Sawitree Pamee—Getty Images/EyeEm
By Tim Chen
June 6, 2018

For the 40% of Americans who don’t have the cash reserves to cover a $400 emergency expense, payday and other high-cost loans may be the only option when they face an unexpected cost. But these loans quickly drain consumers’ pocketbooks as interest rates balloon into the triple digits.

That’s why it was heartening last week when the Office of the Comptroller of the Currency proposed a solution for consumers who need an alternative to the high-cost lending trap.

The OCC called on the national banks and federal savings associations it regulates to begin making short-term, small-dollar installment loans. These loans, for $300 to $5,000, are now a $90 billion market. If banks follow the OCC’s advice, consumers could have new options with trustworthy lenders that allow them to pay their bills, build credit, and return to the road of financial solvency.

The high-cost, small-dollar loan market exploded in recent decades as income volatility rose and workers struggled to make ends meet. Payday lenders offer people a way to borrow small amounts, typically $300 to $1,000, for an average fee of $15 for each $100 borrowed. But the entire loan is supposed to be paid with the borrower’s next paycheck, and many people with fragile finances can’t cover the full amount. That leads many to borrow again and again, creating a debt trap that costs them dearly. According to The Pew Charitable Trusts, the average payday loan customer paid $520 in fees annually to repeatedly borrow $375. That’s not a good deal for consumers.

Lately, high-cost lenders have been switching to installment loans, which offer borrowers larger amounts and give them longer to repay. But these loans still carry triple-digit interest rates that can devastate consumers’ finances.

High-cost lenders say they must charge sky-high rates to cover the substantial cost of advertising and attracting customers and the considerable chances those customers will default, since many have damaged or nonexistent credit scores.

Banks, by contrast, have advantages that would allow them to offer such loans much more affordably.

The first advantage is low customer acquisition costs, since banks would be serving existing customers. In addition, these financial institutions have cheaper access to capital and already own the software—currently used for overdraft protection—to make such loans quickly and at low cost. Pew estimates banks and credit unions could profitably make a five-month, $375 loan for less than $100, or about one-sixth the cost that the average payday borrower incurs now.

In the past, a few banks experimented with offering customers “payday advance” loans, but those replicated some of the worst aspects of payday loans, including triple-digit effective interest rates and balloon payments that led borrowers into debt traps that were hard to escape. In 2013, the OCC cracked down on the banks and they stopped offering the loans.

Credit unions, meanwhile, experimented with more consumer-first “payday alternative loans.” These loans allow people who have been credit union members for at least one month to borrow $200 to $1,000 with repayment terms of one to six months. The success of that program led the National Credit Union Administration, which regulates credit unions, to propose expanding the program last week. The NCUA wants to raise borrowing limits to $2,000, give consumers up to 12 months to repay, and eliminate the minimum time period for membership.

The NCUA’s announcement came one day after the OCC’s new guidance. The OCC suggested banks allow repayment over two to 12 months and report payments to the credit bureaus to help borrowers build credit. That’s important, since many high-cost loans don’t offer that feature.

The regulators’ proposals are a much-needed start, but other safeguards are needed, including:

  • Affordable payments, limited to 5% of the borrower’s income
  • Interest rates that decline with loan size, with total costs that don’t exceed 50% of the loan amount
  • Loan payments that don’t trigger overdraft and non-sufficient funds fees, since such fees can add dramatically to the cost of small-dollar loans

Banks and credit unions also should offer financial education and an option to build savings with a portion of the payments, to reduce the future need to borrow.

Financial institutions can afford to do this because they’ll be building more creditworthy customers they can route into mainstream loans. High-cost lenders, by contrast, have no incentive to help consumers out of the vicious debt cycle.

 

The OCC and the NCUA, along with other regulators such as the Federal Reserve and the Federal Deposit Insurance Corp., must do more to incentivize financial institutions to offer these low-dollar loans while including enough guardrails to ensure they don’t become just another high-cost debt trap.

Financial institutions have an opportunity to do well by doing good in this space if they create truly consumer-first products rather than merely profitable ones.

Tim Chen is CEO and co-founder of NerdWallet and sits on the Consumer Advisory Board of the CFPB.

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