Making business loans to credit union members

While the fundamentals of business lending are similar to those for consumer lending, the skills, documentation, risks and payoffs are dramatically different. Many credit unions are expanding their business lending portfolios or are introducing business loans for the first time. The reasons are many. Some credit unions offer business loans to meet changing member demand. Other credit unions are looking to business lending as fertile ground to grow loans when consumer loan demand is slowing. Commercial lending is a trickier sea to navigate than consumer lending. For instance, the average consumer borrower can verify income with pay stubs. Typically, pay stubs represent a relatively stable source of income, though it may fluctuate depending on overtime, commissions, etc. Business income can fluctuate dramatically from season to season and from year to year. Further, while you rarely update a member's wage information after a consumer loan is made, a business lender needs to track a business all through the loan term to ensure that the borrower remains financially stable and maintains key ratios within agreed-upon ranges. Also, the loan amounts are usually larger than consumer loans, therefore the risk of loss looms greater. Lending to the self-employed can mean two different things. One of them most credit unions already do, the other, only a few, but growing number, get involved with. The first is making consumer loans to self-employed members. The second is making commercial loans to self-employed members. A consumer loan is for such things as a personal car or home mortgage. This is not a commercial loan, even though the income may come from self-employment, as it does not fit the NCUA definition of commercial lending. Even though it is not a commercial loan, some of the process of commercial lending is used; namely, reviewing, analyzing, and cashflowing the borrower's personal income tax return. Analyzing a tax return is a special skill, and few credit union lenders truly understand tax returns. Many simply take the Adjusted Gross Income (AGI) from the borrower's tax return and divide by twelve. By coincidence, this method is right sometimes. But even a broken clock is right twice a day. A tax return can contain hidden expenses, or include incomes that are not true cash flow. Fortunately, there are software products on the market to take the mystery out of this process such as our Lenders Tax Analyzer program or TaxFlow from Cotton, Parker, Johnson and Co. A commercial loan is one in which both: 1) the proceeds from the loan are used for business purposes, and 2) income to repay the loan is derived from business assets. When processing commercial loans, the regulations, though always cumbersome, are actually fewer than for consumer loans. One major regulation that doesn't cover commercial loans is Reg. Z, Truth-in-Lending. But that doesn't mean commercial lending is easier, it isn't. Commercial lending is much more difficult than consumer lending. Commercial lending requires a lender to understand financial statements, financial trend analysis, financial ratios and what they mean for the specific industry your borrower is in. Oddly, comparing a business to its industry peers is only marginally useful. As a credit union you understand that, as you are often compared to your peer credit unions and no two credit unions are alike. That is why trend analysis is so critical. It is most important to compare a business against itself over time and see if it is stable, improving or declining. Every lender knows the 5 C's of consumer lending. Commercial lending still comes down to the same 5 C's. One banking author likes instead to use the 4 P's of commercial lending. These are Purpose, Payment, Protection and People. Purpose means understanding what the proceeds will be used for, and does it really make sense. If the loan is to provide `working capital', but the business only needs working capital because the business spends more than it earns, that is not a good purpose. Payment is just the C of Capacity but, as usual, it is more complex with a business. The cash generated to repay the debt must be adequate, it must be available at the appropriate time, and it must last at least as long as the term of the loan. Protection is the secondary source of repayment. This is a guarantor or collateral that can repay the loan if the primary source of repayment fails. But the most important of all the P's is the People. As one veteran commercial lender once told me, "businesses don't pay you back, people do. So know the people". It seems that moving into commercial lending is a logical step for many credit unions. However, it is an area that requires different skills, knowledge and experience than consumer lending. It is important to plan and staff properly for commercial lending. With proper preparation and follow through, your credit union could become even more important to your members and more profitable.