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Letter To Lenders: Don’t Overlook Unsecured Lending

Mortgage loans are down, home equity loans and lines are up. In today’s consumer credit market, these are the products in the spotlight. But what about unsecured loans and lines of credit? In today’s lending market, they may be well worth considering. Among other advantages, they represent an effective cash-access borrowing alternative to cash-out refinances, which remain at historically low volumes.

Although fintechs have been making big inroads into the category (estimated to be around half the volume), traditional financial institutions have deposit data and lending expertise that can help reduce risk and drive profits.

From a borrower’s point of view, unsecured loans and lines of credit offer these advantages: no collateral required and therefore no risk of losing assets, quicker and easier access to funds and competitive rates for those with strong credit. If there’s a downside, it applies to those with lower credit scores. Besides having a harder time being approved, these borrowers will pay higher interest rates and be extended lower borrowing limits.

From a lender’s perspective, unsecured loans and lines of credit can provide high risk-adjusted returns, but credit risk can be a significant issue and competition from fintechs is intense. That said, access to deposit data can give financial institutions an edge over their fintech rivals.

A Growing Category

With $200 billion in outstanding balances, the unsecured lending market is already twice the amount of home equity installment loans, according to IMF+TransUnion and Curinos LendersBenchmark Analyzer data. And S&P Global Market Intelligence predicts a 13.4% compound annual growth rate (CAGR) for personal loans from 2022 to 2025 in the fintech space. That would put volumes in 2025 at three times those of 2020. This combination of size and growth highlights a formidable opportunity for unsecured lending that some lenders may do well to reconsider. (See Figure 1.)

Figure 1: Projected Annual Originations By Digital Lending Platforms Focus ($B)

Data compiled between 1/1/22 and 2/3/22. Projects current as of 2/2/22. Small and medium-sized enterprise-focused lender originations do not include Paycheck Protection Program loans. A = actual (includes estimates for certain companies); E = estimated; P = projected Source: S&P Global Market Intelligence; company-provided information and disclosures; DBRS Morningstar; S&P Global Ratings and KBRA Bond Ratings reports; proprietary estimates

Adding to the opportunity is the current relationship between personal savings and credit card debt: Consumers are saving less, spending more and paying higher interest. According to the latest data on personal income from the U.S. Bureau of Economic Analysis, the national personal savings rate sank to only 2.4% in November after having soared to 33.6% in March 2020. This can be attributed to inflation-driven spending that came on the heels of a steep drop in spending during the pandemic. At the same time, average credit card debt skyrocketed to $1.2 trillion by the end of 2022, up by more than $200 billion in only two years. (See Figure 2.) And the average interest rate shot up to 19.07% — the highest level since records were first kept in 1995. (See Figure 3.) Such an environment is fertile ground for debt consolidation and refinancing of high-interest credit card debt, the primary drivers of unsecured volume. 

Figure 2: U.S. Savings Rates vs. Credit Card Debt

Source: U.S. Bureau of Economic Analysis

Figure 3: Avg Credit Card Interest Rate

Source: U.S. Bureau of Economic Analysis

Okay, there’s significant upside, but what about credit risk? As the name indicates, unsecured means no
collateral required.

Studies show that unsecured credit risk is elevated primarily in the non-prime and lower income brackets, where it is even higher now than before the pandemic. It isn’t, however, a meaningful concern (for now) among prime and super-prime borrowers (FICO 660+), who represent about 70% of all originations. Overall portfolio delinquency rates are in the sub-4% range, similar to that of credit card and auto portfolios, and they are anticipated to rise only slightly in 2023. Historic lows in the U.S. unemployment rate, a proven indicator of delinquencies, is also adding to lender confidence.

Fintech Competition

Fintechs are making their mark in the unsecured market (also referred to as marketplace lending in the non-bank space, or MPL). Led by about 10 players, fintechs represent half the volume, even as they reject applicants at four times the rate of conventional lenders. Curinos attributes fintech success to three factors: backers’ return-on-investment requirements, frictionless applications and quick approvals and higher interest rates.

  1. Return on investment. To many institutional investors, unsecured lending is an asset class that offers high risk-adjusted returns, low correlation to other fixed-income investments and access to consumer or small-business credit. Rates of return typically exceed Treasuries, mortgage-backed securities, municipals and high-grade corporate debt. Furthermore, durations are far shorter. For those invested in the category, these advantages appear to outweigh their concern that an economic downturn could impede performance.
  2. Frictionless applications, quick approvals. Much of fintechs’ rapid success in unsecured lending can be directly tied to their accessibility. For a growing number of customers who seek unsecured loans, digital access, especially through mobile apps, is expected and preferred. Fintechs have made it easy to apply, but their real advantage over conventional lenders is what comes next: a quick answer and fast funding. For applicants who are approved, proceeds hit their account as early as the same day or the next day, compared with what can take several days to more than a week through a conventional lender. This is similar with some of the recent advancements in home equity, where fintechs are now offering seven-day cycle times compared with nearly two months for conventional lenders. (See “A Look at Home Equity” in this issue.)
  3. Higher lending rates. Fintechs reap the benefit of charging significantly higher unsecured rates – by about 250 basis points currently — than conventional lenders. This, in turn, is driving up rates across the category due to fintechs’ growing market share. That rate discrepancy may seem self-evident because of the added risk fintechs presumably are taking on, but (perhaps surprisingly) fintechs have expanded the low end of their credit box to only 30 points below their FI peers. This would indicate that fintechs are being rewarded in the marketplace less for their assumption of credit risk than for the convenience they bring to the lending experience.

How Banks Could Gain An Edge

Even though fintechs tend to reach lower into the credit box than most banks for unsecured lending and are rewarded for it in higher rates, banks have something most fintechs don’t: deposits. Information embedded in their deposit books can be predictive when applied to their credit underwriting. Correlations can be made between deposit levels and activity on the one hand and the probability of delinquencies and defaults on the other. Curinos research has found that applying deposit behavioral analytics can reduce the risk associated with a 660 credit score to a more creditworthy 740. (See Figure 4.) Fintechs that don’t have consumer deposits, on the other hand, need to rely on information reported by applicants, which can sometimes paint too rosy a picture and isn’t always verified.

Figure 4: Advanced Deposit Behaviors Discriminate Bad Rates within Traditional Score Bands

Source: Disguised client lending and deposit data, Curinos Analyses Bad definition: any instance of 90 days past due in first 24 months on book; Good: never more than 5 days past due in first 24 months on book

Unsecured Doesn't Have To Be Cyclical

With the specter of a possible recession looming, many providers may ask whether this is the time to accelerate participation in unsecured lending. Curinos reminds them that most unsecured borrowers are prime and super-prime credit risks and, as fintechs have shown, the market will pay elevated rates for accessibility, frictionless underwriting and fast decisions and funding.

In addition, while today’s high interest rates on credit cards provide a tailwind for unsecured lending, past rate cycles have revealed unsecured borrowing to be stubbornly acyclical. No matter what the rate environment, credit card rates have been, and are likely to remain, significantly higher than those of unsecured loans. And because the lion’s share of unsecured borrowing is for credit card debt consolidation, consumers are most likely to continue exercising this form of arbitrage in their personal finances.

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