High debt levels pose a risk for members trying to maintain a sound financial base. Financial institutions may experience increased greater loan losses, delinquencies and bankruptcies as members struggle to meet their financial obligations. Sam Gerdano, the Director of the American Bankruptcy Institute recently made the following prediction: "The number of Americans filing for consumer bankruptcy increased by nearly 40% in 2007 over 2006. The spike in 2007 presages an even higher number of filings this year as the heavy consumer debt load is made worse by the home mortgage crisis."
U.S. consumer bankruptcy filings increased 47.7 percent nationwide in April from the same period a year ago, according to the American Bankruptcy Institute. Credit unions are also seeing an increase – Q1 data shows that the number of members filing for bankruptcies increased 42% over the same period last year.
An important point for lenders to realize is that members in a financial bind will come to a lender for more money before they go under. Therefore, interviewers and underwriters should be on the lookout for members that are heading down bankruptcy's road. A number of years ago, I learned the three statistically validated early indicators of bankruptcy and this knowledge saved our credit union hundreds of thousands of dollars in potential loan losses (and it can do the same for you).
1. Escalating Debt
Simply put, this is how much debt a member is bringing on and how fast they are bringing the debt on. In order to measure escalating debt, you need to look at three things:
- The number of inquiries on a member's credit bureau report: Obviously, if a member is applying for new loans, their debt load is about to escalate. Remember to look carefully at the inquiries. If a member has 12 inquiries at auto finance companies over two weeks, consider it one inquiry (because they are just buying a car). But if they have 30 or 40 inquiries at every type of lender over a two-year period, that's a warning sign. According to www.myfico.com the average American has only one inquiry per year.
- The number of new loans with balances: I recommend that lenders go back 18 months and count new loans with balances. How many is too many? The answer is tied to a member's income. If the member makes $30,000 a year and they have five new loans in the last 18 months, it is way too many. They are not used to those loans and the payments will bury them.
- The number of total loans with balances : How many is too many? Again, that depends on income. A member that makes $120,000 a year can handle a lot of debt. If your member makes $40,000 a year and they have ten loans with balances, it is just too many.
2. Excessive Unsecured Debt
Considering the financial destruction a high interest rate credit card can cause, it is no surprise that excessive unsecured debt is a bankruptcy predictor. A member with an $8,000 credit card balance at 18% interest who pays the 2% minimum payment would take 47 years to pay off this debt. If it takes this long to pay off an $8000 balance, how long does it take to pay off $30,000 or $40,000 in credit card debt? And what happens if they are late one month or a credit score drops and suddenly their rate jumps to 24%?
The unsecured debt ratio (UDR) is calculated by dividing total unsecured balances by a member's annual gross income. For example:
UDR = $20,000 (unsecured balances) / $60,000 (annual gross income)
UDR = .33 or 33%
I include these loan balances in the unsecured balance figure (the numerator) above:
1. Credit card balances.
2. Signature loan and unsecured line-of-credit loan balances.
3. The “mystery” installment loans (the finance company loans that jump to 24% if not paid off during the introductory period.)
4. The new unsecured money I give the member today (signature loan or the advance on a credit card or line-of-credit loan - not the credit limit that I don't know if they will use).
I do not include any secured loans or student loans (government-backed student loans cannot be included in a bankruptcy filing ) in the unsecured balance total.
Once you have calculated this unsecured debt ratio, you can observe the following guidelines:
- An UDR < 20% : Generally speaking, the member should be able to handle this amount of unsecured debt.
- An UDR between 20% & 30%: Slow down & be careful. This doesn't mean you can't do a loan, but your preference would be secured or consider giving less unsecured money then what the member is asking for.
- An UDR > 30%: Danger! I'm not saying that all of these loans have to be denied, but this is a lot of unsecured debt. If you are going to approve a loan, it should be a secured loan.
3. Maxed-Out Revolving Lines
Interestingly, we learn that maxed-out revolving loans are a bankruptcy predictor from the FICO credit score. The Capacity component comprises 30% of the FICO score and is based on how much of the revolving loan limits are being utilized. If several revolving loans on a member's credit report are maxed-out, it is a very big red flag.
But this calculation doesn't consider balances. In other words, one member who has only 10% of revolving loan limits available can be in financial trouble (because they have $36,000 in card balances and $40,000 in limits); but another member with 10% revolving available may not be in financial trouble (they have $900 in balances and $1000 in limits).
What do You do Now?
Once you have been trained to look for bankruptcy predictors they will jump off the page at you as you review member credit reports. The three predictors often exist with A, B and C-paper members that have had years of perfect credit.
At many credit unions, up to half of all credit union charge-offs are caused by members that file for bankruptcy. When a member is applying for a loan and the three bankruptcy predictors exist, would you want to approve them for an unsecured loan? Probably not, although it does depend on the severity of the predictors.
You can never completely avoid bankruptcy - you can make a great loan today and bad things happen down the road to good loans and good people. But you do need to learn how to spot the obvious cases of members heading down bankruptcy's road.