Within the financial sector, competition between the main players (MFIs-MFIs, Banks-MFIs, Banks-Banks) may sometimes lead to practices that can seriously harm clients in the long term. We have witnessed on our recent missions that financial institutions, in attempts to increase market share, promote services to attract customers away from the competition. One of these practices is through the promotion of “credit consolidation” services.
What is credit consolidation?
Credit consolidation is a process to convert one or more existing loans into a single loan. There are several terms for credit consolidation: consolidation loan, loan consolidation, debt consolidation, restructuring, consolidation, or refinancing. Loans targeted are often mortgages, consumer loans and credit card balances. To be eligible for consolidation, these loans must be in compliance with legal standards and other “qualifications” that vary, depending on the policies of the financial organisation.
Note that in the current competitive environment between MFIs and banks in Africa, the practice of loan consolidation may be less motivated by goal of offering an improvement of the customer’s repayment conditions, but rather to get capture a larger market share.
How does it work?
It is practiced by two distinct applications: the internal credit redemption and the external credit redemption:
- Internal credit consolidation: in this form, the loan officer offers the client a refinancing of their existing loan into a larger loan. Once the client agrees, the new loan is disbursed to him after netting out the balance of the original credit (this means that he does not receive the entire current loan but the difference over the balance of the previous loan). The transaction is effected within the institution.
- External credit consolidation: Similar to the internal credit consolidation, except that in this situation, the institution proposes to the potential customer to purchase the loan held at another financial institution in order to replace with a larger loan. The objective of the bank or MFI is to capture the customer’s commercial relationship away from its competitors.
In both these situations, the new consolidation loan is set up by the financial institution with monthly payments and interest rates that may be higher or lower that the original loan and with an extended repayment period. The financial institution will evaluate the income and third party guarantees that the borrower can provide. The criteria for approving a credit consolidation loan varies and takes into account the borrower’s family and personal situation, his solvency, his age, the quality of the property offered in guarantee, his payment history, as well as, the purpose of the funding.
What are the risks of over-indebtedness for the client?
Let us focus our analysis on the two principal risks: risks related to product design and internal processes.
- Risks related to product design: In some cases there are no restrictions placed on the products terms and conditions. Customers access the product or service as many times as they wish, with additional costs incurred each time.
- Risks related to internal processes: The loan officer is oftentimes is given the authority to approve whether the client is eligible for the facility without the need for further approval from an internal risk specialist. Thus, to improve the quality of his portfolio, the loan officer does not hesitate in offering the service to the customer. This practice could be likened to a general loan rescheduling undertaken as part of a risk assessment in order to improve the quality of the loan portfolio.
The immediate consequence is that the customer may find himself led into a spiral of debt based upon a monetary illusion. Indeed, the practice of “credit consolidation” increases the borrower’s repayment burden over time. The consolidation loan swaps short-term debt for a larger long-term debt. Clearly, the debt does not disappear, on the contrary, it increases with the increase in duration and the related additional expense.
In summary, the operation of credit consolidation in a financial institution, instead of offering a solution to relieve the debt burden of the customer, actually leads him to incur additional debt or to subsequent loan consolidations and inadvertently lead the client to over-indebtedness. The practice can be counter to social and financial responsibility.
It should be noted that an over-indebted customer is not necessarily a customer that will fall into a payment default, but rather may force a person to liquidate or sell his personal assets through informal channels in order to honor his contractual obligations. In other words, over-indebtedness can lead to a situation in which the client is cornered and finds himself or herself forced to make unacceptable sacrifices to repay his debt.
Some advice on how to best manage credit consolidation
- Ensure that the client is in a good financial position to honor the payment of the fixed monthly payment;
- Set up an internal system to better control the offering and servicing of this type of product or service. It is important to collect and maintain specific statistics on its consolidation loans, as well as limiting the number of loan consolidation opportunities for the same client;
- Sensitize the client on the consequences or risks involved in the refinancing transaction;
- Consider using credit consolidation only to lower the debt leverage of customers and not to burden them further through the offer of quick and easy cash.
Gilles Da Costa