Mark Hauser, co-managing partner at Hauser Private Equity, describes the ins and outs of consumer loans, and gives valuable insight to consider.
Making an important milestone purchase, such as a new vehicle or a home, has often been a significant challenge. Many consumers simply don’t have the discretionary funds to pay cash for these high-ticket items. Historically, they have asked their local bank or credit union for a loan.
Although these financial institutions remain viable choices, several other lender types have entered the marketplace. New classes of consumer loans have also become available. Private equity expert Mark Hauser explains how consumer loans work and discusses seven criteria lenders use to evaluate each application.
Snapshot of Consumer Loans
A consumer loan collectively describes all loan products geared to the consumer market. Let’s say a consumer wants to purchase an item, but they cannot pay the full amount due. A consumer loan can provide the remainder of the funds. In exchange for this privilege, the loan recipient agrees to pay back the funds (with interest) to the lender.
Traditionally, consumer loans have targeted high-dollar purchases such as vehicles and homes. For decades, college students have racked up substantial debt via their student loans. Personal loans and credit card debt are also included in the consumer loan category.
Today, some consumers also obtain loans for relatively small retail purchases. These “Buy Now, Pay Later” (or BNPL) loans require equal payments. The loans are often interest free if the consumer makes timely payments.
5 Common Consumer Loan Characteristics
Consumer loans have five distinct characteristics. Together, these attributes make them stand out in the loan industry.
- Loan products are available for borrowers with different backgrounds and credit profiles.
- Loan types typically have different interest rates. Credit cards have historically high interest rates while mortgages and auto loans generally offer lower rates.
- Lenders often grant loan approval without the need for collateral.
- A consumer’s future spending can be impacted by their past loan obligations. If the borrower takes out too many loans, their debt utilization rises. This may reduce their chances of qualifying for future consumer loans.
- Businesses (including retailers) may offer in-house financing for customers’ purchases. Auto dealerships frequently provide branded financing options.
Closed-End Credit vs Open-End Credit
Consumer loans (or consumer credit) are divided into two fundamentally different categories. Each loan type has a distinctive structure.
How Closed-End Credit Works
Private equity principal Mark Hauser says closed-end credit, or installment credit, has specific loan parameters. The loan is structured for a defined purpose, amount, and duration. The borrower usually makes an equal monthly payment.
A loan agreement (or contract) spells out all the repayment terms. Examples include the exact payment amount, number of payments, and cost of the credit (including interest). Mortgage payments and auto loans are common types of closed-end credit.
When creating a closed-end credit agreement, the seller retains ownership (or title) of the goods until the borrower has completed all payments. For example, an auto dealer will affix a “lien” to a vehicle until the borrower has paid off the entire balance.
How Open-End Credit Works
Under an open-end (or revolving) credit structure, the consumer has a predetermined “line of credit,” often from a bank’s credit card. Retail stores and oil companies have similar branded cards that can only be used at the company’s establishments. In each case, the consumer can purchase merchandise only up to their credit limit.
The card-issuing bank or merchant requires the consumer to make at least partial regular payments. Many consumers do not pay their bill in full every month. As a result, Mark Hauser says the creditor charges them an often-hefty interest rate.
Secured and Unsecured Consumer Loans
Consumer loan issuers want to minimize their risks while getting a return on their investments. Each lender carefully evaluates each borrower’s situation before issuing a secured or unsecured loan. In this regard, says Mark Hauser, consumer and business loans are much the same.
Secured Loans
Creditors may lend larger amounts of money while offering lower interest rates and longer repayment terms. However, the lenders want some assurance that they’ll get their money back if the borrower defaults on their obligation.
Therefore, the lenders issue loans that are secured by collateral. These hard assets will cover the loan in the event of a default. If this occurs, the lender will seize (and liquidate) the collateral to recover the unpaid loan balance. Home loans and car loans are commonly structured as secured loans.
Unsecured Loans
In contrast to a secured loan, an unsecured loan is not backed by collateral. Instead, the lender makes the loan based on the borrower’s promise to repay the amount due (plus interest). Because the lender faces increased risk, they generally extend lower amounts of financing. In addition, the borrower is assessed a higher interest rate and shorter repayment period.
If the borrower fails to repay their unsecured loan, the lender can file suit and receive a legal judgment against the borrower. Based on that state’s laws, the lender may be able to force the borrower to sell other assets to pay the judgment. Alternatively, a portion of the borrower’s wages could be garnished until the judgment is paid in full.
Types of Consumer Loan Providers
In the 21st century, traditional consumer loan providers have been joined by digital lenders. Mark Hauser notes that borrowers’ needs and credit profiles may help to dictate their choice of lenders.
Commercial Banks
Commercial banks (including local and regional banks) extend loans to carefully vetted borrowers with a demonstrated ability to repay the loans. Banks make three major types of loans to borrowers.
Housing Loans
These loans pertain to residential home construction and residential mortgages. Home improvement loans also fall into this category.
Consumer Installment Loans
Most of these loans pertain to vehicles, boats, furniture, and other pricey durable consumer goods. Borrowers must make monthly payments that include interest.
Credit Card Loans
A credit card loan is a cash advance linked to the borrower’s credit card. A predetermined credit limit applies for these loans. Most cash advance loans have substantially higher interest rates compared to rates for consumer purchases.
Credit Unions
A credit union is a non-profit cooperative that serves a group united by a common attribute. In many states, for example, state employees’ credit unions cater to this growing group.
Because of their non-profit status and lower costs, credit unions can provide better savings and loan terms compared to commercial banks. Less-rigid loan standards and faster loan service make credit unions a popular choice.
Consumer Finance Companies
Consumer finance companies issue second mortgages and personal installment loans. These companies must follow the same rules and regulations as a commercial bank.
A consumer finance company is generally a very accommodating lender. These businesses often allow applicants with no established credit to borrow funds without collateral. Individuals with a checkered credit history may also be able to obtain loans. However, their interest rates are higher because of the increased risk.
Sales Finance Companies
A sales finance company frequently extends loans for big-ticket purchases. Examples include a vehicle, a high-end computer system, or a group of major appliances.
The auto dealer or retailer informs the purchaser that their installment financing note has been sold to the manufacturer’s sales finance company. The purchaser makes monthly payments (including interest) to the finance company instead of the dealer or retailer.
7 Criteria Lenders Evaluate in Each Loan Application
Regardless of the loan type or specifics, lenders consider seven factors when approving or declining an application. When applicants thoroughly understand the evaluation criteria, they can improve their chances of approval.
The Applicant’s Credit Score
A good credit score indicates that an applicant can handle borrowed money. A poor credit score indicates just the opposite and increases the applicant’s default risk. Credit scores fall between 300 and 850, with an ideal score in the 700s to 800s range.
Employment History and Income
Lenders want to see an applicant’s stable employment history with consistent income. The lender also wants to know that the applicant makes enough money to easily afford the loan payments.
Debt-to-Income Ratio
This factor examines the applicant’s monthly debt as a percentage of their monthly income. Mark Hauser emphasizes that lenders prefer a low debt-to-income ratio under 43 percent. Some lenders will approve an applicant with a higher ratio if their income is higher and their credit is in the “good” range.
Available Liquid Assets
Lenders want to see that an applicant has available cash in a savings, money market, or other liquid account. This shows that they have some backup financial resources. An applicant with little (or no) liquid assets may be assessed a higher interest rate.
Value of the Loan Collateral
For a secured loan, the collateral value partially determines how much the applicant can borrow. In addition, the lender wants to know the value of the assets the applicant will forfeit if they default on the loan payments.
Amount of the Down Payment
If the loan requires a down payment, the amount paid dictates the amount the applicant must borrow. Applicants should understand that a small (or no) down payment means they’ll pay more interest over the entirety of the loan.
Term of the Loan
A borrower’s financial situation could change over a longer loan term. Therefore, a lender would likely prefer to lend money for a shorter term, as the applicant will likely be better able to repay the loan over the shorter period. Applicants should understand that a shorter loan term will save money on interest. However, their monthly payments will be higher.
Mark Hauser recommends that applicants with a less-than-ideal financial situation make a substantial effort to improve it. When they do, they’ll have a greater chance of loan approval.
Photo by Scott Graham on Unsplash
