Pricing Home Equity Loans

CU360
November 4, 2009 | COMMENTS

There's still is a lot of potential in home equity lending, which until recently grew at a hearty 15% annual pace and generated roughly 25% of profits at retail financial institutions. But a different market is unfolding in the wake of the housing downturn, with caution and selectivity replacing the former gold rush mentality.

One question, posed in the Bank Administration Institute's Banking Strategies magazine, is how to achieve acceptable levels of growth and risk-adjusted profitability in an era where the rules have changed. Within that context, many institutions are revisiting home equity pricing, or the internal decision process used to set market rates.

A recent survey by Novantas revealed these five major performance issues in home equity loan pricing:

1. Compensating for risk.
2. Measuring performance.
3. Calculating internal funding costs and required returns.
4. Responding to local market variations.
5. Providing adequate staffing and expertise.

Addressing these issues will help you fine-tune your strategy and help you realize your opportunity within your field of membership.

Tomorrow's leaders in home equity lending will use measurements of risk-adjusted profitability to set pricing floors, and harness calculations of price elasticity of demand to set market ceilings. In turn, these metrics will provide critical guidance in capturing margin and growth opportunities within select markets, risk tiers, and member segments.

Credit unions were charging an average of 4.7% on home equity lines of credit and 5.5% on first mortgages as of June 30, 2009, according to CUNA's economics and statistics department.

Risk-Adjusted Pricing

Many lenders have work to do in setting adequate risk-adjusted pricing floors. A top priority is to either introduce or fully cement risk-adjusted performance metrics, such as risk-adjusted return on capital. Underwriting and pricing models clearly need to be recalibrated, with improved analytics used to evaluate the current book of business and upgrade the origination process. Doing so will help detect risk/return imbalances within your portfolio and install adequate safeguards in the loan origination process.

Some of these safeguards include strategies to minimize so-called “adverse selection,” or an overload of subpar accounts. Overly low prices, for example, can turn balance growth into a self-defeating exercise by attracting a flood of high-risk credits. Conversely, overly high prices can put off the most creditworthy borrowers, tempting them to take their business elsewhere. Ultimately, a pricing strategy is needed for each major risk tier.

Risk-adjusted metrics are useful in portfolio evaluation and loan pricing, and also as an advance warning system. Some situations simply cannot be accurately or feasibly priced for risk and should be avoided altogether.

Performance Measurement

The three major applications of performance metrics in home equity lending are:

1. Line-of-business budgeting and planning.
2. Portfolio performance tracking.
3. Pricing.

Many institutions use a combination of metrics in these three interrelated areas. Despite a variety of metrics currently in use, many institutions still don't have a firm grasp of lifetime loan value on a risk-adjusted basis. Too many home equity lending decisions are being based on nominal short-term profitability.

Beyond setting risk pricing thresholds, each institution needs to develop a picture of economic returns that fully reflects the cost of capital. It's also helpful to anticipate balance usage and repayment risk over the expected life of the account, and incorporate those factors into up-front pricing. Too often, lenders fail to price to achieve adequate returns on accounts with high risk potential over the life of the borrowing cycle. This “hollow growth” is especially self-defeating in light of the up-front costs entailed in acquiring new account relationships.

Funding Costs

An important exercise in home equity lending is determining the full cost of providing credit, including funding, production, and required returns on equity. Such calculations often are beyond the purview of the home equity line of business but have a powerful bearing on its competitiveness and potential profitability.

The challenge starts with funds transfer pricing (FTP). Combining current market rate benchmarks with allowances for possible future volatility in rates and borrower behavior, FTP forms the foundation estimate of what it will cost your credit union to fund a loan.

While it might seem that competing institutions would often arrive at roughly the same estimates for FTP, the Novantas survey revealed a wide FTP dispersion on home equity loans and lines of credit among participants.

Learning to systematically vary prices by local market, risk tier, and consumer behavioral segment represents a significant near-term opportunity for many institutions. At a time when some players are sticking with shotgun-style pricing strategies, others are beginning to pick apart the market and target “sweet spots” for margin enhancement and/or balance formation.

The case for “granularity,” or detailed pricing variation, is underscored by Novantas research showing competitive pricing variations of 100 to 150 basis points within various markets. These skews demand attention from the many home equity lenders that continue to set a single rate structure for their geographic service footprint.

Staffing

The Novantas survey confirmed that home equity pricing teams are typically quite lean and, in fact, often a solo staffer carries the entire load. At larger institutions, the workload may be staggering—upwards of $20 billion of home equity loan balances per person. That's a stark contrast to the retail deposit or credit card lines of business, where robust staffs range up to dozens of people.

Given widespread shortfalls in staffing, governance, and expertise, home equity pricing models often lack sophistication and easily become stale. To move forward in this regard, leading institutions must begin with a deliberate approach to major pricing performance drivers, such as capabilities, processes, governance structures, and technology platforms.

Along with profound changes in borrower circumstances, property values, and the rate environment, the competitive landscape has been scrambled. Opportunities exist for those willing to learn how to tap remaining pockets of healthy growth in a market that remains unsettled overall.

Pricing represents one of the most immediate and powerful means of responding to these market forces in home equity lending. Each institution must identify where it stands in the continuum of competitive pricing capabilities, and then pinpoint the strategies and tactics that will contribute strongly to near- and mid-term performance improvement.