Topics | A Fundamental Need: Small-Dollar, Short-Term Credit
A dramatic series of events related to small-dollar value, short-term credit has unfolded over the last 18 months. Legislators, regulators, and the financial services industry have been closely scrutinizing the payday loan industry and creating market incentives for private-sector innovation. As a result, the landscape has changed.
Consumers have always needed small amounts of credit, although that need has been filled in different ways. In the United States, the market for short-term, small-dollar credit has a long history. As banks over time stepped away from these small-dollar loans in favor of credit cards and overdraft-type services, alternative providers arose to meet the demand. Evolving from personal finance companies, payday lenders had developed into the dominant source for such loans by the 1990s.
Consumers have paid a high toll for the rise of payday lenders. With fees generally ranging from $15 to $30 for every $100 borrowed and a repayment structure that can lead to frequent loan flips, a short-term loan can easily turn into a long-term problem. In response to the recent scrutiny, the FDIC has established guidelines and a pilot loan program to encourage banks to offer payday alternatives as a business opportunity that would also earn Community Reinvestment Act credits. The need for increased innovation will continue to grow as the regulatory environment makes it more difficult for payday lenders to operate.
Regardless, innovation has been growing within the financial services industry, laying a foundation for better service for this market niche, salary advance-type products, a downscaling of credit lines, and new installment loan products.
Salary-advance loan products are now available through several credit unions on both an individual and a cooperative basis. These products offer much of the utility of a payday loan but are more consumer friendly, with lower fees and sometimes with savings components. All of these offerings directly acknowledge the growth of payday loans and seek to provide a more valuable and economical service to their member consumers.
Along with credit unions, several banks have sought to answer this market demand by offering small lines of credit as well as salary advance-type products. These products are designed to provide access to short-term financing along with installment repayments. They are available in addition to current overdraft products. Some banks now offer advance products, charging borrowers $2 per $20 advanced, equivalent to an APR of 120 percent. Other providers have developed lower-dollar-limit line-of-credit products to address the same market need but for a slightly different customer. These services have expanded the options available to consumers.
The FDIC’s two-year Small-Dollar Pilot program is also examining best practices for banks offering small-dollar loans. With 30 banks participating, the program will review profitability, demand, and operations of a small-dollar loan product available through financial institutions. Significantly, the pilot is also testing the 36 percent APR interest rate cap and seeking to determine whether the economics of small-dollar loans are the same for large and small banks. Given their different infrastructures, underwriting models and related functions could present critical differences.
The influx of microlending to the United States recalls the time when credit approvals were largely interpersonal and manually underwritten. Some time will be needed to evaluate the success of these new underwriting processes. The ability to lend based upon a deep knowledge of a community and the borrower has proved critical to the success of micro-lending activities outside of the United States.
So what does it all mean? The use of payday lenders and related alternative financial outlets has shown that underbanked consumers frequently have difficulty obtaining cost-effective services for small-dollar value, short-term credit needs. To meet this consumer demand, a broader suite of such credit products are needed. These products will not succeed, however, unless they are developed and delivered in a way that is both fair to the consumer and profitable to the service provider.
From a product perspective, the subtleties of pricing and repayment are the critical elements of a successful small-dollar loan product. While the proper price point for these loans is not yet clear, it is obvious that to build demand, the products must be priced fairly, have effective and timely risk-management procedures, and be delivered cost effectively for the service provider and the consumer. They must also incorporate realistic repayment schedules so the consumer can establish a positive pathway to savings and away from debt. Only thus will a long-term relationship be established.
