By: Bob Schroeder
Before Lending Solutions Consulting Inc. or LSCI provides on-site consulting services with credit unions we conduct a portfolio analysis. We review loan policies, pricing, and approximately seventy-five loan files including delinquencies and charge offs. This is where we identify opportunities to make a positive impact on your credit union’s net income. We compare our portfolio analysis to the exam one receives at the doctor’s office prior to a diagnosis. When conducting reviews of delinquencies and charge offs I see a much higher percentage of members with student loans than in the general population. This tells me that these members are struggling and credit unions may not be addressing student loans properly in their underwriting.
Are student loans a bubble? I’m hearing this concept discussed in the media. As I travel around the country it is not unusual to see borrowers having $100,000 or more in student loans. According to the Federal Reserve statistics 3.5% of the 37.5 million student loan borrowers owe more than $100,000 in student loans. The average student loan debt per borrower is $25,000. Outstanding student loans are now greater than credit card debt and auto loans in America. How do you address student loan obligations in your loan underwriting? When you see a member with student loans what guidance do you offer your staff or the member?
Lets take a look at four key underwriting ratios, guidelines used by LSCI and how student loans affect these ratios. The four ratios and LSCI guidelines are:
1. Debt to Income - 45% or less
2. Unsecured Debt to Annual Gross Income (AGI) - 25% or less
3. Secured Loans to AGI - 75% or less
4. Mortgage Debt to AGI - 2.5 or less
Typically student loans alters only the Debt to Income, ratio 1 of the above four ratios. At a recent University of Lending the discussion lead to the amount of monthly payments to use in the debt to income ratio when student loans in deferment. Some of the more aggressive CU’s did not add a monthly payment on deferred student loans. Rex Johnson the founder of LSCI and class instructor suggested .006 of the original student loan balance is a good number to use. The class participants came up with three alternatives methods. When researching the Internet I found seven options for student loan repayment plans. These repayment plans include standard, graduated, extended, income based, pay as you earn, income contingent and income sensitive. There is no one absolute correct number, however I to recommend the .006 solution.
Some may argue student loans are unsecured loans and should be included in Unsecured Debt to AGI, ratio 2. LSCI uses this ratio as a bankruptcy indicator and since federally backed student loans are not dischargeable in bankruptcy we recommend you exclude them from this calculation. This ratio identifies the dollar amount as a percentage of AGI one would benefit from filing bankruptcy. We believe your members will be tempted to file bankruptcy once their dischargeable debt exceeds 25% of their AGI. That is 25% of a year’s earnings tax-free. Some may hold out for 30 or 35%, however we all have our limit.
Outstanding student loans do not change the Secured Debt to AGI, ratio 3 or the Mortgage Debt to AGI, ratio 4.
When a borrower has student loans outstanding is it reasonable to have the same limits on ratios 2 through 4 as those with no student loans outstanding? If you have student loans up to 50% of your AGI should you also have a car loan to 75% and a mortgage of 2.5 time your AGI?
I see many credit unions take losses on consolidation loans because they fail to realize the impact student loans have on their members. These loans would be great loans if the member did not have the additional burden of student loans.
I recommend a new ratio for those with student loans. Unsecured debt plus student loans to Annual Gross Income. If this ratio is over 50% of AGI you must use caution when structuring new loans. Members with excessive student loans may file bankruptcy when dischargeable debt is less than 25% of their AGI. The federally backed student loans may not be discharged in bankruptcy, however the extra student loan debt pressures the member to get rid of any debt they can. You have to have a conversation with the member about bankruptcy and their attitude about it.
Let your members know all the reasons you like the loan and you want to do everything you can to help them out. Tell them you lend out federally insured money and you have examiners that must be satisfied.
Ask them for approval to ask personal questions. Once you get their approval, ask if they have ever considered filing bankruptcy. No right or wrong answer. Let them know that it’s OK to file bankruptcy. If they file bankruptcy we want them to file now, before our consolidation loan. If they file after we consolidate their bills we will take the loss while the high interest rate lenders receive full payment with interest. Once you have an understanding on the member’s attitude about bankruptcy it should be easier to come up with a solution.
Let me share with you an experience I had at a credit union I was working with. The following are loan notes. The member names were changed to protect their identities.
“Connie came in and was embarrassed about an NSF fee on their account. She was talking with a MSR and they suggested for her to talk with a Loan Specialist to see what we could be done to assist them. Connie came in and did a credit review with a Loan Specialist. After reviewing everything, we thought the best option was to refer them to a credit counselor for assistance with the credit card debt. Bob from LSCI was visiting and wanted to talk with Connie and Sam to see if there may be a different way to handle it.
Connie & Sam have been members of the credit union for 15 years and we have their payrolls coming in. Connie works for the local clinic as a surgical tech. Sam is a general manager at a local restaurant. This is a good job and he is currently making $52,000 a year. Connie reduced her hours down to 20 hours a week in 2010 to return to school. She graduated in August of 2013 with her BA of Science & Nursing. Since then, she has been studying for her boards, which were in April. Once she passes her boards, she will increase her pay to $27.50 per hour from $23.45. If she should not pass them, she will be able to maintain her current job at her current pay rate.
They currently have 2 vehicles, 2012 Forrester & 2011 Legacy. The Legacy is on lease with approximately $5,800 left. The Forrester is at 3.97% and they owe approximately $15,400.00. Both vehicles are in good shape. They bought their home in 2009. Since buying the home, they have remodeled their daughter’s bathroom, re-roofed the back patio and partially finished the basement. Connie has a 401K with approximately $40,000 in it. Sam does not have any 401K.
Connie & Sam have used their credit cards to live on since Connie went part time. This is amounted to over $33,000 in unsecure debt. Bankruptcy is not an option for them. They feel like bankruptcy is a “cop out” and would make them feel like failures. She has student loans that are coming due. They are struggling financially and need assistance.”
Pretty good loan notes! How does your CU compare? I remember the calls well. The husband was more adamant about not filing bankruptcy and stated that if he filed bankruptcy he would be a failure in the eyes of his recently deceased father. It was a quite powerful statement. We even discussed the strength of their relationship. Large unsecured debt consolidations loans are only as strong as the marriage. A divorce would certainly result in a bankruptcy and charge-off.
The following is a list of their non-student loan unsecured obligations:
Creditor Balance Monthly Payment
Kohl’s $1,440.65 $184.00
Marathon $1,230.07 $62.00
Levin $2,668.08 $94.00
Pottery Barn $715.56 $73.00
Care Credit $1,598.74 $87.00
Care Credit $3,299.79 $138.00
Milestone $681.04 $157.04
Best Buy $1,644.98 $54.00
Best Buy $1,985.02 $152.00
Citi Card $7,490.97 $1,094.60
Sears $1,236.52 $40.05
Discover $1,388.13 $47.00
Discover $5,018.88 $101.00
Citi Card $3426.76 $81.56
Total $33,825.19 $2,365.25
This is a list of their student loan obligations:
Loan Balance Monthly Payment
Student loan 1 $41,800.00 $259.00
Student loan 2 $10,100.00 $177.00
Student loan 3 $10,100.00 $177.00
Student loan 4 $11,000.00 $233.00
Student loan 5 $24,500.00 $200.00 (In Deferment)
Total Student Loans $97,500.00 $1,046.00
One of the loan officers at the credit union has experience working with members and consolidating federal student loans. After discussion with this member we recommended they contact the appropriate authorities and consolidate her student loans. She came back with the following solution. She was able to consolidate five loans into one with a balance of $97,500 and starting monthly payments of $400, reducing her monthly payments by $646 per month. This is not a fixed payment and the monthly payment will increase every 2 years for a total of 12 times making it a 25-year repayment plan.
Once the member reduced their student loan payments $646 per month the credit union was able to come up with a consolidation loan that made sense. A financial makeover was complete:
Before: Balance Payment
14 Non-Student Unsecured Loans $33,825 $2,365
5 Student Loans $97,500 $1,046
19 total loans $131,325 $3,411
After: Balance Payment
One Signature loan ($800 cash out) $34,625 $893
One Student Loan $97,500 $400
Total $132,125 $1,293
Debt to income prior to consolidation loan & student loan consolidation – 116%
Debt to income after consolidation loan & student loan consolidation – 44%*
Finance Charges to be collected by the CU - $18,955
Continuing a life long relationship with these members – priceless!
*This is based on Connie working full time.
Reducing the monthly payment on the student loans allowed these members to “buy time” to get the consolidation loan paid off and then attacking the student loans with the additional $893.00 a month once the consolidation loan is paid. This plan would pay off the student loans within 10 years after the five-year consolidation loan is paid. This is a fifteen-year plan, which puts them at about 65 when they are completely debt free and ready for retirement.
The following are links to the web pages that were used by these members to obtain their consolidation of student loans. The only caveat is that private student loans will not qualify for this, however, there are some loans with private financial institutions that are actually federally backed loans and those will be eligible.
As student loans become more prevalent your credit union will need a student loan expert to assist members in navigating the system. The following are details on the many repayment plan options.
Standard Repayment Plan: Payments are fixed with terms up to ten years. Minimum payment is $50 per month.
Extended Repayment Plan: Payments are fixed or graduated with terms up to twenty-five years.
Graduated Repayment Plan: If your income is low now, but you expect it to increase steadily over time, this plan may be right for you. Under this plan, your monthly payments start out low and increase every two years. Graduated repayment plans are made for up to 10 years. The payments will never be less than the amount of interest that accrues, and won’t be more than three times greater than any other payment.
Income-Based Repayment Plan: Income-Based Repayment (IBR) is designed to reduce monthly payments to assist with making your student loan debt manageable. If you need to make lower monthly payments, this plan may be for you. Payments are 10 -15% of discretionary income (income in excess of 150% of the poverty rate).
Pay As You Earn Plan: The Pay As You Earn Repayment Plan helps keep your monthly student loan payments affordable, and usually has the lowest monthly payment amount of the repayment plans that are based on your income. Payments are 10% of discretionary income.
Income-Contingent Repayment (ICR) Plan: If you need to make lower Direct Loan payments, but you do not qualify for the IBR or Pay as you earn plans, the ICR Plan may be for you. Payments are the lower of 20% of discretionary income or fixed payments with a twelve-year term.
Deferment / Forbearance: Under certain circumstances, you can receive a deferment or forbearance that allows you to temporarily postpone or reduce your federal student loan payments. Postponing or reducing your payments may help you avoid default. Deferment is more consumer-friendly as the interest does not accrue.
We recommend using caution when working with members who have a substantial amount of student loans. Caution does not mean turn the loan down. Ask the tough questions about bankruptcy before granting loans that will not survive bankruptcy. The above example is a good loan, only because the credit union knows the member’s attitude about bankruptcy. The $18,955 in finance charges the credit is expecting to collect would not of happened without the lender helping the member consolidate their student loans. Most credit unions would have declined the loan and/or referred them to a credit counselor and received less than a $1,000 in investment income.
I want to give special thanks to my friends at Community One Credit Union of Ohio, including Jason Norris, Melissa Harness, Gina Jones and Evelyn Canterbury for contributing to this article
Bob Schroeder, vice president, consultant of Lending Solutions Consulting Inc. or LSCI began his thirty plus year credit union career in collections before moving on to lending. He has eleven years experience with two of the largest credit unions in the country, rising to the level of vice president of credit before moving on to serve as CEO of a community credit union. During his twenty-one year tenure as CEO, the credit union experienced a period of rapid growth and strong earnings. Bob can be reached at email@example.com.