When compared to traditional consumer credit products, home improvement purpose consumer loan performance is declining. We think increased competition from emerging point-of-sale lenders may be contributing to this trend and is indicative of an expansionary phase in the consumer credit cycle.
Home improvement borrowers are migrating to digital lending: One survey indicated that roughly the same percentage of respondents would consider an unsecured consumer loan and HELOC / HEL to help pay for a home improvement project.
Purpose-focused originators are lending to these borrowers because they are relatively good credit risks: Lending Club (LC) home improvement purpose loans tend to prepay faster, are smaller in size, and attract borrowers with a slightly better credit profile than a comparative cohort, although they tend to charge-off at a slightly higher rate.
LC unsecured home improvement loan performance has diverged from that of traditional secured loans: In 2011-2012, the monthly charge-off rates for consumer loans was roughly equivalent to the deep delinquency rates of auto loans and HELOC’s and the default rate of bankcards. Since then, digitally-originated loan charge-off rates have increased while risk indicators for comparative products have trended down.
The lender specialization trend augurs well for credit markets. Differentiation in asset performance is a hallmark of the expansion phase of the credit cycle and may indicate a further market normalization as unsecured credit warrants a larger risk premium.
Introduction
It is no secret that digital lenders have made major inroads into lending markets in the last decade. In the next decade, we expect their reach to grow further into niche verticals including real estate-related products like home improvement loans. So here, we shine a light on the products consumers use to finance home improvement and pay special attention to digitally-originated consumer loans used for home improvement purposes. In this piece, we (1) recount the evolution of home improvement products, (2) describe the features and claim on assets of traditional and new products used for home improvement, (3) provide a performance comparison of Lending Club home improvement purpose loans to a consumer loan control set, and (4) discuss the LC loan set’s relative risk to more traditional products using Federal Reserve and S&P / Experian data.
When compared to traditional consumer credit products, home improvement purpose consumer loan performance is declining. In the past, these loans had a similar risk profile to HELOC’s and auto loans, but recently their charge-offs have risen on a relative basis. We think increased competition from emerging point-of-sale lenders, who can offer cheaper financing, due in part to a secured claim on property, may be contributing to this trend. Consumers already consider digital lenders and HELOC’s / HEL’s similarly when looking at financing options for home improvement[1]. And home improvement is the third most popular loan purpose for LC loans originated in 2016. With the cost of customer acquisition rising, it only makes sense that digital lenders partner with service providers to offer their products and satisfy consumer needs.
Going forward, the trend towards point of sale lenders may accelerate as further originator specialization occurs and new platforms pick-off desirable customers, like home improvement purpose borrowers. In fact, our analysis indicates that LC home improvement purpose loans tend to prepay faster, are smaller in size, and attract borrowers with a slightly better credit profile than
a comparative cohort, although they tend to charge-off at a slightly higher rate. For purpose-agnostic lenders like Lending Club, the specialization trend may be a net negative, but it augurs well for credit markets. Differentiation in asset performance is a hallmark of the expansion phase of the credit cycle and may indicate a further market normalization as unsecured credit warrants a larger risk premium.
A Look Back
After the 2008 financial crisis, heightened regulatory burdens and cost imbalances contributed to traditional lenders curtailing consumer lending activity. This was especially true for home equity lending products as issuers reeling from write-downs due to home value declines cut issuance. Home equity revolving balances outstanding fell from their peak of $714Bn in Q1 2009 to $472Bn in Q3 2016.
Sensing opportunity, digital lenders filled the consumer credit void and are now projected to generate over $10Bn of ABS issuance in 2017[2]. Digital lenders have proven that issuing consumer, small business, and student credit online is a desired service and a viable business model. Now, we see digital lending pushing into other complex, fragmented, or underserved credit markets, including real estate-related lending. In fact, digital lenders that specialize in underwriting mortgages (e.g. LendInvest), real estate-related lines of credit or financing (e.g. Patch of Land), and point-of-sale appliance (like HVAC units) purchase and installation loans (e.g. Financeit in Canada) have already emerged, and are growing rapidly.
Consumers Have Options
The home improvement financing products consumers use have changed before and after the financial crisis. Pre-crisis, borrowers used HELOC’s, home equity loans, and home improvement loans. Whereas post-crisis, those products were harder to obtain, so some homeowners used digitally-originated consumer loans instead. In fact, one survey indicated that roughly the same percentage of respondents would consider an unsecured consumer loan and HELOC / HEL to help pay for a home improvement project. Below we compare these products by first describing their structure.
Home Equity Line of Credit (HELOC’s): HELOC’s allow for a great deal of flexibility in structure. They are typically lines of credit, but can be structured as amortizing loans (with fixed rates, terms, and payments), or loans that require balloon payments at the end of a draw period. They are long-dated, with terms of 5 to 20 years and their size is dependent upon the home value and borrower equity. They are typically variable rate instruments and payments can be designed to be interest-only upfront. HELOC’s are secured by real property claims, even though they are typically non-recourse with respect to a borrower’s personal finances. They are generally subordinate to a mortgage in a bankruptcy and liquidation process. The interest paid on these loans are typically tax deductible for the borrower.
Home Equity loans (HEL’s): Home equity loans are less configurable than HELOC’s although they share many characteristics. Like HELOC’s, these loans are secured by a borrower’s home equity. Therefore, their size depends on the home value and equity amount. They are variable or fixed rate, typically 10-15 years in maturity, and subordinated to the primary mortgage holders claim. The interest paid is typically tax deductible. Unlike HELOC’s, these are typically amortizing installment loans, where borrowers make pre-determined monthly coupon payments.
Consumer installment loans used for home improvement: These loan’s structures are incrementally more rigid than HELOC’s and HEL’s. They have fixed interest rates, terms, and payments. They are generally short-dated (3-5 years in term). Unlike HELOC’s and HEL’s, consumer loans are typically unsecured. These loans are increasingly digitally originated.
Since the crisis, some digital issuers have carved out a niche in this product. For example, One Main Financial, Financeit, and Lightstream issue home improvement loans online, as well as point-of-sale channels.
Home improvement loans: Home improvement loans may have the least flexible structures of the bunch. These loans are issued for the express purpose of financing home improvement projects. The originator may require contractor estimates and home appraisals as inputs to the underwriting process. The originator may also hold back a portion of the loan disbursement until the project is completed or project milestones are reached. The loans typically are less than 7 years in term. Sometimes the loans are secured by liens on property, which are subordinate to the mortgage.
Further Discussion on Claims on Assets
A key difference between HELOC’s / HEL’s / home improvement loans and consumer installment loans used for home improvement is the relative claim on real property. As mentioned in the last section, HELOC’s and HEL’s are secured by the property value, while home improvement loans may be issued with a secondary property lien, which is a weaker claim.
On the other hand, consumer installment loans are effectively unsecured, although there are methods for recovery. Consumer loan originators have the option of filing a judicial lien on the borrower’s property. However, these liens are tenuous and can take years to litigate. Furthermore, they may be beneath other liens emanating from the same project. For example, if a homeowner stops paying his bills, and both a lender and contractor file liens on the property, then the lender’s claim may be subordinated to the contractor’s lien on the home improvement value.
In Canada, some loans used for home improvement purposes are on slightly firmer ground. The Personal Property Securities Act (PPSA) passed in 2012 defines the claims lenders can enforce on debtors.
To paraphrase, lenders can repossess fixtures used in the project, while other building materials embedded within the property can only be recovered through a mechanics lien registration and litigation[3]. For example, a lender can repossess lighting used in a project relatively quickly, whereas a loan used for structural support may require a forced sale to generate recoveries.
Home Improvement Loan Borrowers Are Desirable Customers
Based on our comparison, Lending Club home improvement purpose loans tend to have a higher credit quality and perform marginally better. Before delving into the conclusion further, we describe the data sets used. Both our home improvement and control sets contain loans where the borrowers are homeowners or mortgagers. The loan subset with home improvement as the purpose (HI loan sample) had over 56,000 loans or over $800MM in issuance. Conversely, the control set (non-HI loan sample) did not have a home improvement purpose and contained over half a million loans and over $8Bn in issuance. These two sets have a similar distribution of grades and annual vintages.
On average, LC loans with a home improvement purpose have marginally higher credit quality. Before 2014, LC home improvement borrowers had a median FICO score that was 8 and 15 points higher than the non-home improvement control set and auto-loan borrower scores. However, that difference has fallen for more recently issued loans. Meanwhile, the average LC home improvement loan borrower has a lower DTI over the entire sample set (roughly 3 points). In addition, LC loans used for home improvement are smaller in size (by ~$1,300) and carried lower interest costs for loans originated before 2014. Since then, the average interest cost difference has shrunk substantially, but both are generally cheaper than interest charged for loans on used cars. 
Performance-wise, LC loans used for home improvement tend to prepay faster, while maintaining a similar or slightly higher level of defaults. High grade (A thru D) home improvement loans prepay at a quicker pace and charge-off at slightly higher to similar charge-off levels. Meanwhile, lower quality (E thru G) three-year loans tend to prepay slower, but charge-off less than their non-home improvement cohort. Lower grade five-year home improvement loans tend to prepay faster and default at lower levels, but the sample size is small. 
When segmenting by vintage, the story is similar. Across vintages the home improvement loans prepay faster, but charge-off slightly more. The only outlier is five-year term, 2013-originated loans, which appear to charge-off at a lower rate after one-year of age.
More Originator Specialization and Fiercer Competition Ahead
LC home improvement loans have become riskier than comparative products with a secured claim on assets. However, this was not the case in 2011-2012, when the monthly charge-off rates for consumer loans was roughly equivalent to the deep (90+ days) delinquency rates of auto loans and HELOC’s and the default rate of bankcards. Since then digitally-originated loan charge-off rates have increased while risk indicators for comparative products have trended down.
Why this divergence in performance? We think an increased competition for desirable prime borrowers may be contributing to the change. Since Lending Club proved the marketplace business model, new platforms have created competition for desirable prime borrowers by reducing interest costs and mitigating losses through securing their claims on property and reducing customer acquisition costs by partnering with contractors at the point of sale. For example, Financeit allows contractors to refer customers to its loan program for minimal cost after project estimates. While some of the decline in the LC home improvement purpose loan borrower’s FICO score may be due to a secular trend lower as consumers levered up their balance sheets, much of it may be due to fiercer competition.
More broadly speaking, unsecured consumer loans underperforming secured loans is a healthy sign for credit markets, but a potential net negative for purpose-agnostic lenders. The fact that defaults were similar previously, may have been an anomaly and indicative of a repair phase in the credit cycle. The fanning out of performance may indicate that credit markets have healed and matured, and that new credit suppliers may be joining the fray. This may be good news for investors, who may anticipate a greater stratification of credit risk going forward, and borrowers, who may enjoy lower costs and more customized products.
Author
Aspire Fintech. Aspire enables Originators and Investors to better access, unlock and empower lending data. Aspire counts Marlette Funding, Progressa and Prosper among its data partners.
Contact Information
Aspire Financial Technologies Inc. 250 University Ave, Suite 231 Toronto, Ontario M3H 3E5
+1 647 317 7180
www.aspirefintech.com
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