Designing and building compliant credit products

How to take a new credit product you want to launch and build it in a compliant way. The product requirements need to translate to acceptable regulatory

Designing credit products is hard. It’s exponentially more complex to design credit products compared to debit products. This is because of all the different product variables and the regulations that apply to them. Complying with these additional regs requires a deep understanding.

Generally, fintech products like debit cards all work the same way. In most cases, regulatory framework doesn’t change for different debit products. They differentiate based on consumer experience. That’s it. There are fewer dials to optimize the product for a certain population. This allowed BaaS providers to offer the product through the banks.

But credit products are on the opposite spectrum. They have 10x degrees of freedom and different values for these variables completely change the regulatory requirements.

To design new credit products, it’s important to reframe products in fundamental variables. As you think of the product, you need to list all the variables and how they will work.

Let’s say you want to launch:

• a credit card with rewards - for high income people with limited credit history

• a new way to pay rent - advance for rent which borrowers pay over time

• a safe way to build credit - advance funds secured through cash and report repayments to credit bureaus

These are a few examples but startups are working on a lot of new and unique products. These products can only scale if they are compliant with regulations. To make sure products are compliant, you’ll need to map them to how regulations are written (and how these products are viewed).

When desigining a credit product, here’s a list of variables to think about (in no particular order):

Target market - Consumer or Commercial? Most of the detailes below apply to consumer credit.

Product type - is it closed end or open end?

A closed end product has a pre decided end date (it’s in the loan agreement). Closed end products are generally installment loans.

Open end products have no end date (similar to credit cards) and are generally revolving.

Revolving or amortizing - if the credit amount can be reused after repayments, it’s revolving

When amortizing, the loan balance reduces over time (highest at the beginning); once paid, the repayment can’t be used again e.g. personal loans, mortgages

You have to pick one of these, you can’t have both.

Amount range - Have a sense of the amount range you want to offer. Sometimes, different regulations apply for small or large amounts.

If it’s a line of credit, will the credit limit stay constant throughout or will it change? Frequently changing credit limits requires clear underwriting guidelines.

Repayment Term - what is the number of months for repayment and is this repayment term defined at the time of origination

Some companies don’t want to define this term upfront. This makes the product extremely tricky to design.

If the repayment term can change after origination, you need to be really clear how/when will it be changed.

Know that term changes can actually make the product feasible or infeasible (if the term is really short and you charge a fee, it can be akin to payday lending).

Repayment frequency/amount - daily, weekly, biweekly, monthly, one-time, etc

It’s important to define when and how much is the borrower expected to pay. Regulations apply differently to closed end and open end products.

For closed end products, it’s important to know the monthly payment at the time of origination.

Interest rate/APR - decide if you want to charge interest and if yes, what is the interest rate range you want; always annualize the interest rate.

Somtimes, we want to charge a one time fee and call it a 0% APR product. Doing this is a TILA violation. Make sure fees charged for access to credit are included in the annualized APR calculation.

Fees - do you want to charge fees and when do you want to charge it?

There are many types of fees - origination fee, subscription fee, late fee, NSF, tips, etc.

Fees such as origination fee and subscription need to be included in the APR calculation but late fee/NSF doesn’t need to be.

Autopay - required or optional? Do you require borrowers to sign up for autopay before giving them funds?

Different regulations apply depending on when and how Autopay is required.

Disbursal type - when and how much you want to disburse?

Sometimes we want to disburse the full amount but other times in stages. Depending on the product type, disbursal in stages may not be possible or regulatorily compliant.

Security type - is it secured by a physical item or cash?

Different regulations apply in each case. Whenever a loan is secured by property, it’s significantly more complicated.

Access to funds - when and how funds will be accessed; options - instantly, ACH transfer, WIRE, etc.

If we want to transfer funds to a merchant account, it needs to be clear in the promissory note.

Suite of products - is the credit product offered standalone or as a part of a suite - if offered as a part of suite, it needs additional considerations.

Because of the complexity of credit products, it’s important to make sure they comply with all applicable regulations.

Even simple details that may be considered not important can make a product infeasible from a regulatory point of view.

e.g.

Are you trying to charge a fee for each advance? It is close to the definition of a payday loan especially if it needs to be paid in a short period of time.

A general principle to use is “what if this fee were considered an APR” or “what is the equivalent APR of this fee”? Whether you want it or not, at some point a regulator may regard the fee as an APR.

There are many more similar questions that need to be answered to actually launch a credit product.

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Hope this is helpful when thinking about your next credit product.

Feel free to follow me or send me a note on Twitter @rohitdotmittal. I am always around for discussions.

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