Types of Consumer Loans Three types Installment Credit cards/revolving credit Noninstallment Installment Loans Require periodic uniform payment of principal and interest Frequently used to purchase durable goods Typical maturity is 2-5 years Usually secured by the item being purchased Direct (between bank and consumer) or indirect (funded by a bank through a separate retailer/dealer) Can be extremely profitable for the banks Credit Cards and Revolving Credit Revolving credit requires a monthly payment whose amount depends on the outstanding balance. By 2002 over one billion credit cards had been issued in the United States. The entire population of the country is only 280 million. Average balance is $5,800. Banks are usually franchises of MasterCard and/or VISA rather than issuing their own cards. That way the banks’ cards will be accepted anywhere. Cards usually require a one-time initial fee plus annual charge. Competition is leading increasingly to no-annual-fee cards. Credit limits are prearranged but the timing and amount of loans are determined by the cardholder. Consumers can get credit cards easier than they can get a bank loan but the interest rate is much higher. -2- Interest rates are extremely high and "sticky,” unless the rates are variable. Variable rates are usually quoted as prime plus. Credit cards allow banks to acquire a nation-wide customer base. Banks are being created that deal only in credit cards and even only online. Banks are seeing increasing competition from nonbanks, e.g., store chains, credit unions, airlines, GM, etc. Credit cards can be obtained online in less than a minute. Applications are evaluated using a credit score (like FICO). Banks try to lure credit card customers away from other banks with attractive introductory offers on balance transfers, e.g. 0% interest for 12 months. About 40 % of credit card debt has been securitized. Banks have been criticized for making credit cards too easy to obtain, leading to higher default rates. The default rate on credit card is high and rising, as the stigma associated with bankruptcy has largely disappeared. -3- Credit Card Report The 10 largest credit card issuers account for 75% of the market. For 2001: Accounts Charge-offs Delinquencies (90+ days) Citigroup 92.9 million* 5.91% 1.98% MBNA 4.86 5.09 First USA 55.6 5.59 4.46 Discover 3.02 Chase 5.48 Capital One 43.8 4.42 4.95 Providian ** 12.70 8.81 American Express Bank of Am 4.90 Household 6.69 4.10 Compare to Wells Fargo’s net charge-off rate of .84% of all loans. *North America **Providian used to be a major subprime lender*** but is abandoning the market because of huge losses. Secured Credit Cards The vast majority of credit cards require no security. People with a poor credit history can obtain secured credit cards. Funds must be kept in an account at the bank usually equal to the credit limit on the card. In case of default, the bank can use the funds to pay off the account and close it. ***Subprime Lending Banks may actually seek out less-than-prime-creditworthy customers, assuming that the higher the risk, the higher the expected return. -4- Overlines and Open Credit Lines An overline is a prearranged loan to cover overdrafts of checking accounts: overdraft protection Authorized customers can write checks which exceed their Balances. The bank covers the overdrafts with loans, usually in increments of $50 or $100 or so. Customer pays interest from the date of the overdraft. The loan is repaid with direct deposits or with periodic payments. Open credit lines (prearranged) allow potential individual borrowers to obtain a loan by simply writing a check for the amount of the loan. Noninstallment Loans Some consumerloans require a single payment of principal and interest. Credit is extended temporarily in anticipation of a well defined future cash inflow, selling a house, a large tax refund, etc. Bridge loans in new home buying would be a typical example. Impact of Taxes Consumer credit interest expense is no longer ('86) tax deductible. That has greatly increased the popularity of the home equity loan, because interest on those loans is still tax deductible.