The Student Loan Landscape
According to a recent Forbes article, student loan debt has more than tripled since 2004 totaling $1.52 trillion with the average student loan debt per borrower totaling $37,172. Some borrowers struggle with minimum salaries in an entry level position, if a job is available at all, in addition to car payments, credit card payments, and living expenses. The burden of both debt and living expenses force many to continue living with parents because these debts are greater than the money coming in, and it creates a disruption of major life events including getting married, buying a house, saving for retirement, and participating in the economy.
Some credit union members even have suggested that, in order to keep loans in deferment, they will enroll in 6-8 hours of college courses each semester or consider working abroad. If this sounds familiar in a member’s story during a loan interview, then we must question how this impacts the way loan officers and underwriters lend.
Nationally, the lending industry faces a student loan crisis and many consumers are facing their own financial crises as a result. Over 2.3 million borrowers owe over $100,000, and 10.7% of student loans are 90-days delinquent. Many credit unions are underestimating the impact of student loans and are moving forward with loan approvals as their protocols suggest. This practice has proven to be costly.
Credit unions must adjust when underwriting student loans. The laws of mathematics support this to be true; members can only pay off so much debt at one time. To improve current practices with student loans, credit unions need to adjust instruction and training for consumer loan underwriters and loan officers and ask the right questions during the loan interview. However, the biggest problem is that there is a lack of structure defining what to do. One CEO demanded, “We need more guidance to know how to approach this.”
Using the Right Ratio
For years, Lending Solutions Consulting (LSCI) has focused on a number of key ratios to help determine a member’s credit worthiness. These ratios include Debt to Income, Unsecured Debt to Annual Gross Income or AGI, Secured Debt to AGI, and Mortgage Debt to AGI. For those who have attended the University of Lending or use our HYLS Underwriting Guide, this information may sound familiar, but not every one of these applies to a student loan situation.
Some underwriters may argue that student loans should be included in the unsecured debt to AGI ratio. This is not recommended. While the purpose of the ratio is to identify a bankruptcy risk, student loans are in most cases non-dischargeable in bankruptcy. If it is included in the ratio, it distorts the bankruptcy risk analysis.
Student loans only impact the debt to income ratio. Consider this example: A member with a $50,000 AGI has $5,000 in dischargeable credit card debt and $20,000 in student loan debt. The unsecured debt to AGI ratio is 50% ($25,000 / $50,000 = 50%) including student loans. Any number over 25% indicates a bankruptcy threat; the higher the number the greater the threat. In this case, the true unsecured debt to AGI ratio is only 10% ($5,000 / $50,000 = 10%). This member is not a bankruptcy threat with only $5,000 of debt. This example shows why putting student loans in an unsecured loan ratio could be a false alarm and pollute the data; the data should speak for itself and indicates where levels of risk are to assist in making an informed decision.
LSCI instructs not to ignore student loans, and the amount of secured loans and unsecured loans need to be adjusted lower if the borrower has student loans. It is straightforward that borrowers will not be able to pay the same amount of signature loans and secured loans than if there are no student loans.
A Solution with Secured Loans
LSCI recommends using a Secured Debt Ratio or SDR (Secured loans / AGI) when underwriting loans. A good rule of thumb to make decisions by is to calculate 50-75% of AGI, 75% for seasoned A and B borrowers and 50% for those with C, D, E credit scores, new borrowers or those with student loans. Adding “those with student loans” to the 50% limit is new. It is most important to document in the loan notes why the CU will get repaid when exceeding this guidance. For example: “Approved to finance a car with a 65% SDR because the member only owes $3,500 in student loans and has no other unsecured debt.” This way the underwriter’s decision shows the compensating factor to exceed this guidance based on having no unsecured debt.
It is understood that most members will pay the credit union for their auto loans before they pay their student loans, especially if a car is needed to secure a good source of income. For this reason, it is essential to keep the auto loan within the recommended secured loan ratio where our member has a good chance to avoid delinquency and pay back the student loans.
A Solution with Unsecured Loans
Some may argue that student loans are not dischargeable in bankruptcy and therefore should not change the measure of a bankruptcy threat. Even though student loans are non-dischargeable, they are real and will create pressure on the borrower to get out of whatever debt they can. Our expertise has shown that a bankruptcy threat for a member without student loans may be 25% unsecured loans to AGI. A member may be a bankruptcy threat at 10 – 15% unsecured loans to AGI if you add enough student loans to their debt.
Most members can handle up to 25% of their AGI in unsecured debt. Once in the 25% range, members become a bankruptcy threat. If they can handle 25% of the AGI with no student loans, that number must be lowered when education loans are present. To make that adjustment, determine how much unsecured you would lend a member without education loans, then subtract half of the dollar amount of education loans from that amount. This is the adjusted amount to lend your member unsecured if they have education loans.
If the member has large amounts of education loans the above “how much to lend unsecured” calculation may be a very low or negative number. If this is the case, you can adjust the “amount to lend unsecured” to the greater of 5% of AGI or $5,000. Unsecured lending at this amount would not be considered a bankruptcy threat.
Note that the upside-down amount on secured loans is considered unsecured.
Example 1: Example 2:
AGI: $100,000 $60,000
FICO: 730 (A+) FICO 670 (B)
Education Loans: $60,000 $6,000
CU Unsecured Guidelines, % of AGI 25% 20%
1) Unsecured Guidelines in $ $25,000 $12,000
2) less 50% of Education Loans -$30,000 -$3,000
3) Subtotal (Line 1-2) -$5,000 $9,000
4) Floor amount (up to 5% of AGI or $5,000) $5,000 $5,000
5) The greater of line 3 or line 4 $5,000 $9,000
6) Less negative equity in secured loans -$0 -$2,000
7) Less other unsecured loans -$1,000 -$0
8) * Unsecured amount to lend (Line 5-6-7) $4,000 $7,000
*Only if you feel the CU will be repaid!*
Loan Interviews Make a Difference
Each loan situation is unique, and in our judgement-based business of lending, LSCI believes in relationship lending and getting to know the borrower during the interview process. The member’s story is essential to our decision-making process.
During the underwriter’s interview process, loan officers should ask questions to uncover the motivation for the loan while reviewing the credit report. Additional questions that pertain to the student loans are also essential. Some examples include:
- Are you currently making payments and what is your monthly payment?
- Have your loans come out of deferment?
- Have you considered consolidating your student loans?
As the student loan crisis persists in your credit union, consumer loan underwriters and loan officers need to learn more about how to adjust practices to better serve a credit union for the future. Having a solid understanding of the member’s current situation along with using the guidance on the ratios will help underwriters better assess the loan decision.
With 32 years experience in collections and lending, Bob Schroeder, CLE, Vice President and Consultant at Lending Solutions Consulting, works to improve the financial performance of client credit unions through the University of Lending and on-site consulting.
Bob can be contacted at 877.915.7675 or firstname.lastname@example.org