American Banker's Jeanine Skowronski recently posed an important question: Can the payday loan be reinvented?
According to the California Reinvestment Coalition, a consumer advocacy group, the current state of the payday loan industry makes this reinvention close to impossible, leading to the conclusion that payday lending should be scrapped altogether.
As the co-founders of a startup focused on alternative short-term lending, we respectfully disagree. Additionally, we think there are three main problems with the payday debate today that desperately need to be addressed.
First, arguing for regulation to ban a product used annually by 14 million people who collectively borrow $44 billion is simply counterproductive. Although banks have unparalleled legislative support designed to encourage the distribution of credit and create market liquidity, they have been unable to keep pace with consumer demand or service underbanked or subprime borrowers. The notable reluctance of traditional financial institutions to serve this segment, in the interest of avoiding risk, ignores the tremendous potential for good that can be done when this segment is served responsibly.
Payday lenders play a vital role in serving consumers with limited access to credit and no manageable path towards building credit scores. Typically barred from banks, credit unions and community development financial institutions, these customers are denied access to money they need for basic living expenses. People will continue to demand credit, and the more at risk they are, the more they need competitive options that are safe, friendly, and accessible. A ban on one of their only accessible alternatives will lead them directly into the arms of those who choose to defy our legal system.
Second, the debate condemning payday is centered on pricing instead of practices. The tension here needs to critically examine which alternative is better, a 36% annual percentage rate product loaded with fees that can accumulate exponentially and lead customers deep into debt, or a simple fee product that charges a fixed maximum of $30 and does not allow borrowers to accrue further debt.
We did our research and found that among customers and finance professionals alike, the use of APR is misleading while a flat fee structure leaves no room for confusion. Transparency is key in making sure that the consumer understands the terms of the loan from initiation until repayment and that their loan terms will not change without notice.
Lastly, the debate about payday loans and how they get customers into debt does not take into account the root of the problem, which is continued dependency on these high-interest loans for monthly survival, not just the occasional emergency expense.
Payday loans are part of a larger money management routine for most borrowers, so by rewarding good borrowing behavior we can add value to a process that otherwise keeps people trapped in debt. There are proven innovative and socially responsible approaches similar to Grameen Bank's model of Microcredit (whose founder Muhammad Yunus won the Nobel Peace Prize in 2006) in which a lender lends small amounts that increase over time. These approaches encourage regular interactions with borrowers, injecting credit education into the borrowing process. Borrowers can therefore demonstrate their financial responsibility over weeks, month or years, which earns them access to higher dollar loans (and in the case of LendUp, lower interest rates as well).
Businesses built using these types of socially responsible models can use lending to help members of our communities build their credit scores. These models allow us to turn a "predatory" product into a stepping stone towards building credit. The public benefits of higher credit scores extend far beyond access to lower interest financial products, as credit scores are becoming the de facto standard by which banks, landlords, employers, and even some dating sites profile their consumers.
The California Reinvestment Coalition argues that there are small tests, such as the Federal Deposit Insurance Corp. loan model, which have demonstrated some level of success. If these solutions were, in fact, so successful, why has not there not been massive adoption of this type of program? While we would applaud the proliferation of this model, the lack of adoption indicates that it either fails to truly solve the underlying customer need or is not actually sustainable for lenders.
The real solution is a complex one. We believe the three components that are necessary to recreate this industry are 1) regulation that more effectively aligns the interests of lenders and borrowers, 2) consumer education and outreach and 3) market-driven solutions.