An increasing number of Americans are turning to nontraditional credit sources for quick access to cash. Every year, an estimated 15 million people access small-dollar credit products to meet their financial needs. And tens of millions more rely on subprime credit cards, checking account overdrafts and other expensive forms of credit when their access to traditional credit is limited.
There is a critical market need for consumer-focused innovations to develop high-quality financial services that could help meet this demand for short-term liquidity without the risks posed by many small-dollar credit products. To date, however, high-quality innovation in this market has been limited by a lack of objective, data-driven research on consumers' experiences and points of view regarding existing products.
In response, the Center for Financial Services Innovation, with support from the Ford Foundation, has undertaken extensive consumer research to examine the needs, decisions, and experiences of small-dollar credit consumers.
Our report is intended to inform the development of high-quality credit products and other financial services that promote success and create opportunity for millions of small-dollar credit borrowers. The analysis shows that listening to their need for credit provides a meaningful framework to identify and classify these consumers in the marketplace. Many small-dollar credit consumers could benefit from financial management solutions and innovative approaches to help them better budget and save. Financial services that help consumers reduce cash flow shortages and help build emergency savings have great potential to address the underlying financial needs that drive many small-dollar credit consumers to use credit.
The analysis also suggests that a variety of safe, affordable, high-quality credit products are necessary to meet some of the need cases in the SDC market. There is no one-size-fits-all solution to consumer credit. Instead, the four need cases described in our report present opportunities to customize credit features and delivery channels to reach the various small-dollar-credit consumer submarkets.
Below we summarize our initial observations from the analysis of small-dollar credit borrowers' financial needs:
Unexpected expense borrowers. These consumers need infrequent but accessible loans of both large and small amounts for expenses related to an unexpected or emergency event, like a car repair. They may benefit from amortized installment loans with extended terms that facilitate repayment within their monthly budget.
Misaligned cash flow borrowers. Because of a misalignment of income and expenses, these borrowers frequently need access to small-dollar credit products to pay bills and meet regular household expenses. They may be better served through low-limit, open-ended credit lines that are both flexible and structured to support repayment.
Exceeding income borrowers. These consumers are the most financially at-risk, with expenses regularly exceeding their income. They also tend to be among the most frequent users of credit, accessing small amounts for everyday expenses. They reveal an industry-wide need for better underwriting practices and more comprehensive non-credit solutions, such as income supports, savings and financial management.
Planned purchase borrowers. These consumers rely on longer-term credit to finance larger loans for major purchases and asset building. They may benefit from products that support credit building and graduation to conventional credit sources.
The four need cases identified in this paper present a new way to explore the challenge of when and how to responsibly extend small-dollar credit. Notably, this analysis highlights an important role for better underwriting in the small-dollar credit industry. Cash flow shortages that drive credit use may be recurrent but short term, as with misaligned cash flow borrowers, or they may represent a longer-term, ongoing problem and indicate an exceeding income borrower.
Determining borrowers' ability to meet expenses and repay debt is crucial for identifying credit needs and who can successfully repay a loan, and is a critical underpinning of high-quality credit.
Identifying income shortfalls is challenging for small-dollar credit providers, especially in the very short-term credit marketplace, where both lenders and borrowers are motivated to make quick transactions. These realities point to the need for streamlined methods during the underwriting process to capture and analyze a borrower's recent financial history, including expenses and debt payments. While a challenge unto itself, better and more comprehensive underwriting can lead to more complete understanding of consumers, a solid foundation upon which to build new and better products and services that improve consumer outcomes.
Furthermore, the fact that consumers' financial lives change over time underscores that even the best underwriting practices are not sufficient to ensuring success for consumers and providers alike throughout the course of a loan. Small-dollar credit lenders that can accurately monitor the financial status of their borrowers in real time, and offer flexibility and helpful customer service in response to inevitable changes in borrowers' financial situations, will be best positioned to manage their own risk and prevent some of the more harmful consequences of credit use.
The small-dollar credit industry should continue to develop new consumer-focused products and related services, with an emphasis on serving consumers' financial needs and promoting their financial health. This research is intended to offer one new approach to achieving that goal through a closer examination of consumer needs.
Additional consumer research will be critical to better understand the demand for small-dollar credit as well as other aspects of consumer credit use, decision-making and outcomes. We believe that the challenge of how to responsibly extend small-dollar credit can be met, and it starts with knowing the needs of the borrower.
Nicholas Bianchi is a research analyst and Rob Levy is director of research at the Center for Financial Services Innovation. This post is excerpted from their paper "Know Your Borrower: The Four Need Cases of Small-Dollar Credit Consumers."