Loans are inevitable facts of life. They are mentioned in The Bible, Shakespeare wrote about it, religious scriptures often forbade high interest rate. In reality, most people need to borrow at some point to pay for something. Most people also accept that it will cost them something to get access to funds they don’t already have.
For most things in life, we expect to pay more to get more, better phones cost more, bigger houses cost more. Consumer banking is one place where the customer drives the pricing. So, some customers pay higher prices for the exact same product.
Data shows that people with lower credit score default on their loan more than those with higher credit score. Low credit score people often have low income too, but these two are not completely correlated. Some correlation between income and credit behavior is not hard to understand because lower income provides little cushion for unforeseen expenses or loss of income. To compensate for this, lenders often charge low credit score customers higher fees and finance charges to ensure profitability.
Conversely, customers with higher income and assets often have better credit behavior and receive the lowest fees and finance charges. When I was an international student financing school with credit card, issuers charged me 29.99% or worse, closed my credit line even when I was making timely payments. Over the years as my income grew, I have been rewarded with $30,000 credit line and 2.7% mortgage rate.
Most credit scores are determined by length and quality of credit history (grossly simplified). After 2008 financial crisis, regulators added a check for ability pay. This often means a calculation of discretionary fund by comparing customer’s income with obligations like rent or mortgage and other loan payments. Besides loan approval decision, loan amount, interest rate or other loan terms are often also based on credit score.
So, the people who need the loan most and find it hardest to pay, are charged the highest fees and finance charges. However, slapping a higher monthly payment, are we making the problem worse?
Credit score is an indication of past behavior and penalizes people for long time after they have improved their income and payment behavior. In fact, our lending system is entirely focused on borrower’s past and makes no adjustment for the borrower’s future. Current income and potential of future income could be a higher predictor of future default than past credit behavior. This assumes that most people, except fraudsters, want to pay off their debt if they have the money. Many people with reasonable income (e.g., newly employed college graduates or newly employed worker after a short-term disability) are forced to pay very high fees and interest rates.
What if income was given a more central role in determining loan terms? Can borrowed funds be paid off as a percentage of income? To be totally transparent, I came across this idea from an innovative FinTech. Income contingent repayment is available for federal student loan. Main purpose of the plan is to make payment more affordable during lean times. What if we apply the same concept to other loans?
Instead of interest, a loan can be structured with upfront fixed fees which are then paid back as a fixed percentage of gross or discretionary income. One important difference is that the duration of the loan could be initially estimated based on current income (e.g., 48 months) but may vary based on future income. When income goes down, borrower pays a smaller amount (and may never pay less than a minimum payment amount). When income increases, borrower automatically pays more and thereby pays off the loan faster.
How would it work for the borrower? It is a good option for many who have variability in income or expecting income to grow in future like graduating professionals. It takes away stress of fixed monthly payment when incomes are volatile e.g., for gig workers, entrepreneurs. When income grows, loan payment amount automatically increases. In fact, by automating faster repayment, borrower gets debt free faster. Consumers love automated, set-it-and-forget-it solutions. FinTech’s have taken it to new heights by allowing consumers to invest in stocks in small fractional increments, save money by rounding up transactions. There is no reason a similar automated loan payoff plan to get rid of debt faster would not work.
Today’s lending system is based on a fixed repayment plan where both early and late payments are considered a risk to lender profitability. In the proposed scenario, lender still makes the same fee no matter the duration of the loan. In a diversified pool of loans, some borrowers will make lower payment when their income decreases while other borrowers will make larger payment at the same time if their income goes up. Since the loan is fixed fee, faster repayment, improves the lender’s bottom line. Adjusting payment based on income may lower actual default rate (no payment at all) thereby lowering credit loss, overhead for collection and related operational expense.
Sure, the lender may not be maximizing profitability by charging the highest possible APR with fixed payment amount a borrower could have agreed to pay. But the proposed income based structure does not prevent lenders from getting a targeted return on the capital. This is the S in ESG. It’s time that consumer banking’s ESG policy goes beyond ESG funds and ETFs.