Thursday September 14, 2023 | Greg Ulankiewicz, Performance Analytics Product Manager
It wasn’t that long ago when the Fed Funds rate was at near zero, everyone had more money than they knew what to do with it and inflation was seen as a transient guest who would leave soon after the party was over. A year and a half and 11 rate increases later, the Fed Funds rate is at its highest level in over 15 years. Consumers’ pocketbooks are no longer flush with cash and inflation has hung around a lot longer than most anyone expected or wanted. With these dynamics in play, the lending arena suddenly looks a lot different, and more challenging, than the salad days of the pandemic era. For financial institutions, this means loan strategies must adapt to continue to drive profitable sales and growth.
The Cracks Are Starting to Show
An expected consequence of the Fed’s rate actions, consumer demand for loans has begun to taper off after soaring to unprecedented levels in 2020 and 2021. When Raddon surveyed consumers last October for its annual Lending Insights study, 45% of households stated they had demand for a loan in the next 12 months, a decline from 52% in 2021 (Figure 1). Though 45% of consumers with loan demand is still exceedingly strong, in the time since we fielded our survey the Fed has applied a collective 225 basis points of additional rate increases. With even higher rates and stubborn inflation, it’s a safe bet loan demand will show further decline when we survey consumers again later this year.
Figure 1: Percentage of Households That Anticipate Applying for Any Loan in the Next 12 Months
Source: Raddon Research Insights Q: Which of the following loans do you anticipate you will be applying for during the next 12 months? (n=1,234)
While consumer demand for loans is waning, loan delinquencies are edging up. According to the quarterly New York Fed Consumer Credit Panel/Equifax study, the percent of total loan balances transitioning into delinquency has been on the rise since the middle of 2021 (Figure 2 and Figure 3). Delinquencies for auto, credit card and other consumer loans are effectively back to pre-pandemic levels. Real estate loans are still performing slightly better than pre-pandemic levels though non-revolving mortgage loan delinquencies have steadily increased since the middle of 2021. The sky is not falling, but borrowers are beginning to exhibit stress they haven’t shown since before the pandemic. Going forward, preserving margin will require more effective risk-based pricing. Achieving loan growth goals will in part depend on a financial institution’s capacity and ability to lend into less-than-ideal credit quality households.
Figure 2: Percent of Loan Balances Transitioning Into Delinquency (30+ Days) by Loan Type
Source: New York Fed Consumer Credit Panel/Equifax
Figure 3: Percent of Loan Balances Transitioning Into Delinquency (90+ Days) by Loan Type
Source: New York Fed Consumer Credit Panel/Equifax
That Student Loan Thing
In the charts above, the trendlines for student loan delinquencies stand in stark contrast to the others. With the federal government instituting a pause on student loan repayments amid the pandemic, delinquencies in this category fell precipitously to negligible levels and have remained there ever since. In case you haven’t heard, this student loan thing has been kind of a hot topic of debate in Washington. After the Biden administration unveiled a plan last August that included loan forgiveness canceling nearly $400 billion in student loan debt, some states sued the administration claiming it did not have the authority under federal law to enact such a plan. In late June 2023, the Supreme Court ruled in favor of the State of Nebraska, effectively killing the initiative. In turn, after more than three years of a repayment pause, student loan borrowers will again have to make payments beginning after September 1, 2023. The Biden administration may continue to seek other means to eliminate student loan debt for borrowers, but a mass clearing of the slate certainly seems off the table for now.
With monthly student loan payments averaging close to $300, according to the Federal Reserve, consumers carrying student loan debt will take an instant hit to their pocketbooks. Their buying power, and borrowing power, will be diminished, putting further pressure on financial institutions to drive loan growth.
Higher Pricing Calls for a High-Tech, High-Touch Approach
A majority of borrowers consider the interest rate to be the most important factor when applying for a loan. When Raddon asked borrowers to rank the importance of six different loan attributes in their decision to apply, almost two-thirds (63%) ranked the interest rate as the most important attribute (Figure 4). Price is clearly top of mind when borrowers shop for a loan, which doesn’t necessarily mean they always obtain the best price that might be available to them. As rates remain high or continue to climb higher, financial institutions that offer better pricing than their peers will certainly have a competitive advantage. However, relying too much on price to win loan business will quickly erode margins and profitability.
Figure 4: Percent of Borrowers Ranking Loan Attribute Number One in Importance in Decision to Apply (Any Loan)
Source: Raddon Research Insights Q: When considering the loan you applied for, please rank the following features in terms of their importance to your decision to apply. (n=1,265)
To drive profitable loan growth, banks and credit unions will need to develop competitive advantages beyond price. Taking a different approach, Raddon also asked consumers to rate the importance of loan attributes by assigning points to each attribute given a total pool of 100 points (Figure 5). Reponses show the interest rate on the loan was still the most important attribute (20 points on average) but was only somewhat more important than the monthly payment (17 points) and the convenience of applying for the loan (16 points).
Figure 5: Average Points Assigned to Loan Attribute’s Importance in Deciding to Take Out the Loan (Respondents had 100 total points to distribute across all attributes)
Source: Raddon Research Insights Q: Assign a value for how important the following attributes were in making your decision. You have 100 points to distribute between six attributes. (n=556)
Financial institutions must leverage data and technology to streamline their loan processes in order to appeal to borrowers on convenience and to reduce fixed costs per application to preserve profitability. While you may offer a competitive rate, are you sacrificing loan opportunities because the application experience on your mobile platform is clunky compared to your peers? How well are you using data to automate loan adjudication and technology to speed up time to funding? Are your in-branch loan officers hamstrung by time-consuming manual processes? Investing in high-tech solutions will be paramount to driving efficiencies and will free up your staff to identify more leads and close more loan sales.
Data and technology must also play a bigger role in how financial institutions target and engage loan prospects. Transaction data from existing checking or credit card accountholders at your institution provide incredible insight into their personal idiosyncrasies and can help identify their pending loan needs further in advance than other data at your disposal. Institutions that leverage this information effectively can automate turnkey target marketing and will be better equipped to offer more personalized ads for the right product to the right prospect at the right time.
While financial services have become increasingly digital, another key differentiator for financial institutions is their people. Develop your staff to be recognized as trusted advocates for accountholders’ financial well-being as they pair borrowers with loans that have terms and conditions most appropriate for their needs and personal situation. Your employees will also be instrumental in helping loan prospects understand the intricacies of more complex borrowing needs such as purchasing a first home or taking advantage of a home equity line of credit with an option to lock in a fixed-rate, fixed-term for any portions of outstanding balances. A high-tech, high-touch approach will prove critical to driving profitable loan growth in a high-rate environment.
Get Creative With Product Design
In many respects, loan products are largely commodities. But well-intentioned nuances in product design can be another differentiating factor that enable financial institutions to rely less on price in order to drive loan sales. In the above Figures 4 and 5, borrowers cite the monthly payment as the second most important loan attribute in their decision to borrow. Consider then, Ford Credit’s Flex Buy financing option. This product provides borrowers with a 15% or 18% discount on payments for the first three years of the loan thereby helping consumers to purchase the vehicle of their choice within their existing budget. Bait-and-switch arguments aside, this product is clearly designed to appeal to the value borrowers place on affordability.
Also consider the influence the recent Buy Now Pay Later (BNPL) phenomenon has had on borrowers’ psyches. Consumers have long had the ability to make purchases on credit at the point-of-sale with a credit card. Buy Now Pay Later is little more than a creative twist on such purchases by offering borrowers fixed-rate, fixed-term repayment certainty. And BNPL can compete on price by driving revenue through agreements with merchants who stand to benefit from consumers’ newly gained purchasing power.
Financial institutions offering traditional credit card products that typically try to differentiate via rewards, balance transfer offers, or promotional interest rates now face a new challenge that wasn’t a significant threat as recently as three years ago. To compete against BNPL, banks and credit unions must look to replicate this borrowing experience through their existing credit card suite. Here, the mobile capabilities attached to the credit card account play a significant role in affording credit card accountholders the flexibility to manage their payments in a budget-friendly way. Look to implement mobile banking features that enable cardholders the ability to customize repayment terms, so they are more inclined to make purchases with your card than they are to rely on the enticing offer from the shiny, new-fangled BNPL service providers.
Think Differently, Lend Differently
The economics and consumer behaviors surrounding the pandemic have certainly entailed a roller-coaster ride where the fallout has ushered in a brave new world in lending. Without coming across as too hyperbolic or even macabre, it might be fair to say that lending is at a crossroads where there are only two paths forward for traditional lenders: adapt or die.