Debt Consolidation in Credit Unions

When considering if debt consolidation would be beneficial for a credit union and its members, it’s useful to consider the approach taken by banks and other mainstream lenders in comparison to credit unions. A bank’s criteria may not stipulate a need for there to be a ‘benefit’ to their customers and in many instances there could be little or no long-term benefit for the customer when having taken out a loan for debt consolidation. Although relief may be provided in the short term, circumstances could worsen further down the line. Ethical lending is a major factor that motivates people to use credit unions and all lending should be based on a desire to ensure that practices within the credit union do not place members at a disadvantage. A strong underwriting policy can ensure that debt consolidation loans can consistently provide many benefits to members while minimising the financial risk posed to the credit union. If done right, debt consolidation can carry no more risk than other types of loan products, but what do we mean by benefits?

Benefits of debt consolidation

Members using high-cost credit (products carrying a high APR) may benefit from a DC loan where the rate offered by the credit union is lower than the rates applicable to outstanding debts and it could be that a member currently makes payments to multiple lenders, and it would feel more manageable if those debts were consolidated into one monthly payment. Not all credit being consolidated could have a higher rate than the loan being applied for in the CU but there could be an overall reduction in monthly payments coupled with a lower APR especially if high interest credit cards are being consolidated. Consolidating high interest credit cards also ensures an end date (fixed term) when the loan will be paid off and this could help to disrupt an ongoing negative lending cycle especially prevalent when credit cards are being relied on to service living expenses. For members experiencing difficulties managing credit cards, 0% balance transfer offers should be considered instead of taking out a debt consolidation loan as no additional interest charges will apply for a fixed period (usually 12 – 18 months).

Ideally, the overall total cost of debt/s being consolidated be reduced compared to the total cost of the new loan over the full term. A borrower may have short term, high interest rate debt, and their monthly repayments could be managed-down and made more affordable as well as (i) consolidating at a lower APR; (ii) consolidating and extending the repayment period over which existing debts would be repaid or (iii) a combination of both. It’s a balancing act between new interest rate and the new repayment period, because giving the borrower longer to repay (and therefore reducing the monthly repayments) also increases the total cost of the debt under the consolidation loan.

Benefit could be defined as:

• A reduction in overall monthly payment, which may or may not carry a higher rate of interest but impacts income and expenditure positively by making finances more manageable – reducing monthly outgoings thereby increasing disposable income.
• Reduction in the amount of interest paid each month.
• Peace of mind. One payment to make each month which will reduce some of the financial stress and worry by making finances more manageable.
• Convivence of Payroll deduction schemes – automatic payments made weekly / month.
• Repairing a credit profile and increasing the possibility of obtaining more competitive /  prime interest rates.
• Promoting financial stability. Saving while repaying a loan and potentially using the pot of money built up to pay the loan off when the balances align but also having the safety net of savings being available (unattached shares) if needed.

A valuable question is to ask how approving a DC loan will positively the members quality of life and factor in how personal circumstances may be affected as well as financial wellbeing. Debt consolidation isn’t a fix for all financial difficulties, but in some instances it may offer multiple benefits and significantly impact the home life especially where a limited disposable income is having a negative impact.

Risk v Reward

Obtaining credit, available limit, and the level of APR applicable are all dependent upon the condition of an individual’s credit profile – the APR offered is based upon the perceived level of risk involved. Although not all companies use the same credit reference agencies and not all credit reference agencies have the same reporting methods, in general, entries on a credit report that have a ‘settled’ status positively impact a credit report, positively impacting a credit score and therefore influencing the decision-making process. Settled accounts, and particularly those with a full history of payments being honoured on time, indicate that a consumer is financially responsible.

Debt consolidation usually frees up income as outgoings are reduced but an individual may be tempted to apply for further credit once their debts have been consolidated. Ultimately this is determined by how responsible an individual is where their finances are concerned. When taking out a new line of credit this can sometimes initially have a negative impact on the credit profile / score. Taking out several lines of credit over a brief period could negatively impact ability to obtain additional finance as a lender could perceive the applicant as credit hungry. Clarifying the reasons why a member has taken out sever al lines of credit over a short period of time (if applicable) can help determine if additional credit will be applied for in the near future. If an application is approved and then additional lines of credit are taken out the level of disposable income will reduce even further and this could affect a member’s ability to repay their loan, other debts and could negatively impact overall quality of life due to having a reduced level of disposable income.

Debt consolidation loans can carry an increased risk. One of those risks is that once a member’s loan is approved, they could enter an IVA, Trust Deed, DMP or Bankruptcy. There are several elements that can be employed to assess and reduce overall risk involved in approving a loan. A ‘triangle of assessment’ includes reviewing bank statements, assessing the credit report (and cross referencing those documents), and then interviewing the applicant – gathering as much information as possible and then deciding whether the level of risk involved warrants an application being approved and for the highest risk loans the APR should reflect the level of perceived risk of the loan ‘going bad.’

Most raw data required to assess an application will be contained in the credit report but reviewing the bank statement may highlight relevant information the credit report cannot provide but context is important: a high volume of cash withdrawals could indicate a gambling issue or substance misuse, but it might just mean that a member prefers to pay for living expenses in cash. Determining the risk posed by an applicant requires an overall assessment of the credit profile not just select elements where context is limited. In addition, it should be considered what level risk applies throughout the entire term of the loan. Some credit unions gauge risk based upon the loan amount being approved – the greater the loan amount, the higher the interest rate. Assessing risk based upon loan amount may not be as reliable as identifying the likelihood of an agreement being honoured throughout the entire term: is there evidence that the applicant has done this?

Risk Appetite

Risk appetite is a major factor in deciding whether debt consolidation is a desirable option and the reluctance to explore DC is understandable. A relaxed lending criteria can result in bad debt increasing and an important consideration is whether the income generated from additional lending would create sufficient income so that any potential increase in bad debt can be easily managed. This can be mitigated by ensuring a robust, unambiguous underwriting policy is in place that promotes consistent decision making by empowers staff to feel confident when assessing applications.

I & E

Ensuring a member’s income and expenditure is accurate is vital in protecting both the individual and the credit union over the term of the loan. Being able to afford the loan throughout the entire term should be one of the main priorities when processing an application and having access to information from all active bank accounts should be a standard part of the application process. If a member has several bank accounts but is only willing to provide a statement of the ‘main’ account, there is a risk that there are additional outgoings that will not be included on the I&E assessment and therefore the level of disposable income calculated could be inaccurate. Requesting additional information from a member may delay the application process or make it overly complicated but it’s well worth it. A credit union should request whatever information necessary (within reason) to ensure that the application is being processed in a thorough manner. It’s also possible that there are one or more outgoings that are not listed on either a credit report or bank statement such as making regular payments to a friend a family member because of personal debt and, in some instances, the only way this can be established is through conversation with the applicant, but this relies on the applicant being honest and open.

Calculating disposable income accurately and potential changes throughout the term of the loan became even more significant due to the Cost-of-Living-Crisis: uncertainty around fluctuating energy bill prices, rising mortgage rates and general living expense increases made assessing income and expenditure unreliable meaning the process had less certainty. The I&E process should be reviewed at regular intervals to ensure any potential risk is minimised. Applying a minimum level of disposable income (either percentage of income or fixed monetary value) could help in promoting greater confidence that the loan term is likely to be honoured.

Underwriting Policy & Loan Application Process 

A credit union can decline an application for any reason without the need to clarify with the applicant why the decision was made. It could be argued that debt consolidation loans should only be approved for people who are nowhere near the point of entering into an IVA or DRO, which could be determined from reviewing their credit report, cross-referencing with bank statements and discussing the application with the member. The reality is that most applicants want to consolidate finances because those debts are becoming unmanageable and there is a desire to reduce outgoings and free up disposable income. Of course, it won’t always be appropriate to approve a debt consolidation loan especially if an IVA / DRO etc. is a more appropriate option and it could be that after having considered all the information, there is a strong indication that the individual is likely to enter into one of those agreements after a DC loan is approved.

Part consolidation

Extreme caution should apply if a member wants to partially consolidate any of their finances because part consolidation leaves an outstanding percentage of the debt unsettled, the monthly payment remains the same, and it is unlikely that the payment/s will reduce. There will be an additional outgoing payment for the new loan which means a greater reduction in disposable income. An overall lower APR is positive but there should be a balance: does reducing an APR benefit a member significantly? In general, part consolidation isn’t practiced widely by financial institutions because of the risk involved. Debt consolidation should reduce financial the volume of debts and expenditure resulting in increased disposable income.

Changing Behaviours

When exploring the complexities involved in debt consolidation, it’s valuable to recognise the ability to recognise if there is a genuine desire to change harmful behaviors that compound negative cycles of lending. What are the underlying issues / reasons for continual debt accumulation? This may be easy to establish where there has been a loss of job etc., but can be more difficult to identify if there are, substance misuse problems, or addiction to gambling or shopping etc. There may be a reluctance from applicants to be honest about historical financial difficulties due to embarrassment or fear of being judged. Confidence in applying effective questioning models such as TEXAS or IDEA can be promoted by training staff so that they become empowered to apply those questioning methods effectively. Regulator training will also promote a greater understanding of the issues affecting behaviours that lead to negative lending cycles. Learning effective questioning techniques develops confidence dealing with individuals so that root causes of that behaviour can be identified. Signposting has always been vital in supporting members who are vulnerable.

To promote healthy financial planning and stability, an effective method could be to offer to clear some of the debts listed and make it a condition of the loan agreement that consolidation of other debts could not be considered after 6 months – 12 months have passed, at which time a review of their credit profile can be assessed and a new application for the additional debt can be made. This may encourage and empower the individual to adopt a more responsible approach to their finances. The main benefit of debt consolidation should be to ease the burden that debt carries, but ultimately it is the responsibility of the individual to ensure that they avoid slipping back into a negative cycle of lending by trying to change harmful behaviours.