Choosing a Source of Credit: The Cost of Credit Alternatives

Individual Credit Rating:

Always the financier should assess the repaying capacity of the customer before advancing money. To assess the credibility and repayment capacity of a customer several methods are made use of. Those methods which are used to assess the credit worthiness and repaying capacity of a customer are called consumer credit scoring methods or credit rating methods.

These methods provide standards for accepting or rejecting a customer and assess the credit worthiness of a customer. Some of the commonly used methods are Dunham Greenberg Formula, Specific Fixed Formula and Machinery Risk Formula. In India, the largest credit rating agency for individual consumer finance is Credit Bureau of Information India Ltd. (CBIL)

A. Dunham Greenberg Formula:

This method is based the customer’s i) Employment Record, ii) income level, iii) Financial Position, iv) Type of Security Offered and v) Past Payment Record. It gives more importance to the customer’s income level and past records. Under this method points are allotted to the various aspects/parameters of the customer. It is ranked out of a total of 100. An applicant scoring more than 70 points is considered as one with good credit standing.

The points allotted to various aspects are:

B. Specific Fixed Formula:

This method is another credit rating formula. It give emphasis to i) Age, ii) Gender, iii) Stability of Residence, iv) Occupation, v) Type of Industry, vi) Stability of Employment and vii) Assets of the Customer in assessing the credit worthiness of a customer. Specific scores are allotted to each of these parameters. The borrowers getting a score more than 3.5, is ranked as ‘excellent borrower’ and those getting more than 2.5 but less than 3.5 is ranked as ‘marginal borrower’.

The method of scoring is as follows:

C. Machinery Risk Formula:

This method is based upon the amount of down payment, monthly income and length of service. Basically this method is based upon the present financial position and future income earning capacity of the customer. Generally this method is used in government Departments to advance loans to its employees. The loan amount to be sanctioned is calculated using the following formula.

Loan amount = Down payment + (0.124 x monthly income) + (6.45 x length of service in months)

Cost Aspects of Consumer Finance:

Like any other mode of finance, consumer finance also has certain costs. Normally financiers charge interest for the capital, service charges for the services rendered and other charges. The financiers used to charge the customer for all the services rendered to the customer. Generally service charges will be collected as percentage of borrowings. Interest will be disclosed either on flat rate of interest or yearly declining balances rate, net interest rate, etc.

The effective rates of interest for consumer finance are higher than other modes of finance. This is because consumer finance is provided based on the integrity and credibility of the customer alone. As the banker is undertaking higher risk, a higher rate of interest is charged as a premium for the extra risk undertaken.

Interest comprises of risk free rate of interest for the capital and a premium for default in future payment of premium. In India there is no ceiling as to the maximum rate of interest. Financiers charge different rate of interest as per the policies and practices of their organization. On an average, in India, the effective rate of interest on consumer finance ranges from 20 percent to 30 percent.

Other charges include documentation fees, processing fees, management fees, examination fees, service charges, brokerage, collection costs etc. Moreover financiers used to take deposits/ guarantee as a precaution against possible default in payment of installments. Interest, service charges, other charges, security deposit, guarantee etc. makes consumer finance costlier. However because of the practical convenience and feasibility of schemes attracts more and more people to consumer credit schemes.

Consumer Credit Portfolio Management:

Consumer credit portfolio refers to the combination of various consumer credits granted by an organization. Consumer credits may be classified according to the tenure of repayment, amount of credit, type of customers, mode of credit, type of security offered, etc. The degree of risk and return varies in each case. The total of all consumer credit granted by an organization to various parties under various forms upon different terms and securities is called its consumer credit portfolio.

Like any other business, consumer financing is also a business set up to make profit. Thus profit maximization is its objective. The ultimate aim of portfolio management is to maximize profit. The portfolio must be perfect, balanced and well managed. The evaluation of the existing consumer credit portfolio, for its credibility, forms of credit, the amount of credit, the risk involved, and to make suggestions wherever necessary, so as to achieve the organizational objective can be termed as consumer credit portfolio management.

It shall not give much stress to any particular type of credit alone. It shall keep a balanced portfolio comprising of all types of credits. The tenure of the credits is to be closely watched. A prudential trade off shall be kept between secured and unsecured credits. Both have their own merits and demerits.

Secured credits are sure to get back but have lower rate return. Unsecured ones are risky but have higher return. The total credit to a single customer is to be checked frequently, as undue credit to one may land the customer in difficulty and thereby the financier as well. For assessing the credibility of the advances scientific tools may be used to analyze the credit worthiness of the customer.