Economic Development

Responsible Lending when Traditional Underwriting Doesn’t Work

For households facing financial volatility, the wrong kind of credit can drag them under. But it can also be a tool for building stability. How can we make loans for big-ticket items like vehicles both good for people and good for business?

The Hidden Lives of America’s Poor and Middle Class The Hidden Lives of America’s Poor and Middle Class This series explores how current programs and policies for helping families escape poverty, build stability, move up the ladder, and invest in the future need to change.

Research from the US Financial Diaries project illuminates the prevalence of volatile incomes and the problems they can cause. But volatile incomes aren’t all bad. Many households need lump sums for large purchases, and spikes in income can make pulling together that lump sum easier than slow and steady saving.

Many households get a large income spike during tax time—either from a tax refund or, for lower-income households, the Earned Income Tax Credit. Other research indicates that a large number of low-income households use this income to purchase things like appliances or to make a down payment on a vehicle.

Vehicles, in fact, are one of the most common purchases. It’s easy to overlook the importance of reliable transportation for a family trying to move out of poverty. A reliable car is especially important for lower-income families in rural America, where work, health care, childcare, and basic necessities such as healthy food are always miles away. Affordable, flexible, reliable transportation is often also the catalyst for getting a better-paying job, or simply earning more from a current one by working overtime, picking up extra hours at short notice, or taking a second shift. In the United States, areas with adequate public transportation to meet these needs are few and far between, making cars a vital tool for financial stability and upward mobility.

Car dealers and auto lenders know that people commonly use tax refunds to purchase vehicles, and they roll out the red carpet to attract buyers who may not have the necessary lump sum to purchase a vehicle any other time of the year. Of course, that makes lower-income households and households with volatile incomes vulnerable to poor decision-making. It’s human nature to struggle with making good decisions when you have a big income spike—that money doesn’t have to literally be in your pocket to start burning a hole. A purchase that would seem unaffordable any other time of the year can feel within reach. And making a decision about the right vehicle—in terms of quality, reliability, safety, and affordability—is difficult at any time.

Too often, low- and moderate-income households have limited options for acquiring a reliable, affordable vehicle (that lump sum from tax time isn’t enough to buy a quality vehicle outright) through conventional financing, and therefore they resort to predatory dealers and lenders. That means higher interest rates and fees, and a higher purchase cost—it’s expensive to be a poor car buyer. And if the vehicle breaks down, it adds to the expense and income volatility they are already struggling with.

We at Freedom First Credit Union set out to develop an automobile financing program specifically to address the challenges faced by these households, particularly because our service area includes a largely rural, five-county area around Roanoke, Va., with little to no access to public transportation.

In creating our program Responsible Rides, we balanced several competing design parameters:

1. Target lower-income households but make qualification realistic for them. To qualify for Responsible Rides, an applicant’s income cannot be more than 300 percent above the US poverty level for their family size (for example, $72,000 for a family of four). In general, they have to have a credit score no lower than 550 (the national average score is 687).  But if their credit score is below the minimum, we allow for compensating factors and give applicants a chance to explain why their credit score is below the minimum We also consider alternative ways of showing credit worthiness, such as a history of regular, prompt payment of bills.

When Paula Jones came to us, for example, her credit was in tatters. Jones made ends meet with two different nursing jobs, and had been struggling to get her finances in order after several years of caring for her aging parents before their deaths last year. She got behind on her own bills trying to keep up with those of her parents, and unpaid medical bills from a hospital stay for debilitating back spasms were the last straw. She wouldn’t normally have qualified for anything other than a sub-prime auto loan, but we got to know her and made a decision based on more than her credit score. It was clear from her attitude and hard work that she was credit-worthy. “[The program] just opened a door I didn’t know was there,” she said.

2. Make loans a stepping stone to greater financial stability for the borrower but also sound lending decisions for us. Of course, we don’t approve everyone. All participants must provide a hardship letter that explains their circumstances and describes why transportation is essential to their household. The household can’t have more than $1,500 in unpaid collections (excluding medical collections) or have filed for bankruptcy in the last 12 months. And they have to have worked for the same employer for the last 90 days.

A loan doesn’t end when the application is approved—that’s just the start. Most of these households will face a financial crisis during the average term of the loan—60 months. We want them to have the tools necessary to navigate through the next hardship, and we want them to know we will be there with them. Borrowers must complete a financial education counseling program, including one-on-one time with our certified financial advisor and group meetings. The topics covered include both traditional financial education—setting financial goals, creating spending plans, understanding credit scores, etc.—and less common topics like a one-hour class on vehicle maintenance and coaching on choosing auto insurance.

3. Trust borrowers but help them make good buying decisions. One of the main reasons Responsible Rides is successful is that we actively help borrowers choose a vehicle. Our program director helps applicants figure out what they need in a vehicle and what price they should expect to pay based on the local market. We make loans only for vehicles purchased from an approved dealership list that we’ve vetted to make sure our customers are treated well.

Since its inception, Responsible Rides has made $1.9 million in affordable loans and enabled 377 individuals to purchase a reliable vehicle. The average loan size is $10,500, the average rate is 13.85 percent, and our delinquency ratio at year-end last year was 3.12 percent.

But of course, households experiencing a high degree of income and expense volatility need more than just auto loans. We’ve also been experimenting with an alternative to payday loans in our community. Borrowers can get short-term credit to help them through a crisis, but their repayments include a savings deposit they can access only after they’ve repaid their loan. The idea is to create a new emergency savings fund to provide a cushion for weathering the next short-term cash crunch without resorting to credit at all. Based on the results, we’re expanding into a “payday consolidation” loan to help families who are caught in a recurring cycle of payday loans. We are hopeful these new programs will make as big of an impact on the lives of low- and middle-income households as Responsible Rides has. 

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COMMENTS

  • Harry Tucci's avatar

    BY Harry Tucci

    ON February 4, 2016 05:53 PM

    We need far more Credit Unions like yours!!!  I had banked with a local Credit Union and they made predatory sub-prime loans look like a joy compared to their Underwriting.  I found Wells Fargo far easier to deal with than a local Credit Union.

  • Great article, Dave. Thanks.
    Very interesting…

    Just wondering… you’re talking about buying reliable vehicles, which make sense naturally.
    What is your definition / criteria for a reliable car?
    Plus, how did you vet the approved dealerships that you work with?

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