The phrase "subprime loan" carries a negative connotation for many lenders, but recent study results show that these alternative loans are actually a key to success for many credit unions. While lending to less-qualified borrowers does introduce more risk for a credit union, it also provides far more lending opportunities, and well-written loans are often able to avoid the pitfalls of unreasonable borrower expectations and eventual loan default.
Credit unions know their members
The membership model makes credit unions unique among financial institutions, and it is also central to their abilities in the subprime space. Unlike larger lending institutions that are unable to look at each individual borrower and accurately assess their financial situation, credit union executives can take time to properly evaluate members' finances. This allows credit unions to offer loans to individuals that large banks would consider unqualified, and makes it possible for executives to write loans that have appropriate interest rates for the relative risk presented by each borrower.
In an end-of-year study conducted by The Credit Union Times, many of the organizations in the top 20 credit unions based on net interest margin specifically target the subprime market. The biggest demand comes from auto loans. The financial crisis made it difficult for many people to secure a loan to purchase a car. Credit unions can capitalize on this demand and increase their membership by targeting the customers spurned by big banks.
No cause for alarm
There are simple ways to mitigate risk when providing loans to alternative borrowers. Most importantly, credit unions should create loans that are conservative, with fixed interest rates and payments. In an overview of trends, the Federal Reserve Bank of San Francisco found these factors were more important for limiting risk than ensuring perfect credit for borrowers.
"The biggest demand comes from auto loans."
The lesson of the financial crisis should not be to eliminate loans to all less-qualified individuals. Rather, financial organizations need to lend intelligently with an eye towards what specific borrowers are capable of repaying. "No lender should put a borrower into a loan he or she can ill-afford," said Professor of Economics at New York University's Stern School of Business, Lawrence White, to USA Today. That simple rule will provide credit union members with the money they need while the union itself remains solvent.
Making these loans may result in a higher level of defaults than if credit unions focus on only the most qualified borrowers, but a sharp focus on the union's financials should ameliorate that increase over a larger number of loans.