Managing credit default risks in a rising-rate environment

Most bank customers have heard that the Fed raised interest rates a half percentage point in early May—and they may also know that rates will likely climb several more times this year.

Like everyone else, consumers are bombarded with varying opinions about how higher rates will affect them financially.

It’s too early to have much survey data on how consumers feel about the Fed’s May interest rate hike, which was the largest since 2000. And of course, whatever sentiments consumers are harboring now might change as rates increase throughout the year.

The Fed clearly signaled plans to raise interest rates at its remaining meetings this year. On April 13, Christopher Waller, a member of the Federal Reserve Board, said that he thought half-percentage-point increases—rather than the typical 25-basis-point jumps—would be justified.

Inflation jitters

Even in the midst of uncertainty, what is perfectly clear is that consumers are concerned about rising inflation, an economic reality that higher interest rates are intended to counteract. In a February 2022 survey by Bankrate, 93% of U.S. adults say they experienced price increases over the past year. Of those individuals, 74% say that the effects on their financial situation have been either somewhat or very negative. 

Economists also believe that inflation might be worse than expected. In fact, 53% of economists in Bankrate’s First-Quarter Economic Indicator poll for 2022 say that inflation will be even more significant than expected over the next 12 to 18 months.

Older Americans are more aware of the impact of inflation than their younger counterparts. In the Bankrate survey, 98% of Baby Boomers noticed higher prices in the past year, relative to 95% of Gen Xers, 89% of Millennials, and 83% of Gen Zers.

Fears about inflation are clearly justified—prices were 8.5% higher in March of 2022 than one year ago, the largest annual increase in inflation in more than 40 years. The rate of inflation picked up momentum in February and March, as energy prices soared because of Russia’s war against Ukraine.  

A variety of barometers

When interest rates rise, can credit delinquencies be far behind? Often, the two seem to go hand in hand.

While it’s far too early to project the effects of higher interest rates on credit card or other loan delinquencies, the potential exists given the mountains of credit-card debt out there. Consumer credit card balances rose to $856 billion in the fourth quarter of 2021, a $52 billion increase from the previous quarter and the largest quarterly jump that Lending Tree has seen in its 22-year history of publishing its credit-card debt statistics report. 

On the other hand, credit-card delinquencies last year were quite low—a situation that could change as interest rates start to rise. In 2021, the annual average delinquency rate was a mere 1.64%, and the charge-off rate, again annually, was 2.18%, according to the Federal Reserve.

Credit cards aren’t the only form of “loan” likely to see an increase in defaults as the year progresses. It’s possible that we’ll also see delinquencies in auto loans and home mortgages, as well.

In January 2022, home loan delinquencies were low; only 3.3% of home mortgages were in some state of delinquency. CoreLogic says that this delinquency rate represents a 2.3% decrease from January 2021.

And yet while home loan and personal loan defaults are likely to remain low for a while, the average amount that borrowers owe will increase. As debt levels climb, so does the risk that more consumers will decide their debt is no longer manageable—and just stop paying it back. While these types of loan delinquencies may be farther down the road, they’re still a real risk for bankers and a situation to monitor closely.

Preventing delinquencies

While rising interest rates present a wealth of opportunities for financial institutions, the threat of rising credit delinquencies may feel like the more compelling and immediate risk. That’s why some financial institutions are feeling the need to take steps to insulate their bottom lines from the risks of rising credit defaults. Here are five strategies to consider:

• Revisit your screening processes. If you haven’t already honed your account-screening process, now is the time to do so. The best way to avoid eventual credit delinquencies is to weed out those consumers at higher risk of falling into default before you finalize their loans.
• Help customers migrate high-interest debt into lower-interest products. Yes, lower interest means less money for the financial institution. However, consumers who feel overly burdened by high interest rates may be more likely to default. Consider using data modeling to identify customers who might benefit the most from rolling high-interest, credit card debt into lower-interest vehicles like HELOCs or personal loans. Many of the same consumers who carry credit card balances have open HELOCs with zero balances! Now is a great time to remind them that lower-cost credit is available to them.
• Get selective when marketing purchased mortgages. Look beyond basic triggers (or marketing signals) and seek additional qualifiers to help identify audiences who will not only be ready to buy but will be able to repay their loans over time, no matter which direction interest rates head. A combination of predictive modeling and information about data assets can help identify these optimum customers.
• Revisit how you screen auto loans. In the fourth quarter of 2021, 3.98% of US auto loans were delinquent by 90 days or more. With vehicle lending historically among the most default-prone types of consumer credit out there, now is a good time to improve how you screen borrowers. Are you, for instance, looking for triggers that indicate customers already have the wherewithal to repay an auto loan? Consumers with expiring leases, who need to take some action to secure a new vehicle or buy out their current lease, are particularly appealing because they have already demonstrated the responsibility and cash flow necessary to finance a vehicle.
• Look at the big picture. How might various scenarios affect your financial institution as a whole? A tool like Banker’s Dashboard allows you to input a variety of economic scenarios to see how each would affect your balance sheet.

A look ahead

As we move into a new interest-rate (and credit default) environment, it’s important to pay close attention to two key-risk management predictions:

1. The Fed says it’s likely to raise interest rates five more times before the end of 2022.
2. As the cost of consumer credit rises, so will the number of consumers who feel they can no longer afford to repay their debt.

Now is the time to consider all the ways that a rising-rate environment might lead to credit defaults and to a more precarious lending environment.