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BankThink

Lenders have reason to encourage faster debt payoffs

When it comes to financing, not all mutually beneficial decisions are immediately obvious. Like this one: Lenders and banks should offer borrowers the option to pay down debt faster.

That statement probably set off more mental maydays for lenders than a five-alarm fire. But there are many reasons lenders should consider offering prepayment.

At present, most U.S. lenders collect on debt by issuing monthly statements, each directing borrowers to repay the same specific amount. The negative reinforcement is that borrowers who do not pay enter into default.

The unfortunate reality is that people’s income fluctuates sometimes due to a change in jobs, a layoff or a better opportunity comes along. And sometimes, consumers realize a positive windfall, like a big tax return or an unexpected bonus.

When times are bad, people can often turn to their lenders for help. But when times are good, people have financial slack and want to pay off debt faster. So we tested it.

Common Cents Lab teamed up with EarnUp — a financial services company that offers software for mortgage, auto and student loans — to learn more about borrowers’ debt repayment preferences.

In the experiment, 213 people were given the option to increase their monthly loan payments beyond the bank-stated amount. For example, if a bank typically asked them to pay $322 each month, people were given the option to round up their payment to $350. The results were impressive.

In the experiment, a whopping 64% of people chose the option to pay more than the required amount due.

If these results held true and were offered to all of EarnUp’s customers, then among those who chose to save, median savings was $16,327 in interest payments for the life of the loan. This results in two years saved off a 22-year loan.

Given how popular this option is and the fact that it’s good for customers’ financial health, all lenders should offer it, right? Not so.

Most lenders don’t ask consumers if they’d like to pay more than the monthly amount and pay more than their monthly payments. Some lenders have actually discouraged it through prepayment penalties that charge a fee if the borrower wants to pay the loan off early. This means there’s a huge latent demand for a product that lets consumers increase monthly loan payments.

Some lenders may think that meeting this demand is bad for business. After all, increasing monthly payments decreases loan duration and, ultimately, interest paid. But as with so much in life, the reality is far more complicated than it first appears.

Yes, faster debt repayment means reduced interest revenue. But dig a little deeper and one will find the pros for giving borrowers a greater say in their payments outweigh this con.

First, the faster a loan is paid off, the lower the likelihood of a default. Not only does this mitigate risk, but the lender now has borrowers who signaled they are likely to repay. This also means the lender can offer more loans at more competitive prices than the market would traditionally offer.

Second, offering borrowers the ability to optimize their debt payments will increase customer trust. If customers see a lender is making decisions that could go against the company’s financial interest, they may feel the lender is on their side.

This will help the lender stand out from the competition and reap valuable reputational benefits.

To understand just how important these benefits are, consider a study that showed eBay buyers were willing to pay a premium of 8.1% on top of the selling price if a seller has a good reputation. In other words, consumers are more likely to patronize with businesses they feel they can trust.

So for lenders looking to get ahead, make a product that gives people the option to pay down debt faster. Not only will it improve the financial well-being of customers, but it should earn fewer defaulted loans, greater customer loyalty and a sharp-competitive edge.

That pays dividends.

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