Recently, American Banker's Jeanine Skowronski asked an important question that is on the mind of consumer advocates, borrowers, bankers, entrepreneurs and policymakers alike: Can the payday loan be reinvented?
As advocates opposed to payday loans, we have been worried about the new players that have been entering the payday lending market. From entrepreneurs to online lenders to big banks, payday lending seems to be the darling of profiteers as of late.
Traditional payday loans offered at corner stores can cost customers up to a 429% annual percentage rate on a two week loan, according to the State of California's Department of Corporations. Most borrowers need to take out another payday loan to pay off the last one, immediately landing them in a cycle of debt. A few banks offer direct deposit advance products that are structured exactly the same way as storefront payday loans, albeit at a slightly lower, but still triple digit APR.
Startups in this space are not changing the structure of these loans either. Rates listed on the website indicate LendUp, at its most affordable charges a 214.13% APR, meaning that the customer must pay back $294 for a 30 day loan of $250. Similarly, the most affordable Spotloan product requires that a customer pay back $52 every two weeks for eight months to pay off a $300 loan, for a grand total of $832.Yes, the cost to the consumer is lower than a storefront payday loan, but is that the standard we should be using?
Any short-term, high-cost, lump sum payment loan guarantees repeat business from borrowers because the populations who are using these products will not make back the income they need to pay them off in one pay period, or two, or three. In fact, most borrowers go through nine payday cycles before they can pay off one of these loans. Vulnerable populations are targeted, and they end up using these products because they have no other choice when faced with income shortfalls.
Skowronski's article details the ways new players are seeking to drive down the cost of payday products using big data. Why are there so many new players in this relatively outdated field? Because payday lending has become increasingly profitable for both storefront payday lenders and banks since the economic recession threw millions of more people into lower income strata.
The efforts from startups to drive down the costs of payday lending might be more effective in the long run, but it seems that there is another question underlying the one posed by Skowronski: How can the banking and financial services industry responsibly serve consumers who are living on small income margins?
No one can refute the legitimate need for small-dollar credit in low and moderate income communities across the country. There are already models out there. The Federal Deposit Insurance Corp. has already tested small-dollar loans under $2,500 lent at a maximum of a 36% APR and paid back over 90 days or more. These loans were found to be feasible for both borrowers and lenders, had a default risk similar to other types of unsecured credit and helped the lenders build and retain profitable, long-term relationships with consumers. The model can be and has been replicated on small scales across the country. As such, the question of what loan terms will work is moot. Instead, what remains to be seen is what loan terms lenders will agree to offer these consumers.
The bottom line is the underserved suffer from cash flow deficits that are a reflection of low wages and an ever increasing cost of living. The major socioeconomic factors contributing to these trends merit separate public policy approaches and regulatory changes that are not necessarily in the purview of the products offered by financial institutions. However, if these institutions are going to target this market and they want to do so responsibly, they need to provide small-dollar products that spread the cost of an income shortfall over a period of time and at an affordable cost of a 36% APR. The traditional payday loan structure should not be the standard by which innovation in this credit space is measured.
Liana Molina and Andrea Luquetta are with the California Reinvestment Coalition, a consumer advocacy group.