New rate caps on military loans and proposed FDIC guidelines on small-dollar loans have forced a broader conversation about the large and growing demand for short-term credit and how to meet it responsibly.
Unfortunately, most of the discussion is focused on price, obscuring other important issues surrounding product structure and reducing banker interest in developing small-dollar products.
Enacted in October, the Talent Amendment was designed to halt payday lending near military bases by instituting a 36% annual percentage rate cap — including all fees — on loans to military members and their dependents.
In the wake of the legislation, the FDIC issued draft guidelines to encourage banks to offer payday alternatives as a business opportunity that would also earn Community Reinvestment Act credit. Among the guidelines was a recommended maximum rate of 36%, though with allowances for setup fees.
Not surprisingly, the conversation among bankers has centered on the profitability of these products in light of rate restrictions. However, while getting the price right for short-term credit is important, the biggest problem with traditional payday loans is the fact that they require repayment in full after two weeks.
According to the Center for Responsible Lending, 75% of payday borrowers roll over their loan at least once, because full repayment for a consumer living paycheck to paycheck is unrealistic. Multiple rollovers lead to a toxic cycle of debt for many consumers, at an ultimate cost that far outweighs the original loan amount.
Still, the debate has fixed on rates. Late last month, for instance, a study by a researcher at the Federal Reserve Bank of New York concluded that payday loan fees are not excessive and reflect high fixed costs and a lack of competition. That study did not analyze the effect of the loans' structure — only their price.
Bankers decry the triple-digit interest rates charged by payday lenders, only to have payday lenders point fingers back at bankers for overdraft fees that, depending on the circumstances, can result in even higher APRs.
For bankers considering whether to offer a payday alternative with a more consumer-friendly structure, the focus on APR raises concerns about reputational risk. Double-digit interest rates in excess of 36% can provoke community outrage, yet over the course of a few weeks what may seem like an overly high rate may generate a relatively small cost to the consumer.
Having a standard to judge the cost of short-term, small-dollar credit is critical for consumers. A better standard might be the total cost of the transaction, including interest and all fees, as a percentage of the loan amount.
For instance, an APR of 60% for a $500 loan repaid in 30 days costs the consumer only $25, or 5% of the loan amount. This is a better deal for the consumer than the average payday loan. Assuming a typical cost of $15 for every $100 borrowed, a $500 two-week payday loan would cost the consumer $75.
Likewise, the scenario seems reasonable when compared with a typical bounced-check fee of $17 to $35 for each check bounced, regardless of the face value.
The beauty of this standard is that it reflects the calculation a consumer might actually make in choosing from different options, and it simplifies comparisons between a short-term loan and a bounced check.
But to truly meet consumers' needs, it is critical that short-term loans be structured to release financial pressures rather than add to them. For instance, to ensure a consumer's ability to repay, loan amounts should bear a relationship to recurring income sources.
Repayment periods should stretch over at least two pay cycles, with provisions for longer-term repayment if needed. As an example, the state of Illinois created a 56-day repayment period with no additional interest charges for borrowers who have trouble repaying their payday loans.
Finally, the single most important thing banks can do break the debt spiral is to build mandatory savings features into short-term loan products. Imagine that every time a consumer took out a short-term loan, 5% of the proceeds were deposited in a dedicated account. At that rate, a consumer borrowing $500 each month would accumulate $300 by yearend, potentially reducing the need for future short-term borrowing in the first place.
It is heartening that the once-taboo topic of payday loans has been brought into the open. Let's not allow eye-popping APRs to divert the dialogue from important conversations about how bankers can help more consumers meet their short-term credit needs and ultimately move beyond them.
