CU Essentials

Make the Payout Ratio Work for Your Credit Union

Credit union leaders are constantly looking for tools or methods that will help them succeed in these challenging times. This article highlights the payout ratio and suggests how it may be useful in pricing deposits.

The term payout ratio was originally applied in the stock market as a measure of return to investors (dividend payout ratio). To calculate this ratio, the dollar amount of dividends paid to stockholders is divided by earnings for profits. The results are used by investors to determine the dividend strategy and expectations of the company.

Over the past three years we have modified the payout ratio for specific application in credit unions. The Interest Payout Ratio from TCT’s CostPro™ Suite is used to measure the percent of interest income that is paid to members in the form of interest on deposits.

This application is analogous to the debt-to-income ratio used in underwriting a loan application. As all lenders know, the debt-to-income ratio is a method of determining what size of monthly payment the borrower can afford to pay. In order to calculate the debt-to-income ratio, the borrower’s income and total payments for loans are totaled. The ratio is calculated by dividing total debt payments by total income. Credit unions put in policy the guidelines for maximum debt-to-income ratio that will be accepted for loans.

To help borrowers stay financially healthy, credit unions set limits on the amount of payments they are committed to make. This is done by setting maximum limits on debt-to-income for borrowers. A higher debt-to-income ratio indicates the borrower is getting overextended and is at a higher risk of delinquency and default.

For the CostPro payout ratio, a similar equation and calculation are made. Dividends paid on deposits make up the debt portion of this equation. Total interest income received from both loans and investments is the income portion. By dividing interest expense by interest income we determine what percentage of interest income is being paid to members on their deposits.

Using a stochastic model we can then determine the optimum payout ratio range for any credit union. The optimum current location in the range changes as the loan-to-share ratio changes. As the loan-to-share ratio increases, the location within the payout ratio range increases as well (up to the maximum of the range).

A higher payout ratio for a credit union indicates that management is keeping the cost of funds high and may not be keeping adequate earnings to build equity and reinvest in the credit union.

I will share more thoughts on the payout ratio, its history and applications in credit unions in subsequent articles.

If you would like more information on TCT's CostPro™ Product Suite, please visit www.tctconsult.com or contact your WesCorp Relationship Manager.