Default loans are a nightmare for every lender, but banks and fintechs can apply a few simple strategies to reduce missing payments once and for all.
According to recent Credit Benchmark estimates, credit default rates in the US are going up and are likely to continue rising, reaching an average 4% for Speculative Grade, and 2.5% for Leveraged Loans in Q2 2024. Such indicators are among the highest within the last dozen years.
As for retail loans, their default percentage typically ranges between 1% and 2% in most countries of the world. However, as the number of small-ticket consumer loans rises, so does the possibility of borrowers neglecting their smaller debts in favour of more significant payments.
Annually, all these defaults result in billions of dollars in missed payments. Moreover, when an organisation has an extraordinarily high level of defaulted loans, it affects its financial stability and bears reputational risks. Financial institutions and fintech lenders often don’t realise they can prevent loan defaults in many ways.
What Is Loan Default?
A default loan is one where a borrower doesn’t make the required monthly payments on the existing debt. It can occur on both secured debt, e.g. mortgage loans, and unsecured debt, e.g. credit cards or student loans. Loan defaults expose borrowers to legal claims and affect their credit history.
They are preceded by loan delinquencies. Although both terms broadly mean the same thing – missing payments – the delinquency doesn’t involve a penalty. Typically, lenders allow a certain grace period (several weeks or months) between the date a borrower misses the loan payment and the time when loans incur additional penalties and achieve ‘default’ status.
Financial institutions have to closely monitor their overall retail loan portfolio, including home loans, auto loans, credit cards, personal loans, etc.
What Can Cause Delinquencies and Defaults?
The main reasons why a borrower may miss a loan repayment are having no money, prioritising other financial needs, and facing difficulties with technology or a repayment schedule.
A typical household has more than one loan, so it is easy to forget when a repayment is due if you don’t use special tracking tools and apps. Moreover, sometimes certain payment methods fail. As they’re not always instant, a person may lack the visibility of the payment’s success. In this case, a second attempt often occurs too late.
Considering all the factors above, lenders can develop a range of payment-facilitating strategies.
Strategies to Reduce Loan Defaults
Once a borrower is close to default, the two sides of the deal can reach a certain agreement (work out an alternative payment plan that is suitable for both parties, develop a loan consolidation plan, etc.). However, a lot can be done before reaching this stage.
At the very first stage of loan origination, when a credit application is considered, typically institutions take into account standard credit scores. However, with modern artificial intelligence (AI) tools and the vast array of financial data available online, alternative credit scoring can be more precise and empowering. AI has great potential to identify patterns and trends within diverse datasets (like e-commerce shopping history, bill payments, credit history, etc). That enables more accurate predictions of credit risk.
Besides more precise estimates of credit risk, the use of AI automation tools for loan approval has a positive impact on the lender, diminishing the time and effort involved in origination, onboarding and underwriting.
Increased Payment Visibility
To be able to manage debts proactively, both creditors and borrowers need a clear overview of the credit status. Banks and fintechs should use a backend software that clearly shows not only missing payments but also attempted payments that have resulted in failure. That would help offer a client timely assistance if needed.
On the customer side, it is important that a banking app they use clearly shows complete credit details: how much they’ve already paid, the amount they still have to pay, the due date for each next payment, how many instalments are left to pay, etc.
Wise and Timely Nudges
Most banks and fintechs use certain reminders to alert their customers about upcoming debt payments. However, not all of them are effective enough. A recent UK Finance study revealed that the most efficient text for a payment nudge is the one appealing to social norms, e.g. ‘did you know eight out of 10 people pay their loans on time?’
At the same time, the impact of various message forms varies depending on the borrower’s income status. Thus, more affluent customers better respond to the moral obligation message stating that by paying on time you will have peace of mind. At the same time, people with lower socioeconomic status react more to financial contract reminders describing the financial implications of falling behind on payments.
These research results indicate that banks and fintechs can experiment with their payment reminders and customise them for different customer segments to reduce delinquencies and defaults. Besides, it is important to send reminders before the actual delinquency and use multiple communication channels.
Avoid Payment Failures
The payment methods you offer to your customers define the quality of your payment experience, and your customers’ ability and willingness to pay. When it comes to money collection, failed payments lead to bad debt. Make sure that you provide plenty of payment options with low failure rates. Estimate your average payment decline and failure rates. In case they are too high, add payment alternatives. If you deal with international borrowers, employ local processing methods that can significantly improve your payment success rate, reducing the risk of cross-border transaction failures.
Advice to Your Business Borrowers
Business loans constitute a large part of many lenders’ portfolios. However, many of them end up non-performing because of business failures. Due to the lack of business management knowledge, many small businesses suffer losses and cannot return the borrowed amount on time.
One of the ways to avoid that is to combine financial assistance with expertise. Banks and fintechs can help organise industry events and invite their own clients. Create a network of business professionals or have your in-house advisory team assist beginning entrepreneurs in managing their businesses and finances, including the loans you provide. Monitor your business loans to make sure they are utilised as agreed.
Make sure to post educational materials aimed at businesses on your organisation’s social media, dedicated websites and blogs. Improve your borrower’s access and awareness of this curated content by subscription to informative messages and resources.