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1 [1] (October 3, 2018)

handle is hein.crs/govchwr0001 and id is 1 raw text is: FF. ' riES- - $rh ,i , October 3, 2018 Consumer Credit Markets and Loan Pricing: The Basics Congress has demonstrated an ongoing interest in consumer credit markets. This In-Focus provides an overview of consumer lending markets, pricing, and legislative efforts designed to facilitate efficient credit allocation and pricing. Ccsw§ nmer KQredk Markets, Credit allows consumers to make purchases today rather than postpone them until some point in the future, thus avoiding the need to save sufficient amounts of funds to make payments in full. The consumer credit (loan) markets consist of multiple products with numerous market prices. Consumer credit may be in the form of mortgages, revolving credit cards, automobile loans, personal loans, and student loans. Consumers may obtain loans from depository institutions (i.e., banks and credit unions) and non-depository institutions (e.g., payday lenders, finance companies). Lenders generally underwrite loans, meaning that they evaluate loan applicants' credit risk by considering factors such as their income and repayment histories of past loans. (Some non-depository lenders, however, make higher-priced consumer loans without formal underwriting.) When a loan default occurs, the contract provisions negotiated by the lender and a third-party loan servicer (who collects payments from borrowers, administers disbursements to the lender and, if necessary, to escrow accounts, insurance providers, etc.), in conjunction with relevant laws, determine (1) whether the servicer can offer loss mitigation solutions and, if so, what types and with what limitations; and (2) when the servicer can begin the formal debt-collection process or initiate foreclosure and, if so, any rules that must be followed and allowable actions. Servicing rules are designed to minimize the costs to collect defaulted obligations, which are primarily borne by the lender. Lenders may attempt to recover debts by doing their own collecting or by hiring contractors to collect the debt on their behalf. The Fair Debt Collection Practices Act (FDCPA) of 1977 prohibits debt collectors from using abusive, unfair, or deceptive practice while collecting consumer debts. If, however, a lender decides to sell the debts outright, FDCPA may not apply to debt buyers. Because resolving defaults can be expensive, these potential costs are frequently priced into loans. Lender profits are principally generated from the difference between the loan price (interest rate charged to the borrower) and the costs incurred by the lender to acquire the funds that will be lent. A loan price may be separated into two components: the risk-adjusted base rate and the mark-up, discussed below. Te hcase Mk.e ad fisk,.d* ,usted B&sse at.e The determination of the price borrowers will pay for a loan typically begins with the determination of the risk-free base rate. Given that U.S. Treasuries have never defaulted (nor do they prepay), Treasury yields or rates are considered risk-free. Hence, the slope of the yield curve (shown in Figure 1) consists of the rates of return that lenders could receive by lending to the U.S. Treasury (i.e., purchasing U.S. Treasury bonds) at different maturities. Lenders require compensation from consumer loans to be at least as high as the risk-free lending rate; otherwise, they would simply purchase risk-free Treasuries. Consequently, the base rates for loans are generally set to comparable yield curve loan maturities. For example, the base rate of a 5-year consumer loan is likely to begin with the current rate of a 5- year U.S. Treasury rate. (The base rate for a 30-year mortgage loan, however, may begin with the 10-year Treasury rate because many mortgage loans are usually repaid or refinanced in 10 years.) Figure I. Upward-Sloping U.S. Treasury Yield Curve S........................................................................... ., ................ i . .. . . . . . .................................................j ................................ ..................................... _ ............................................ IMO WMO 6tM IYR 2R1 3YR SYR 7YR 10YR 20YR 30YR Next, the initial base rate is risk-adjusted to account for financial risks that are idiosyncratic to borrowers. Risk- based pricing is the practice of charging riskier borrowers higher rates to reflect their additional default (credit) risk. Higher-risk borrowers are likely to pay more for credit relative to lower-risk borrowers, but risk-based pricing may result in fewer credit denials and greater credit accessibility. In short, borrowers pay different prices for credit products, often because they pose varying levels of default risk. Lenders may also factor in the prepayment risk of borrowers, or the likelihood that a borrower pays off a loan ahead of schedule when market interest rates change. The markup above the risk-adjusted base rate consists of additional charges and fees that are generally unrelated to borrower financial risks. * Markups include loan origination costs, such as the costs to purchase credit reporting data and verify borrowers' identities, incomes, and employment. * Markups include ancillary costs, such as costs to cover loan servicing. gognpo g\mm , goo g , q 'S a X 11LULANJILiN,

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