest
Installment users of credit cards are far more profitable
due to the interest income they generate
Card providers also earn discount fees (usually 1 to 7
percent of credit card sales) from merchants who accept
their cards
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Types of Loans Granted to Individuals and
Families (continued)
New Credit Card Regulations
New credit card regulations appeared early in 2003 to
slow the expansion of card offers to customers with low
credit ratings
There was evidence that some customers were
charged high fees but encouraged to make only low
minimum payments
Resulted in negative amortization
Regulatory agencies warned lenders that federal
examiners would begin looking for excessive use of
fees and unreasonably liberal credit terms
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Types of Loans Granted to Individuals and
Families (continued)
New Consumer Regulations: Dodd-Frank, CARD Act, and the
New Consumer Protection Bureau
Tricks and Traps The CARD Act and Revised Regulation Z
Appear
Despite the repeated efforts of credit card regulators to deal with
problems in the credit card industry, consumer complaints
continued
Congress passed the Credit Card Accountability, Responsibility,
and Disclosure Act (CARD Act) in May 2009
The new legislation restricted card issuers from raising Annual
Percentage Rates (APRs) unless adequate written notice of a rate
change was given
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Types of Loans Granted to Individuals and
Families (continued)
New Consumer Regulations: Dodd-Frank, CARD Act, and the
New Consumer Protection Bureau
Tricks and Traps The CARD Act and Revised Regulation Z
Appear
Customers must be told the reasons why credit terms were being
changed
Card companies are required to post their contracts on the
Internet so customers can shop around
Card holders must receive periodic billing statements at least
three weeks before monthly payments are due
An expanded box must be included on each monthly billing
statement, indicating the amount of interest paid and the
consequences of paying the minimum amount
Fall within the Federal Reserve Boards Regulation Z
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Types of Loans Granted to Individuals and
Families (continued)
Dodd-Frank Reforms and Protections Push the Rules Farther
Down the Road
The Dodd-Frank Wall Street Reform and Consumer Protection
Act
Named after Senator Chris Dodd and Congressman Barney
Frank
Was signed into law by President Obama in July 2010
Creates the Consumer Financial Protection Bureau (CFPB)
The new bureau is directed to write new rules applying to such
financial services as:
Making of consumer and credit card loans
Warning consumers of possible damaging financial practices
that could result in losses
Promoting financial literacy among consumers
Improving the clarity and transparency of financial-service
contracts for the benefit of the public
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Types of Loans Granted to Individuals and
Families (continued)
Dodd-Frank Reforms and Protections Push the Rules Farther Down
the Road
The Dodd-Frank Wall Street Reform and Consumer Protection
Act
The new CFPB is to be housed within the Federal Reserve
but operate independently with its own budget
The consumer protection bureau is expected to be
controversial because it must write hundreds of rules that
will likely impact the consumer services side of financial-
service providers
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Characteristics of Consumer Loans
Lenders regard consumer loans as profitable credits with
sticky interest rates
Contract interest rates often do not change readily with market
conditions as do interest rates on most business loans
As a result, many consumer loans are subject to significant
interest rate risk
Consumer loans are usually priced so high that market
interest rates on borrowed funds and default rates on the
loans themselves would have to rise substantially before
consumer credits would become unprofitable
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Characteristics of Consumer Loans
(continued)
Why are interest rates so high on most consumer loans?
Consumer loans are among the most costly and most risky to
make per dollar of loanable funds committed to them
Consumer loans tend to be cyclically sensitive
Household borrowings appear to relatively interest inelastic
They are more concerned about the size of the monthly payment
rather than the interest rate that they are charged
Education and income levels materially influence consumers
use of credit
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Evaluating a Consumer Loan Application
Character and Purpose
Key factors in analyzing any consumer loan application are
the character of the borrower and the borrowers ability to
pay
Consumer lenders nearly always check with one or more
credit bureaus concerning the customers credit history
In the case of a borrower without a credit record or with a
poor track record of repaying loans, a cosigner may be
requested to support repayment
Many lenders regard a cosigner as primarily a psychological
device to encourage repayment of the loan
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Evaluating a Consumer Loan Application
(continued)
Other Important Items For Lenders
Income Levels
Deposit Balances
Employment and Residential Stability
Pyramiding of Debt

How to Qualify for a Consumer Loan
Home ownership or ownership of any form of real property
Maintain strong deposit balances
The most important thing to do truthfully answer all of the
loan officers questions

18-15
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Credit Scoring Consumer Loan Application
The basic theory of credit scoring is that lenders and
statisticians can identify the financial, economic, and
motivational factors that separate good loans from bad loans
Underlying assumption the same factors that separated
good loans from bad loans in the past will separate good
loans from bad ones in the future within an acceptable risk of
error
Such an automated credit determining system removes
personal judgment from the lending process
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Credit Scoring Consumer Loan Application
(continued)
The FICO System
Developed by the Fair Isaac Corporation
Most famous of all credit-scoring systems currently in use
Scores range from 300 to 850 with higher values denoting less
credit risk to lenders
FICO score are based on five different types of information
(most important to least important):
1. The borrowers payment history
2. The amount of money owed
3. The length of a prospective borrowers credit history
4. The nature of new credit being requested
5. The types of credit that the borrower has already used
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Laws and Regulations Applying to Consumer
Loans
Numerous laws and regulations limiting the activities of
consumer lending institutions have been enacted
These laws fall into two categories:
1. Disclosure rules
Mandate telling the consumer about the cost and other terms
of a loan or lease agreement
2. Antidiscrimination laws
Prevent categorizing loan customers according to their age,
sex, race, or other irrelevant factors and denying credit to
anyone solely because of membership in one or more of these
groups
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Laws and Regulations Applying to Consumer
Loans (continued)
Customer Disclosure Requirements
Truth-in-Lending Act
Fair Credit Reporting Act
Fair Credit Billing Act
Fair Debt Collection Practices Act

Outlawing Credit Discrimination
Equal Credit Opportunity Act
Community Reinvestment Act

18-19
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Laws and Regulations Applying to Consumer
Loans (continued)
Predatory lending
An abusive practice among some lenders where lenders
may require excessive fees as well as unnecessary and
excessive loan insurance
Subprime Loans
Granting loans to borrowers who have below-average
credit scores
The Home Ownership and Equity Protection Act was
passed in 1994 to protect home buyers from loan
agreements they could not afford
Subprime lending is difficult to regulate

18-20
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Real Estate Loans
Depository institutions and finance and insurance
companies make real estate loans to fund the acquisition
of real property
Homes, apartment complexes, shopping centers, office
buildings, and land
One of the most rapidly growing areas of lending over
the past decade
Real estate lending is different from other loans
Real estate loans can be among the riskiest forms of
credit extended to customers
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Real Estate Loans (continued)
Differences between Real Estate Loans and Other Loans
The average size of a real estate loan is usually much
larger than the average size of other loans
Mortgage loans tend to have longer maturities versus
other types of loans
Maturities of 15 years to 30 years are typical for single-
family homes
With real estate lending, the condition and value of the
subject property are nearly as important as the
borrowers income
Appraisals are critical to the loan decision and must meet
industry standards and government regulations
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Real Estate Loans (continued)
Factors in Evaluating Applications for Real Estate
Loans
The amount of the down payment pledged by the
borrower relative to the purchase price of mortgaged
property
The higher the ratio of loan amount to purchase price, the
less incentive the borrower has to honor the terms of the
loan
Lenders may be willing to give a mortgage loan
customer a lower loan rate for a pledge that the
customer will use the lenders other financial services

18-23
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Real Estate Loans (continued)
Factors in Evaluating Applications for Real Estate
Loans
Other aspects of each credit application that require
assessment:
Amount and stability of the borrowers income
The borrowers available savings and where the borrower
will obtain the required down payment
The borrowers track record in caring for and managing
property
The outlook for real estate sales in the local market in case
of repossession of the property
The outlook for market interest rates

18-24
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Real Estate Loans (continued)
Home Equity Lending
Homeowners can borrow the equity in their homes
Equity is defined as the difference between a homes
estimated market value and the amount of the mortgage
loans against it
Two main types of home equity loans:
1. Traditional Home Equity Loan
2. Lines of Credit Against a Homes Borrowing Base
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Real Estate Loans (continued)
The Most Controversial of Home Mortgage Loans:
Interest-Only and Adjustable Mortgages and the Recent
Mortgage Crisis
When housing prices were soaring upward during the
recent housing boom, how could lenders make
extravagantly priced homes affordable?
Make home mortgage loans more readily available to
families of even modest means
More families were encouraged to sign up for
adjustable-rate loans (ARMs) during a period when
market interest rates were at historic lows
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Real Estate Loans (continued)
The Most Controversial of Home Mortgage Loans: Interest-
Only and Adjustable Mortgages and the Recent Mortgage
Crisis
When home prices continued to rise, clever mortgage lenders
came up with yet another financial innovation the interest-
only adjustable home mortgage loan (option ARM)
With this type of credit the home buyer is obligated to pay only
the interest on his or her home loan for an initial period
After that initial time interval passes, the home buyer would have
to pay both principal and interest until the loan was finally paid
off
Looked like predatory lending against lower-income families
In an environment of rising market interest rates, many home
buyers with adjustable-rate loans faced higher interest payments
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Real Estate Loans (continued)
The Most Controversial of Home Mortgage Loans: Interest-
Only and Adjustable Mortgages and the Recent Mortgage
Crisis
Now lenders must disclose more about the actual terms of a
home mortgage loan and not represent a loans terms as fixed
when those terms can be changed over time
Dodd-Frank Wall Street Reform and Consumer Protection Act
resulted in tough new rules
Lenders who are pooling and securitizing mortgage loans they
create and sell are responsible for at least 5 percent of the credit
risk attached (qualified mortgages are exempt)
Previously lenders washed their hands of any responsibility
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A Revised Federal Bankruptcy Code as
Bankruptcy Filings Soar
Households in record numbers have sought protection
from their creditors under the U.S. bankruptcy code
Bankruptcy Abuse Prevention and Consumer Protection
Act
Signed in April 2005 by President George W. Bush
Made filing for bankruptcy more expensive and time-
consuming
Before filing for bankruptcy, applicants must complete a
certified credit counseling program
Intended to discourage consumers from taking on too much
debt and increasing their risk profile
18-29
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A Revised Federal Bankruptcy Code as
Bankruptcy Filings Soar (continued)
A means test determines whether an applicant must file
under Chapter 7 or Chapter 13 of the bankruptcy code
Means Test - an average of a debtors past six months of gross
income
Test determines if the debtor has enough income to pay some of
the debt
Under the previous bankruptcy code, most individuals filed
for Chapter 7
Wiped out all or most debts and generally allowed for a fresh
start
Makes it harder for applicants to apply for Chapter 7
More applicants, as a result must file under Chapter 13
Stipulates that at least some debts must be repaid
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Pricing Consumer and Real Estate Loans:
Determining the Rate of Interest and Other Loan
Terms
A financial institution prices every consumer loan by setting
an interest rate, maturity, and terms of repayment

The Interest Rate Attached to Nonresidential Consumer
Loans
The Cost-Plus Model
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Pricing Consumer and Real Estate Loans:
Determining the Rate of Interest and Other Loan
Terms (continued)
Annual Percentage Rate (APR)
Annualized internal rate of return that equates expected total
payments with the amount of the loan
Takes into account how fast the loan is being repaid and how
much credit the customer will actually have use of during the
life of the loan
Under the Truth-in-Lending Act, lenders must give the
household borrower a statement specifying the APR
Allows borrowers to compare a particular loan rate with the
loan rates of other lenders
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Pricing Consumer and Real Estate Loans:
Determining the Rate of Interest and Other Loan
Terms (continued)
Simple Interest Rate


Adjusts for the length of time a borrower actually has use of
credit
If the customer is paying off the loan gradually, this approach
determines the declining loan balance, and that reduced balance
is then used to determine the amount of interest owed
18-33
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Pricing Consumer and Real Estate Loans:
Determining the Rate of Interest and Other Loan
Terms (continued)
The Discount Rate Method
Requires the customer to pay interest up front
Interest is deducted first and the customer receives the loan
amount less any interest owed

The Add-On Loan Rate Method
One of the oldest loan rate calculation methods
Any interest owed is added to the principal amount of the loan
before calculating required installment payments
Only if the loan is paid off in a single lump sum at the end will
the add-on rate equal the simple interest rate
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Pricing Consumer and Real Estate Loans:
Determining the Rate of Interest and Other Loan
Terms (continued)
Rule of 78s
A rule of thumb to determine how much interest income a lender
is entitled to accrue at any point in time from a loan that is being
paid out in monthly installments
Important especially when a borrower wants to pay off a loan
early
Rule arises from the fact that the sum of the digits 1 through 12
is 78
To determine the borrowing customers interest rebate from
early repayment of an installment loan, total the digits for the
months remaining on the loan and divide the sum by 78
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Pricing Consumer and Real Estate Loans:
Determining the Rate of Interest and Other Loan
Terms (continued)
Rule of 78s
Example
A customer requests a one-year loan to be repaid in 12 monthly
installments
Customer would also like to repay the loan after only nine months
Interest rebate that the customer is entitled to receive back




The lender is entitled to keep 92.31 percent of the finance charges
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Pricing Consumer and Real Estate Loans:
Determining the Rate of Interest and Other Loan
Terms (continued)
Interest Rates on Home Mortgage Loans
Since the 1930s, most loans to finance the purchase of new
homes were fixed-rate mortgages (FRMs)
In 1981, adjustable-rate mortgages (ARMs) were
authorized for offering by all federally chartered
depository institutions
Created in response to the pressure of inflation and volatile
interest rates
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Pricing Consumer and Real Estate Loans:
Determining the Rate of Interest and Other Loan
Terms (continued)
Interest Rates on Home Mortgage Loans
Whether a customer takes out a FRM or ARM, the loan
officer must determine what the initial loan rate will be
and what the monthly payments will be
The formula to compute monthly mortgage payments is
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Pricing Consumer and Real Estate Loans:
Determining the Rate of Interest and Other Loan
Terms (continued)
Charging the Customer Mortgage Points
Home mortgage loan agreements often require borrowers
to pay an additional charge up front called points
Points are prepaid interest and may be deductible as home
mortgage interest
For example, suppose the borrower seeks a $100,000 home
loan and the lender assesses the borrower an up-front
charge of two points
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Quick Quiz
What are the principal differences among residential loans,
nonresidential installment loans, noninstallment loans, and credit card
or revolving loans?
What are the principal advantages to a lending institution of using a
credit-scoring system? Are there any significant disadvantages to a
credit-scoring system?
What laws exist today to give consumers fuller disclosure about the
terms and risks of taking on credit?
What is home equity lending, and what are its advantages and
disadvantages for banks and other consumer lending institutions?
What options does a loan officer have in pricing consumer loans?
How is the loan rate figured on a home mortgage loan? What are the
key factors or variables?
18-40
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