The Federal Reserve dropped interest rates to 0 percent to stimulate the economy during COVID-19. It’s a move last seen during the 2008 housing crisis after the economy collapsed due to poor lending standards and subprime mortgages.
Slashed interest rates might make you think now is a great time to borrow money. But banks are moving away from relaxed lending standards to avoid the risky COVID-19 economy. Take a look at this overview of how you can navigate tougher loan standards in 2020.
Why The Tougher Loan Standards?
In 2019, lenders toughened loan standards. According to the Federal Reserve’s survey of senior loan officers, borrowers won’t be approved at the same rate in 2020 because of stricter criteria.
Unfortunately, banks were making moves to raise loan standards well ahead of the start of COVID-19. The decision came from the fear that borrowers won’t have the financial stability to repay loans and that the value of the collateral could drop.
Collateral is important in reducing the risk of a loan. For example, if your home is collateral for your mortgage loan, this means the bank has something to take if you can’t repay the mortgage.
As long as the home is worth more than the mortgage loan, the bank has a chance of making up the loss if you default. If the home value drops below the amount of the loan, the bank loses money.
Banks aren’t willing to take on the risk of loaning money when they aren’t sure they can secure the loan using collateral. Credit cards are usually a form of unsecured debt which means there is no collateral given to the credit card company.
Instead, the credit card company has to trust that you’ll pay based on your income level and financial stability. If there’s worry consumers can’t repay the debt, credit card companies are less likely to issue new accounts.
What About Mortgage Lending Standards?
Borrowers who have good to excellent credit and collateral to offer on a loan won’t have a problem getting mortgage loans. For example, if you have cash in your emergency savings and a 750 credit score you’re more likely to be approved.
Lenders are most concerned about borrowers who are subprime. These are borrowers with a credit score below 620.
Subprime loans were one of the fastest-growing industries from 1994 to 2003 increasing at a rate of 25 percent each year. Lending standards were loosened after new regulations made it attractive for lenders to give subprime mortgage loans to people with low income.
After the Community Reinvestment Act of 1977, lenders had strong incentives in place to encourage them to offer subprime loans. These loans could be issued with higher interest rates and fees to make sure the loan was profitable.
Of course, the higher fees and interest rates didn’t help reduce risk enough. Borrowers with subprime loans on big-ticket items like mortgages helped topple the economy in 2008.
The federal government placed new regulations on how lenders could offer loans in the subprime market to prevent abusive practices. These limits make subprime mortgages less profitable and, therefore, less attractive to lenders.
What About Mortgage Refinancing?
Home values have been on the rise for the past decade. Studies show that the average homeowner has around $119,000 in equity. Usually, this could provide a major safety net in a financial emergency through a refinance.
But how do homeowners get access to their equity if mortgage lending standards are stricter? Do the new loan standards apply when refinancing?
The short answer: yes. COVID-19 brings fear of lending money on homes that might not sustain their value after the summer.
With so many Americans out of work, lenders fear a repeat of the 2008 housing collapse. For example, Bank of America recently raised its minimum credit score for approval from 660 to 720.
Banks hope to reduce the number of applicants looking to create a financial safety net using their home equity. Bank of America estimates that raising the minimum credit score will reduce applications by as much as 75 percent.
In these unsettling times, that’s helpful in a number of ways. Banks can reduce the exposure of its employees to COVID-19 by limiting their workloads and not become overloaded with loans that don’t have reliable collateral.
Are Tighter Lending Standards Fair?
The irony of the tighter loan standards is that it affects people who need the money most. People who fall on hard times have trouble making debt payments on time which causes their credit scores to drop.
Once their credit scores drop below a certain point, they’re less likely to get approved for a loan. In this current economic climate, layoffs are widespread.
Companies plan to furlough hundreds of thousands of employees while millions more are laid off. The snowball effect of losing a job and having no income to make debt payments will hit millions of American families in 2020.
Not having access to an emergency loan from a bank can be the difference in whether you lose your home in a year once forbearance periods are up. But from a lender’s perspective, federal programs that place a moratorium on foreclosures and evictions make giving out loans to anyone much riskier.
For example, even a high-income borrower can be laid off and eventually fall behind on mortgage payments on a $1,000,000 home. With no mortgage payments being made to the lender and no way to sell the home to make up for the loss, the lender loses twice.
Subprime mortgages offer twice as much risk to the lender because these are borrowers who are less likely to have other assets they can sell to keep up with bill payments. They are also less likely to have emergency savings or fully understand their debt recovery options.
The result is the lender having to take a loss to make up for the borrowers who won’t likely be able to repay the debt.
What Options Do Consumers Have?
All isn’t lost because of new loan standards. It’s still possible to get access to financial assistance even if you can’t get a new credit card or auto loans.
Borrowing money is actually one of the least helpful solutions when you’re in a financial emergency. If you need access to more cash, here are a few ways to instantly put money back in your savings.
Social distancing is a gift and a curse. On one hand, you don’t get to enjoy the same entertainment and social activities as before the lockdown.
Government curfews limit where you can go after hours and where you can travel on vacation. But you also have the opportunity to reduce your spending.
To create more money during the pandemic, cut your expenses down to the bare minimum. Get rid of subscriptions you don’t use or avoid takeout and cook at home.
The shelter in place order gives you much needed quiet time to assess your monthly budget and decide what expenses you can slash to put money back in your pocket every month.
Protect Your Income
State and federal loan programs emerged to help freelancers, business owners, and independent contractors protect their income. If you fall into one of these categories, don’t fret about losing clients because of the pandemic.
You may be eligible for the Paycheck Protection Program, a low-interest loan that gives you access to two years’ salary at a rate of 1 percent. This is a forgivable loan backed by the federal government instead of your personal or business collateral.
This makes it easier for banks to still loan money to people in need without taking on extra risk. Contact your business banker to get access to the Paycheck Protection Program loan application.
Mind Your Credit
Consumer credit scores are still being reported during this time. Don’t take advantage of unneeded relief programs like mortgage forbearance or waived credit card penalties if you can help it.
These programs are intended to provide emergency assistance and should be used with caution. Keep paying your debt down to improve your credit score over time.
With on-time payments and reduced credit card balances, you can emerge from COVID-19 with solid credit and access to the loans you need to secure your future.
Surviving the Financial Crisis
COVID-19 is creating fear in lenders that won’t end any time soon. Until the global economy stabilizes, the only thing you can control is how your payments are made with the income you have.
Tighter lending standards are a problem for those depending on debt to run a business. If you’re looking for a loan or credit card for personal reasons, now might not be the best time.
All industries are vulnerable to cutbacks that could mean reduced income or layoffs for employees. Buckle down and protect what you already have to avoid more debt.
For more information and personal finance tips, check our blog for updates.