Payday Loans: Predatory Evil or Absolute Necessity: Debt, Banks and a New Policy Perspective

Dan Leibsohn

Community Development Finance

November 2019

Introduction

Pay day loans are very controversial.  On one hand, payday loans are reviled by many public officials, members of the clergy, policy makers, academics and researchers, analysts, journalists, advocates and others who have created a somewhat relentless attack on this financial service product over the last several years.

Payday loans and associated non-bank financial services are not popular products by the standard definition. Depending on which figures one uses, 3 percent to 5 percent of American consumers view payday lending or associated non-bank financial services like check cashing favorably.

That, according to Americans for Financial Reform, makes those products less popular among the average American than used car salesmen or Wall Street bankers. According to recent data from Pew Charitable Trusts, 70 percent of Americans want to see payday lending and non-banked consumer services reformed, and 80 percent believe they are too expensive as currently offered.  (“Everyone Hates Payday Lenders And Check Cashers (Except The People Who Use Them))”, By PYMNTS, June 27, 2017 .

At the same time, people who need access to the short term loans line up for them and eagerly try to obtain payday loans.  Some seem resentful about the rates but have little or no other alternative while others seem very happy or satisfied with these loans.  And of course, the payday lending industry is an active supporter of this product.

Lenders usually tout the supposed strengths of these loans: the high fees reflect the high costs and loss rates in making these loans; yet payday loan fees are often lower than other alternatives such as bank overdrafts; the actual loan structure offers an easy way to understand the loan; and the loans create a built-in incentive for lenders to lend responsibly as they want to be sure the loans are repaid.  Furthermore, they believe that if these loans are outlawed, people needing to gain access to needed capital will face a much more difficult time, as the remaining sources are not adequate to allow effective access to funds.

On the other hand, critics contend that the interest rates charged are very high and predatory. They believe that the loans are too expensive and are designed to trap borrowers in a debt spiral since the loans require a balloon or bullet repayment in an extremely short time period that is unrealistic.  Further, they believe that the loans are not underwritten for affordability for the borrower and are allotted to people who either renew the loan or are forced to default in this short time period because of their inadequate income.  Finally, they are concerned that the lender also has access to the borrower’s bank account and is able to obtain repayment before other bills that need to be repaid and which might result in unpaid debts or bills for these other matters.  In addition, this account access can lead to further costs through overdrafts charged to their accounts.  In total, this structure helps to trap the borrower in a never-ending debt spiral.

Our nonprofit organization, Community Development Finance (CDF), has had experience with these and other types of loans.  CDF opened the only nonprofit check cashing store in the country in Oakland, CA in 2009; we offer much lower prices, financial coaching and financial literacy training, and policy perspectives along with check cashing and other financial services typically found in other check cashing stores.  In recent years, we have become mostly a lender and financial coach/financial literacy trainer; and we focus on finding solutions to these issues.

CDF also operates two personal lending programs for the underbanked, targeting very low and low income people with credit scores mostly between 400 and 600, a population with great need for access to capital and which most traditional financial institutions are unable to serve – especially at scale.  We have tried to develop alternatives to the predatory services which now dominate the market.  We use the payday loan structure for smaller loan amounts up to $300, but we charge much less – a maximum of half the market rate and a lower rate for many others who need a lower one.  We also use the payday loan structure for our Emergency Loan which offers a 12% APR for borrowers in our financial coaching program to save money to repay other payday loans or other small debts.  We try to talk people out of these loans by recommending that they stop altogether or take smaller loans or less frequent loans.  We limit the amount of the loan based on income, financial condition and the source of takeout.  And we also use our larger consumer installment loans to take out other payday loans.  We work closely with borrowers who have had problems making repayment.

We have had a lot of success with these methods in assisting people to lower their costs, or avoid or reduce their reliance on these loans.  In total, we have made payday 7,283 loans for $1,869,811 through September 2019.  We also underwrite the loans and our loss rate is 0.65%, although the delinquency rate usually is much higher.

We also offer larger, longer-term, lower-interest rate, unsecured personal loans through consumer installment loans.  Overall, we have made or been responsible for making a total of 320 consumer loans totaling $1,048,311 through September 2019.  Our loss rate on our own 230 loans is about 1.3%.  In total, we have made or been responsible for $2,918,122 in payday and consumer loans combined.

What is a Payday Loan?

A payday loan is a short-term loan usually obtained at a check cashing or payday loan store or online.  It usually is due at the time of the borrower’s next paycheck – roughly two weeks – or within 31 days, maximum, which is the case in California according to state law.  It is secured by the borrower’s post-dated check (on the pay day date or the date when other payments – e.g. pension, disability, Social Security – are received).  The fee is a specific dollar amount taken out of each $100 borrowed: $15 fee per $100 borrowed is a common one although there are higher amounts in some states.

In this example, the borrower would receive a loan less the fee but would owe the entire amount including the fee at payday.  So an applicant would borrow $300 – and receive $255 but owe $300 in two weeks or 31 days in California.  If the borrower cannot repay, the loan is renewed with the same fee and extended for another short term.  It is in this manner that a borrower becomes trapped and, in many cases, requires a long period of time to repay the loan.

Payday loans are regulated by each state, so there can be a lot of variation in the loan structure.  As noted above, payday loans usually are due in full in two weeks based on the date of pay from employers or up to 31 days if the payment is monthly in California.  The loan term usually cannot be longer except in a handful of states.  The payments generally are balloon payments with the full loan amount due within the short loan term.  In addition, the loan amount typically is capped – in California, the cap is $300; it is $500 in Virginia, Florida, Iowa, Missouri, Kentucky and several other states; and other cap amounts exist in other states.  Illinois and Texas appear to allow loans up to $1,000.  The state law variations result in some loans with repayment terms in installments of 90 to 180 days or more.  Although called payday loans, these usually are closer to installment loans and have a completely different loan structure although they also may charge very high rates.  Overall, 31 states allow some form of high-rate payday loan.  Other states prohibit them or cap the rates at much lower levels.  (Consumer Federation of America, paydayloaninfo.org/state-information).  Rates also can vary: the average is near 400% but can go as high as 700%.  (“This map shows the states where payday loans charge nearly 700 percent interest”, Megan Leonhardt, Aug 3 2018, cnbc.com.)

It also is very important to recognize that these issues are not at all new.  Anne Fleming writes in City of Debtors that these issues have been around in U.S. cities since the 1890’s.  Variations of these present-day loans and their terms, similar legal arguments, similar political positions and organizations (reformers and industry representatives), similar anti-lender movements – all have been around in some form since the early years of the twentieth century.  At that time, the country’s urbanization left workers without adequate income to pay all their expenses and at the mercy of high-cost lenders.  It is very similar to today when so many people struggle to pay bills even with multiple jobs that don’t pay much and are forced to use the services of predatory financial institutions.  Also, there is a very strong anti-payday loan narrative today that is similar to movements in earlier years.  So even today, these two approaches dominate the dialog, although neither is achieving much progress toward finding a better product after all this time.

This history indicates a very complex set of issues that exists behind these arguments. Urbanization, industrialization and now, the transformation to service sector jobs (with another transformation to an artificial intelligence/robotics economy looming) has continued to leave many people out of the economic mainstream and force them into an often daily struggle to survive financially.  Other financial institutions – those in the banking mainstream which could offer great assistance – have continued to avoid reaching out to them as customers on any scale throughout most of this time period.  And this condition exists not just in the U.S. but in many other countries around the world as well.  The present time may be different though as the same issues now are spreading to the middle class.  (“America’s Middle Class Is Addicted to a New Kind of Credit”, Christopher Maloney and Adam Tempkin, Bloomberg, October 29, 2019; “The Maybe-Dubious Rise of the Loans-for-Sneaker Business” GQ, Cam Wolf, October 9, 2019.)

So alternative financial services institutions have been created in place of banks to offer financial services.  Today, much of the external focus has been on two of these providers of key financial services: payday lenders and check cashers.  They appear to be thought of as aberrant bad actors that should be eliminated as lawful business entities or regulated into being better actors.  However, the issues extend far beyond two or a limited number of financial services.

Debt and Dual Financial Economy

The causes of poverty are complex and deep rooted – inadequate health care and education, discrimination, public policies of all kinds, an economic structure generating massive inequality, an inadequate safety net, unequal tax policies, lack of child care, unequal access to political decision making, etc. – and all are part of the issues that lead to greater or lesser poverty, mobility, asset building and success in today’s economy.

While these other factors are obviously crucial, our focus remains on financial services as one of the key hinge points to work with to create meaningful change.  We therefore view the payday loan issue in this historical and economic context and see it as part of a much wider set of issues encapsulated by the overall issue of high debt that faces low and very low income households especially those who are unbanked and underbanked and who have bad credit.  Low and very low income households often face severe debt issues; while payday loans are problematic, there are many other sources of debt – both predatory and non-predatory – that are much more burdensome cumulatively and can be added to the focus of policy and programmatic efforts.

We believe that payday lenders and check cashers are part of a much larger institutional framework of financial services that serves low income people, including pawn shops – there probably are 50% more pawn borrowers than payday loan borrowers and pawn shops can be very damaging in states that don’t regulate them; rent-to-own (RTO) stores; subprime credit cards; installment loans; car title loans; Refund Anticipation Loans; remittances; subprime mortgage lenders; etc.  We call this a Dual Financial Economy because this set of financial services can trap low income people into financial circumstances that, together, make it much more difficult for them to escape poverty.  It is not just payday loans that create debt traps for people; it is many of these other financial services that all work at the same time to trap people in high levels of debt and create a much deeper problem.  And it is this entire system that needs to be addressed.  (“Analysis of Business Models and Financial Feasibility of Fringe Banking Institutions”, Daniel M. Leibsohn, Southern New Hampshire University Press, 2005.)

Beyond these institutions, there are other key debt issues facing low income households which, like medical debt, are non-loan sources of debt: bank overdrafts, state and local government fines and fees in addition to unpaid bills, mostly utility and phone bills.  Solutions need to be found for all of these debt sources.  (Consumer Debt: A Primer, Aspen Institute (EPIC), March 26, 2018.)  Other, typically non-predatory debt sources also exist that can plague low income households such as credit card debt, collections, auto loans, etc.

We now are living in a time of massive personal debt for most U.S. households.  The U.S. set new records for mortgage debt in the last decade; this debt remained high and just surpassed the previous record of over a decade ago.  (“U.S. Mortgage Debt Hits Record, Eclipsing 2008 Peak”, By Harriet Torry, Wall Street Journal, Aug. 13, 2019.)  At the same time, auto loans and student loans have reached new highs and credit cards and other revolving credit have reached their second highest level.  (“The State of the American Debt Slaves, Q2 2019”, Wolf Richter, Aug 7, 2019 and “The State of American Debt Slaves, Q3 2019, November 8, 2019; “Consumer Debt: A Primer”, Aspen Institute (EPIC), March 26, 2018; “The Complex Story of American Debt: Liabilities in family balance sheets”, PEW Foundation, July 2015; “The Savings Crisis and the Need for Holistic Solutions”, Prosperity Now, 2019; “Tackling Debt: Closing the Racial Wealth Gap is Imperative”, Karen Murrell, Asset Funders Network, 2019; “Lifting the Weight: Solving The Consumer Debt Crisis For Families, Communities & Future Generations”, Aspen Institute, 2019; “The Finance 202: Personal loans are surging. That’s an economic red flag.”, Tory Newmyer, Washington Post, November 22, 2019; “Personal loans are ‘growing like a weed,’ a potential warning sign for the U.S. economy”, Heather Long, Washington Post, November 21, 2019.)

And income growth does not appear to be matching the increases in debt.  For households with high enough incomes, the increased debt may be manageable.  However, for low income people, these debt increases can be much more burdensome, and even crushing as they try to keep up with debt growth with level incomes that prohibit any real effort at savings.  As a result:

Just 35% of Americans have enough savings to cover three months’ expenses, and 28% have no emergency savings at all. Additionally, 39 million U.S. adults have been carrying credit card debt for at least two years, and another 8 million can’t recall how long they’ve been in debt. A quarter of debtors expect to die in debt. All of this despite an extraordinarily low unemployment rate of 3.7%. I fear what could happen to credit card debtors if that rises to 5%, 6% or 7%, let alone the 10% we saw in 2009.  (“The next recession could crush many with credit card debt”, Ted Rossman, CreditCards.com, September 18, 2019.)

Others indicate that even these high numbers may be understated.

Fifty-seven percent of Americans don’t have enough cash to cover a $500 unexpected expense, according to a new survey from Bankrate, which interviewed 1,003 adults earlier this month. (“A $500 surprise expense would put most Americans into debt”, Aimee Picchi,MoneyWatch,January 12, 2017.)

Non-prime (620-679 score) millennials may be among those who are particularly vulnerable.

Life as a non-prime millennial consumer means more debt and less financial confidence, with the majority of these consumers living paycheck to paycheck.  Nearly 60% (58%) of non-prime millennials live from one paycheck to the next, according to the Millennials’ Day-to-day Finances: The Non-Prime Experience released today by Elevate’s Center for the New Middle Class.  It follows that non-prime millennials are also more likely to run out of money before the end of the month, something about 40% of them do at least every other month according to the study of about 1,200 American millennials.  (“40% of Non-Prime Millennials Run Out of Money Every Other Month”, Grace Noto, bankinnovation.com, July 12, 2017.)

There are many impacts from high levels of debt such as physical and mental affects, in addition to many others:

Consumer debt is often a positive force in people’s lives and supports economic growth,    but its negative impacts on households are serious, widespread, and inequitable. Consumer debt is most likely to cause financial distress when a household has a high debt burden, as measured both by the proportion of income used to service debt and their subjective perception of financial stress. Carrying too much debt can create a rapid downward spiral that starts with higher debt servicing costs and can lead to court judgments and garnishments of wages, tax refunds, and other payments. The ultimate negative consequence, bankruptcy, fails to deliver long-term relief to many filers. Debt can also curtail households’ ability to save and build wealth. The pathways through which credit and debt lead to mobility have become less reliable and are broken for some borrowers.  (Consumer Debt: A Primer, Aspen Institute (EPIC), March 26, 2018.)

In that context, we believe that there are worse lending services in the marketplace that are much more burdensome and damaging than payday loans.  Further, the public policy focus on payday loans is overdone and additional policy focus needs to be directed at these other, more damaging financial services.  While there have been many reports on the debt issues facing low income households (“A Larger and Longer Debt Trap”, National Consumer Law Center, October 2018; “Consumer Debt: A Primer”, Aspen Institute (EPIC), March 26, 2018; “The Complex Story of American Debt: Liabilities in family balance sheets”, PEW Foundation, July 2015; “The Savings Crisis and the Need for Holistic Solutions”, Prosperity Now, 2019; “Tackling Debt: Closing the Racial Wealth Gap is Imperative”, Asset Funders Network; “Lifting the Weight: Solving The Consumer Debt Crisis For Families, Communities & Future Generations”, Aspen Institute, 2019), the depth of the political focus on payday loans has been far greater.

If someone were to walk into a check cashing store in California, there could be three types of loans available:

• Payday loans up to $300 with an APR of about 460%.
• Unsecured, consumer installment loans between $2,501 and $5,000 with interest rates between 150% and 186% APR. (Some lenders/online loans may be over 200% APR.)
• Secured (by auto title), consumer installment loans between $2,501 and $25,000 with APRs generally between 130% and 142%.

There is a noticeable gap for loan options between $301 and $2,500 in these stores because California has a rate cap of 36% on loans in this range.  This 36% cap apparently is considered too low by the industry to allow an adequate profit.  Although there are some lenders in California who have been lending under 36% or just above it as authorized by special legislation for loans between $500 and $10,000, there is no cap on loans between $2,501 and $10,000.  In September though, the state legislature passed a law with a 36% APR cap on loans between $2,501 and $10,000, and it is on the governor’s desk at this time for signing.  However, even with this rate cap, the legislation apparently allows other add-on charges – credit insurance and other forms of insurance along with fees – that can allow very high rates even with this rate cap.

After packing, loans at California’s proposed 36% maximum interest rate can look more like conventional payday lending, costing borrowers nearly 150%. But because add-on products are not technically loan interest, they aren’t included in rate calculations, and consumers are not aware of the real costs.   “Supposed payday loan reform is a license for predatory lending”, William Rothbard, San Francisco Chronicle, Aug. 23, 2019.)

Assuming the bill is signed, California would have a different rate environment for these loans if these add-ons are not used or outlawed; however, if they are not outlawed, California borrowers still will face very high interest loans as will others in many other states that do not have similar caps in place.  (“A Larger and Longer Debt Trap”, National Consumer Law Center, October 2018.)

The impact that one of these larger loans can have compared to payday loans can be illustrated.  For example, a comparison of a $5,000 secured auto title loan for a car purchase to CDF loans and payday loans can be very troubling.  The loan terms shown in the photos below of signs from one store show 2 and 3 year terms.  At our store, we often see even longer loan terms of 42 months that consistently are used by lenders.  With an APR of 135% and a loan term of 42 months, the loan results in a total interest payment of $18,896.32, or with a two-year term, the total interest paid would be $9,632.80. A 1-year term would result in $4,352 in interest.

CDF follows a different lending approach.  We develop a very detailed budget on an Excel spreadsheet to determine the applicant’s cash flow; and we base the loan term on this cash flow rather than applying the same term to every applicant.  As a result, we have made only one loan over 2 years and almost all of our loans have 1 to 1.5 year terms or less.  Under our loan term and rate (29%), the amount of interest paid on this loan would be $1,819.76.

As another example, take a $5,000 unsecured installment loan at 180% APR for 3.5 years.  This would result in interest payments of $26,589.04 (or $6,068 in interest for one year) compared to a 1-year CDF loan resulting in interest payments of $1,819.76.

In comparison, a payday loan of $300 at California’s market rates would result in an interest payment of $1,170 over one year if it were rolled over precisely every two weeks for 26 times in a year.  Most borrowers do not renew every two weeks for one year; if they do, they typically end up either repaying or defaulting at some point while others renew periodically but after some period of delinquency. In our experience, we rarely have seen a payday borrower make continuous loans for two years; even in those cases, the borrowers often are delinquent for some periods of time so they are not taking out loans every two weeks.

So these higher loan amounts with very high APRs and longer terms can create much greater issues for borrowers than payday loans.  In addition, we have found a second measure of this relative debt burden. We also were able to determine that payday loans may not be that burdensome, relatively, with our own borrowers.  CDF developed an analysis of the debt of our installment loan borrowers to investigate the main sources of their debt.  (“Payday Loans, Debt and the Underbanked”, CDF website: communitydevelopmentfinance.org.)

CDF had believed for some time that the focus on payday loans, while clearly a problematic financial product, nevertheless had been over-emphasized from a policy perspective as most low-income households with poor credit scores have other, much greater debt that far outweighs payday debt. This hypothesis was confirmed by our study, although the results were considered preliminary due to limitations of the data.  We found that our consumer loan borrowers had payday loans equaling about 1% to 1.5% of their total debt.  Other types of debt were much greater burdens in absolute dollar amounts – installment, medical, student, real estate, credit cards, auto loans, collections, etc.  The original analysis was made with 76 loans; however, we have updated the supporting data through an additional 225 loans and the same conclusions are holding firm.  We believe that this conclusion will hold up when we reach 400 loans as well.

Furthermore, the payday loan industry appears to be shifting away from payday loans.  (“America’s Middle Class Is Addicted to a New Kind of Credit”, Christopher Maloney and Adam Tempkin, Bloomberg, October 29, 2019.)  The state regulator for these loans, the Department of Business Oversight, stated that the payday loan industry is shifting away from payday loans in favor of larger consumer installment loans.  (“California Payday Loan Industry Appears to be Moving Toward Larger Consumer Installment Loans”, California Department of Business Oversight, August 8, 2019.)  The number of payday loans in California, while still enormous, is decreasing.  In 2018, there were $2.8 billion in loans down from over $4.17 billion in 2015.  There were 10.2 million loans down from over 12.26 million and 1.62 million customers down from 1.88 million in 2015.  (“Operation of Payday Lenders Licensed Under the California Deferred Deposit Transaction Law: 2018 Annual Report and Industry Survey”, California Department of Business Oversight. June 2019.)  There is one caveat: this decrease could be the result of an improving economy and payday loans could increase again when there is an economic downturn.

Lenders in this dual economy have a history of fighting to maintain their products in the face of legal pressure.  (“The Payday Playbook: How High Cost Lenders Fight to Stay Legal”, Paul Kiel,
ProPublica, Aug. 2, 2013.)  At the same time, they also have a history of morphing into other forms when the political and legal pressures become too great.  (“How predatory payday lenders pop back up even after states crack down”, Paul Kiel, Pro Publica, August 6, 2013.)  This may be occurring in California as payday lenders are moving into consumer installment loans.

Consumer installment loans also represented a very substantial amount of lending.  In 2018, of the unsecured loans between $2,500 to $4,999, 583,379 or 55.51% of the loans had APRs over 100%.  Of those, 392,906 were made online or 61.98% were over 100% APR.  For auto title loans between $2,500 – $4,999, 63,322 or 67.56% were over 100% APR and 30.5% were between 70% and 99.9%; the result was that 98% of the auto title loans in this loan amount range had APRs of 70% and above.  (“Operation of Finance Companies Licensed under the California Financing Law: 2018 Annual Report”, California Department of Business Oversight, June 2019.)

All of these forms of debt that need to be addressed more completely.  This other debt has three distinct sources:

• Potentially predatory debt from other institutions in the dual financial economy: pawn loans; rent-to-own (RTO) stores; subprime credit cards; installment loans; car title loans; Refund Anticipation Loans; remittances; subprime mortgage lenders; etc. in addition to payday loans.
• There are other large sources of debt that may or may not be predatory but can constitute very large burdens: credit cards; auto loans; student loans; real estate; collections; etc.
• And there are non-loan sources of debt – unpaid bills, state and local fees and penalties, bank overdrafts and medical debt – that also may or not be predatory but are very burdensome.

Together, these different sources of debt can be much more burdensome than payday loans and we recommend that a great deal more attention – public policy, legal and statutory, programmatic – should be paid to these issues.

Non-Payday loan options for short term loans

There are many reasons why someone might need a relatively small, short-term loan: 1) an emergency; 2) a planned expense that occurs when the borrower does not have the available funds for the purchase; 3) a shortage of funds to pay recurring bills caused by low incomes; or 4) a job (e.g. in the construction or tourist industries) with volatile levels of income each month.

Emergencies, for example, are a major cause and large numbers of Americans do not have enough money saved to pay for small emergencies as noted above:

Fifty-seven percent of Americans don’t have enough cash to cover a $500 unexpected expense, according to a new survey from Bankrate, which interviewed 1,003 adults earlier this month. While that may appear dire, it reflects a slight improvement from 2016, when 63 percent of U.S. residents said they wouldn’t be able to handle such an expense. The improvement reflects the stronger U.S. economy, but is still far from ideal, Bankrate.com said.  (“A $500 surprise expense would put most Americans into debt”, Aimee Picchi,MoneyWatch,January 12, 2017.)

Slightly larger expenses also are very problematic, most especially for lower income households:

Overall, 48 percent of Americans say they don’t have enough money on hand to “make a major purchase, such as a car, appliance or furniture, or pay for a significant home repair,” according to Gallup.  Even in the highest income bracket that Gallup analyzed — people who earn at least $240,000 — 16 percent believe they don’t have the money to make a major purchase. That’s about 1 in 6 people.  These figures are based on more than 44,500 Americans’ responses to a question asked on the Gallup Daily tracking survey throughout last year.  Because of the large number of participants, Gallup was able to analyze several income ranges. The percentage of adults who said they don’t have enough money on hand for a major purchase were:

• • Earning less than $12,000: 83 percent
  • $12,000 to $23,999: 77 percent
  • $24,000 to $35,999: 63 percent
  • $36,000 to $47,999: 52 percent
  • $48,000 to $59,999: 44 percent
  • $60,000 to $89,999: 35 percent
  • $90,000 to $119,999: 25 percent
  • $120,000 to $179,999: 22 percent
  • $180,000 to $239,999: 17 percent
  • $240,000 or more: 16 percent

Overall, 29 percent of Americans said they don’t have enough money “to buy the things they need,” meaning making ends meet on a day-to-day basis.  Among specific income brackets, 61 percent of respondents earning less than $12,000 said they are unable to fund needs.  “Nearly Half of Americans Don’t Have the Cash to Buy a Fridge”, Karla Bowsher, Money Talks News, January 6, 2016.

While many people turn to payday loans to meet an immediate financial need, there are many other possibilities beyond payday loans.  One observer estimated the size of this “small cash market” at 75 million people in 2011, including 15 million people who used overdrafts.  (“The Small Cash Market “, Michael Moebs, Moebs Services, Spring, 2012.)  They all have their own issues, however.  And none is a great option, although there are some reasonable possibilities.

Here is a list of some of the major possibilities.

• Bank overdrafts. Someone could overdraft an account through a check, charge to a credit card, or an ATM withdrawal as a way to raise an immediate, small amount of cash. However, overdrafts can have a higher APR than payday loans for small amounts.  The time limit to repay is much less than payday loans and one overdraft can lead to many others if they occur with other expenses that are not paid.  In some banks, there may be a limit on the amount that can be over-drafted.  As a result, some people get trapped in overdrafts too; although it is a different pattern than payday loans, some people become multiple over-drafters and spend thousands of dollars a year on these fees.  Banks also may report overdrafts to the credit agencies and place customers on ChexSystems for over-drafting thereby impacting their credit scores.  If the overdraft can be repaid quickly, this approach may work, but otherwise it has its own problematic issues.  Many of our customers have used overdrafts as a means to cover small financial issues.
• Family or Friends. This approach is generally frowned upon.  Financial coaches tell family and friends to avoid making these loans as relationships can be ruined quickly.  If this source is used, they recommend that a contract or promissory note be drawn up stating all the terms, and that the transaction should be treated in a very business-like way.  (“The 3 Golden Rules of Loaning to Friends and Family”, Donna Freedman, Money Talk News, November 24, 2014.)
• Employers. Some employers will make loans directly to their employees, but most do not seem to want to take this step if it can be avoided.  Some employers have teamed up with financial technology companies (fintechs) to offer these loans at decent rates and terms.  Ask the employer if this type of program exists at the specific company.  Other fintechs make these loans available directly to employees of specific companies and some lend to people with good job histories.  See the fintech section, below.  Most of our borrowers do not work in companies where these programs are available.
• Credit Unions. They often offer smaller and larger personal loans at times.  However, the borrower usually has to establish a relationship with the credit union and conduct business there for some period of time, usually one to six months at a minimum.   The loans may be based on credit score, so it is important to build the credit score for future opportunities if it is low presently.  The availability of these loans varies among CUs.  It can be useful to find one that offers these loans and become a member in order to have this source available in the future.  However, this alternative generally is a longer term option.  When available, this source can be one of the best options.  Besides their personal loans, CUs have undertaken demonstration programs to provide alternative loan programs in some localities.  (“New Era for Payday Lending: Regulation, Innovation and the Road Ahead”, Federal Reserve Bank of Dallas, Kevin Dancy, September 2016.)  It is worthwhile to check with the regulator (NCUA) or other groups or trade associations or specific CUs to determine if this option exists in your location.  Most of our customers have credit scores that are too low to qualify for these loans or they are not members.
• Banks. Some banks make personal loans.  However, they generally are for larger minimum amounts (e.g. $2,000 or $3,000) due to the cost of underwriting and servicing the loans and they are typically made to applicants with a strong credit score.  Among the large banks, Bank of America and JP Chase Morgan don’t make these loans while Wells Fargo and Citibank do.  (“Where to Get a Personal Loan”, Steve Nicastro, Nerdwallet, March 19, 2019; “Chase Personal Loans Don’t Exist: 9 Banks to Try Instead”, Elyssa Kirkham, April 30, 2017 .)  People of color also may have more difficulty in obtaining these loans with some banks as they also can face much more difficult terms and fees in merely setting up, maintaining or closing a regular bank account.  (“The Tax on Black and Brown Customers When Dealing With Community Banks”, Brentin Mock and David Montgomery, City Lab, June 21, 2018.)  Most of our borrowers would not qualify for these loans.
• Fintechs. These lenders now make more personal loans than either banks or credit unions; they now comprise over 30% of the market compared to under 1% in 2010.  (“Fintechs Have a Larger Share of Personal Loans than Banks or Credit Unions”, Tatjana Kulkarni, bankinnovation.com, November 27, 2017).  Fintechs automate most of their processes, including the loan decision itself, and operate mostly or entirely online.  Many of them use proprietary systems based on information that often is completely different than traditional banks use.  Because of their cost savings from the use of technology, they can offer reasonable rates.  However, they usually have a floor to the allowable credit score (600 or higher for the most part, with a few at 585 or 580. (“Personal Loans for Bad Credit”, Amrita Jayakumar, Nerdwallet, February 17, 2016.)  And many or most of these companies are tech startups and their real target market is people who are high earners or who likely are to be earning high salaries in the future and who may be interested in other, more profitable products.  For example, the key target market is a HENRY – someone who is a “high earner not rich yet.  (“#Fintech: SoFi + HENRYs”, December 14, 2016, http://lumosbusiness.com/fintech-sofi-henrys/.)  Moreover, these loans can result in a type of debt trap, too.   According to a study by the Cleveland FED, borrowers with online loans from peer lending institutions had the following characteristics:

The study finds that the consumers who took out online loans grew their other debts by about 35% more over the next two years than did their counterparts who did not take out the loans. It also found that consumers who borrowed online had lower credit scores, more delinquent accounts and more total debt outstanding two years later than the similarly situated consumers who abstained.  The findings suggest that online loans — which are often three-year to five-year installment loans of up to $30,000 to $40,000 — are enabling some U.S. consumers to overspend. Even if borrowers use the loans to pay off existing credit card debt, there is nothing to stop them from running up large new tabs on those same cards.  (“Online loans leave consumers deeper in debt, Fed research says”, Kevin Wack, November 10 2017.)

Borrowers can get trapped in all types of different loans that can create difficult long-term issues.  Many new online lenders – e.g. Affirm, Sezzle, Klarna, Afterplay and Quadpay – also may now be trapping people into consuming more than they would otherwise.  (“The Maybe-Dubious Rise of the Loans-for-Sneaker Business” GQ, Cam Wolf, October 9, 2019; “That New Sweater is Yours in Just Four Easy Installment”, Anna Maria Andriotis and Peter Rudegeair, New York Times, September 30, 2019; “The Finance 202: Personal loans are surging. That’s an economic red flag.”, Tory Newmyer, Washington Post, November 22, 2019; “Personal loans are ‘growing like a weed,’ a potential warning sign for the U.S. economy”, Heather Long, Washington Post, November 21, 2019.)

With an eye on these issues, some of the online lenders and programs that may be helpful to explore include Brigit (a subscription phone app), Hellobright.com, Dave.com, Pay advance, Earn it.com, Earnin, Payactiv.com, Upstart, Honeybee.com, Finova Financial, Opportun, Lendup, TrueConnect, SalaryFinance, DailyWage, FlexPay, Fig Loans, Rise, Elevate.  These may be employer-based, online or fintechs. There are many others, so searching through these alternatives may lead to one that truly fits if the rate is fair and affordable, the borrower can qualify, and the borrower is aware of the potential pitfalls – of which there may be many.   So it is important to beware and to undertake research beforehand when pursuing these sources:

Essentially these products share many critical characteristics with payday loans: They’re available to people with no credit or bad credit; they’re fast, with funds dispensed electronically in 15 minutes to overnight; the loans are for small amounts, usually less than $500; and the payments are due back relatively quickly — in either two weeks or four months, usually.  One final, critical similarity: While these lenders may try to get the price down, these small-dollar loans still come with very high interest rates, almost always starting at over 120% APR.  (“‘Good’ Payday Loans Still Very, Very Expensive”, Karen Aho, Nerdwallet, Aug. 16, 2016; “America’s Middle Class Is Addicted to a New Kind of Credit”, Christopher Maloney and Adam Tempkin, Bloomberg, October 29, 2019; “The New Payday Lender Looks a Lot Like the Old Payday Lender”, Sidney Fussell, The Atlantic, December 18, 2019.)

Most CDF borrowers would not qualify for many of these loans and/or they would not be comfortable using the technology.

• Other Online lenders. These lenders also may be fintechs, but one strand of this type of lender has a target market of people with bad credit or who are having greater financial problems.  The loans usually are larger installment loans that can be paid off over a few months or years and they offer both smaller loan amounts and much larger loan amounts.  (“America’s Middle Class Is Addicted to a New Kind of Credit”, Christopher Maloney and Adam Tempkin, Bloomberg, October 29, 2019; “The Finance 202: Personal loans are surging. That’s an economic red flag.”, Tory Newmyer, Washington Post, November 22, 2019; “Personal loans are ‘growing like a weed,’ a potential warning sign for the U.S. economy”, Heather Long, Washington Post, November 21, 2019.)  They may offer some choice of term and amount so the applicants can tailor the payments to meet their income schedules.  Some lenders may start at 36% while others offer rates up to and over 200%; so these loans can be very predatory.  They may be available online or have some brick and mortar stores or kiosks to obtain the loans. Many CDF borrowers qualify for these loans.
• Online Peer Lenders. Another type of online lender allows individual investors to make loans, often for small businesses or other purposes or for fundraising.  Someone in need of a loan or other assistance can create a request for a loan and see if there is some response from investors or grantors through crowdfunding (e.g. gofundme.com).  Some of the primary lending sites include Lending Club, Prosper Marketplace, Upstart, Peerform, Kiva and Funding Circle.
• Credit card cash advances. While many banks don’t offer accessible personal loans, they do offer credit cards for those who qualify.  The card companies also offer loans through their cards.  Some card companies send blank checks while others make cash advances or loans from an ATM or a bank connected to the card’s network (e.g. Visa or Mastercard).  There are upfront fees (up to 5%) and rates often around 25% – 30%+/-, although some may be well below the normal credit card rate; it is typically a variable rate although the rate also can be fixed.  There is no application and no credit check and payments are included in the overall monthly payment cycle.  If the applicant can qualify and avoid the pitfalls, this option can be helpful.  While this source can be useful, this type of debt can sometimes become a trap especially when borrowers only pay the minimum monthly amounts.  Additionally, many low income people or those with bad credit cannot qualify for market rate, non-secured credit cards.  There are some new cards available with slightly better criteria such as Build which takes people with credit scores as low as 550.  But low income people with bad credit do not tend to fare well with credit cards as the card services tend to be uncompetitive on terms offered to higher income people.

In general, the prime borrower experiences credit totally differently than the non-prime borrower. They have access to: credit cards that compete for your business with high limits, lower fees, and enticing rewards in the form of cash or loyalty points that can be converted to purchase goods; lines of credit from banks; and assets that can be more easily liquidified if needed to deal with a major unforeseen expense.  (“Understanding non-prime borrowers and the need to regulate small dollar and “payday” loans”, Aaron Klein, Brookings Institute, May 19, 2016.)

Most CDF borrowers no longer qualify for adequate credit cards.

• Retirement funds. People with an IRA or 401k can borrow from their invested funds. The rates are low – often prime plus 1% — but there may be penalties if the loan is not repaid within a certain time frame.  Using retirement funds also means that these funds cannot be used to earn income toward retirement, on a compounded, tax-free basis, beyond the interest rate that is charged.  Some people also fall into the trap of taking multiple loans and reducing their contributions. If the loan is withdrawn from the fund completely, then penalties and taxes will be due.  The rules are extensive and should be carefully reviewed.  This generally is considered to be an option to avoid if possible.  (“Should you borrow from your 401(k)?”, Lisa Gerstner, Kiplinger’s Personal Finance, November 2019.)  Most CDF borrowers do not have retirement accounts that we are aware of.
• Life Insurance. Holders of whole life insurance policies (but not term life insurance) can borrow against their policies.  There is no time limit on repayment but the death benefits will be lowered if the borrower does not repay the loan before passing away.  A few CDF borrowers do have life insurance although it is not clear if they hold whole life policies.
• Church and nonprofit lenders. In some locations, churches have started small lending programs for people who are in difficult financial circumstances.  (“Churches fight predatory payday lending with political pressure, small loans”, Rev. Frederick Douglass Haynes III, Religion News Service, 11/21/2018.  See also eorg.  See also “St. Vincent de Paul Society’s alternative to payday loans”, Zoey Maraist | Catholic Herald, 3/08/18.)   Nonprofit organizations also have started lending programs in some parts of the country as well.  They generally have very affordable rates and terms, so it is worthwhile to check on the existence of any of these programs in your local area.  (“New Era for Payday Lending: Regulation, Innovation and the Road Ahead”, Federal Reserve Bank of Dallas, Kevin Dancy, September 2016.)
• Pawn shops. This type of institution is well known.  If someone has something of value to pawn (jewelry, weapons and musical instruments seem to be the most popular), a loan equal to some portion of the value of the item can be obtained.  States vary in their regulation – some states regulate pawn lending rates and terms carefully and others do not.  If someone lives in a regulated state with non-predatory rates and terms and has something of value that the borrower can afford to lose if the loan cannot be repaid, then this might be a possible option.  Pawning is an option for many of our borrowers.
• Auto title loans. To obtain an auto title loan, the borrower surrenders the title to the car, truck or motorcycle until the loan is repaid.  The lender will make a loan based on some smaller proportion of the value of the vehicle.  The rates often are very high and predatory (e.g. 130% to 150% APRs) and some have to be repaid in a very short time period (e.g. 30 days) while others can be repaid over a longer term through an installment loan.  If the loan is not repaid on time, the lender takes possession of the vehicle.  So these loans are very risky.  Auto title loans are an option for some CDF borrowers who have enough equity in their autos to qualify.
• “Friends” loans. In some neighborhoods, there are unlicensed and unregulated lenders.  They generally live in the neighborhood and are sometimes referred to as “friends”.  They make loans of smaller and larger amounts at very high rates (e.g. 10% to 20% per month).  There does not appear to be any documentation for the loans and they must be repaid in full because partial payments are not permitted.   (For loans like these in New York City, see “The Shadow Banks of the Barrio”, Mónica Cordero, Constanza Gallardo, and Alma Sacasa, CityLab, Jun 14, 2017.)  CDF also has made a number of loans to borrowers to repay this type of loan in the East Bay area.  The size of the black market for personal loans was estimated at around 1 million people in 2011.  (“The Small Cash Market “, Michael Moebs, Spring, 2012.)
• Refinancing. If some asset exists that is debt free or has an existing loan, it might be refinanced in order to obtain more cash depending on the condition, value, etc.  Most often, this asset might be an auto.  If the new rate is lower, it could generate some extra cash in ongoing months during the term of the loan.  If the rate is higher, however, it could create its own financial issue and trap over time.  Few CDF borrowers have assets that can be refinanced on reasonable terms.

There are options to payday loans.  And there are several possibilities and it should be possible to find a reasonable one if needed.  But clearly, there are no perfect – or even fully adequate – alternatives to payday loans unless a borrower has a good credit score and decent income.  While payday loans are a very difficult and potentially predatory financial product if the borrower gets trapped in these loans, they do offer one clear and quick solution.  And, borrowers also can get trapped in many of these other alternatives as well while also facing predatory terms in some of these situations.

The key to payday loans and most of these other options is to repay them as soon as possible.  Do not get trapped in them if there is any possible way to avoid it.  We have seen people trapped in these loans and have been able to assist them to escape in a variety of ways, as noted in the beginning of this article.  But the escape can be difficult for many people with low incomes and little capacity to save.  For those trapped in payday loan debt, one way to get out these loans is to request an extended payment plan from the lender – as a better alternative to defaulting – to create more time to repay the loans and get out of this type of debt.  Some states have this option written into their laws and regulations, and some lenders will allow it as they see a longer payment period as a better option than default with no return of principal.

Another option is to seek forbearance from other creditors where it may be possible to ask them to extend bill payment deadlines, such as phone bills or utility bills.  Then, the money that would have been used to pay these bills can be used for the more immediate emergency.

Financial coaches often offer a series of additional alternatives to payday loans.  However, their recommendations often are longer term answers rather than immediate solutions for someone needing money right away.  While they may not make sense to someone with an immediate need, they can be excellent long term approaches that can help people be better prepared for similar situations in the future.  So, if possible, pay off the short term loan from whatever source available, and then try to follow these alternatives:

• Build an emergency fund. Create a separate account with a fund to cover emergencies.
• Build a savings fund. This is a second fund that is much larger and holds several months’ savings in order to cover costs if a job is lost, a very large expense occurs, etc.
• Increase income. Find a new job that pays more or find a second job in order to generate more income.
• Sell things in the closet or garage. Most people often have items of value to other people that can be sold to generate reasonable amounts of cash.  The internet has many guides to selling on EBAY, Instagram, or other websites.
• Reduce spending. Many people are able to go through a detailed budget of their existing expenses and find relatively easy ways to reduce spending in order to generate more cash flow so that some funds can be saved and cash crunches can be avoided in the future.
• Increase credit score. Many of the available alternatives are based on a good credit score.  Future loans may depend on having an acceptable score or the rate may be different based on the credit score – the better the score, the lower the rate.
• Credit counseling/financial coaching. Meeting with people who are familiar with the financial services field can reduce the amount of time needed to improve someone’s financial conditions.  They have a very good overview of the steps that need to be taken and typically can offer excellent guidance.
• Join a credit union. Find one that makes personal loans under terms that are reasonable.  Then take any required steps to be able to qualify for them in the future.

There are other possibilities as well.  CDF holds a workshop on earning money from various internet activities and websites.  For example, there are websites that pay for sending grocery receipts.  There are others that pay participants to take surveys, play video games, use search engines, surf the internet, watch videos, etc.  These websites do not pay a large amount for each activity, but the amounts can add up quickly and participants can fit in the activity to meet their own time schedules.  Some of these websites include Pinecone Research, Survey Junkie, SwagBucks, Ibotta, Dosh, Rakuten and many others.  In addition, people can use a cash back credit card when making purchases with a card if possible.  In these ways, someone can earn perhaps a few hundred extra dollars each month, and even more with a greater time commitment.

Finally, someone who is struggling can look into unemployment, disability, workers’ compensation and other public programs that provide assistance.  Those who will fit within qualifying income requirements can look for further assistance through various forms of public assistance such as food assistance, child care assistance, lowering energy/utility bills, help with lowering medical costs, welfare, and use of free tax preparation services.

Generally, someone in need of quick cash faces a series of difficult short term choices with some reasonable possibilities.  And, there are excellent longer term options if some planning and active steps are taken.

Can Banks and Credit Unions Solve the Problem?

Given all these issues, banks and credit unions have been cited as the ideal vehicles to solve these problems.  They offer a full range of financial services, mostly at relatively reasonable or at least lower rates and fees (as much as we like to complain about them).  Their branches are widespread (although they are increasingly leaving low income neighborhoods) so their fixed costs are covered.  Most observers want banks and credit unions to step into this void and that desire makes a great deal of sense.  Their services would be a great improvement over those of the dual financial economy.  And their pricing would be as well, for the most part.

For example, a replacement for payday loans by banks often is recommended at terms of 18% amortized as an installment loan over three months for a loan amount of perhaps $500 or less.  However, a loan on those terms for the average payday loan size in California, about $260, would generate $7.84 in interest over a three-month term.  A similar loan over 6 months yields $23.84 in interest.  If a 36% rate is charged, the interest generated is $15.76 and $28 respectively for three and six month terms.  This pattern is reflected for loans of $500 and $750 as well.  (See Appendix.)

These terms just don’t generate anywhere near enough interest to cover the costs of making the loans and would result in large losses for banks just to cover operating costs and excluding loan losses.  Perhaps with loan sizes of $1,000 with a 1-year term, a small loan this size may break even or may start to make sense for some institutions – the cost structure varies by type and size of institution and specific lenders in all categories have their own approaches that create different cost structures.

To make more definitive statements about what loan terms could create break-even or profitable conditions for a bank or credit union, the cost structures and pricing policies need to be known.  But it is very difficult to find out information about the banks’ costs of making loans, which will vary by the size and type of institutions.  One study found that a bank would have to make a minimum loan of $5,118 just to break even on staff costs ($199.61) for underwriting and servicing in addition to working with some percentage of applications that are denied.  (“Serving Consumers’ Need for Loans in the 21^st Century”, G. Michael Flores, Bretton Woods, Inc., June 2012.)  The study assumed that 9 loans per month per underwriter would be closed while 93 were underwritten and 145 applications were processed.  If some elements of fintech technology were used to reduce the time humans spend on the loan and increase the speed of the transaction, these numbers undoubtedly would be lower, but the overall costs still could be high.

Some large banks seem to confirm these numbers, though, with their loan policies.  Wells Fargo offers personal loans starting at $3,000 with a minimum credit score of 660 with rates starting as low as 5.24% and increasing up to about 21% (based on credit score, income, etc.) and a three-year term or longer in some cases.  The bank also offers unsecured lines of credit for personal loans.  (https://www.wellsfargo.com/personal-credit/rate-and-payment-calculator.)  Citibank personal loans started at $2,000 and US Bank personal loans started at $5,000.  Bank of America and JP Morgan Chase do not make these loans.  (“Where to Get a Personal Loan”, Steve Nicastro, Nerdwallet, March 19, 2019; “Chase Personal Loans Don’t Exist: 9 Banks to Try Instead”, Elyssa Kirkham, April 30, 2017 .)  They seem to make these loans more for supporting customers and as a way to draw them to more profitable products.

In general, the costs and risks seem too high for many mainstream institutions.

Consumer advocates and the CFPB have been quite public in saying the best solution would be for traditional banks, which are highly regulated, to take over payday lending. Banks have plenty of locations, easy access to funds, and can make loans at much lower interest rates and still be profitable. But banks have been cool at best to the idea. Payday loans are seen as a risky and expensive. The costs for underwriting and processing them would eat into profits from the high interest rates they carry.

“Most of our members are willing to do small dollar loans, but they are not very profitable. Application fees don’t cover the cost of doing the application and the processing and the credit check. There are just fixed costs that you just cannot get around,” said Joe Gormley, assistant vice president and regulatory counsel at the Independent Community Bankers of America, a lobby group for small banks.  (“If payday loans go away, what will replace them?”, Ken Sweet, July 07, 2016, The Associated Press.)

Here is a specific numerical example:

To get a sense of why banks aren’t terribly interested in serving low-income customers, take a look at the following example. Imagine it’s 2007, pre-crisis and pre-regulation.  Let’s assume each deposit account costs the bank $250 a year to maintain regardless of the balance of the account. Adam deposits $10,000 into his bank account, while Brenda deposits $100. The bank loans out that money at 7 percent interest, making $700 off Adam and $7 off Brenda. They pay each customer an interest rate of 1 percent, meaning that Adam earns $100 in interest, and Brenda earns $1. But since each account costs the bank $250 to maintain, the bank makes $350 off Adam and loses $244 on Brenda.

Although Brenda’s deposit earns less in interest than it costs to maintain, the bank also makes money every time she swipes her debit card and every time she incurs an overdraft fee. The latter was particularly lucrative for banks, particularly because low-income customers, who tend to have lower balances, are disproportionately more likely to incur overdraft fees. Ten such charges a year would cover the cost of her checking account, even without revenue from debit card transactions.

Today (2102), that equation looks much different: The bank now lends at 5 percent interest, and pays out 0.1 percent on deposits. Adam’s account earns the bank $500, while he only receives $10 in interest; Brenda’s garners only $5, and she earns 10 cents in interest. On balance, Adam’s account is still profitable for the bank: it nets $245. The bank now loses $245.10 on Brenda’s account, and can no longer count on swipe or overdraft fees to make up the difference. There’s no incentive to hold onto a large number of low-income accountholders. Quite the opposite.  (“Why banks shun 30 million Americans”, Tim Chen, Christian Science Monitor, January 5, 2012.)

And this example assumes that the account holders leave their deposits in the bank for the full year, which is rarely the case for low income households.  They tend to put their earnings into an account once or twice a month, but they typically have a very small amount left in the account at the end of the month.  This situation would not allow the bank to earn interest from the funds by lending the deposits out to borrowers.  And this is one of the reasons which drive lenders to earn fees in other ways from these depositors.  Overdraft fees have become a very lucrative revenue base for these accounts as a result.

In addition to these economic, profit and risk limitations, banks now can follow likely easier paths to earnings than this target market. With the immense concentration of wealth and unequal distribution of income and wealth that has occurred in the last decade, with so many more people with much more wealth and people who had great wealth now have even more, it is understandable from a business perspective that banks would increase their focus on wealthy clients.  It is a much more viable market for them than the possibility of trying to break even or making small piecemeal profits that can be generated from very small, marginal accounts and services for lower income households.  These customers require a great deal of work and high overhead for relatively little return.

As a result, banks appear to be moving toward financial services for the wealthy customers.  (“Morgan Stanley beats profit estimates as rising stocks benefit wealth management and fund divisions”, Hugh Son, cnbc.com, July 18 2019; “Goldman wants to manage the assets of the middling rich”, Economist, May 25, 2019; “Many banks are hoping that wealth management can restore their fortunes”, Economist, May 19, 2012; “It’s Billionaires at the Gate as Ultra Rich Muscle In on Private Equity”, Simone Foxman and Sonali Basak, Bloomberg Business Week, June 11, 2018.)  It is much more lucrative and relatively easier to target this population, although the management and cost issues should not be underestimated – the wealthy demand more services and cost more to serve than low income people; the competition is growing and now includes fintechs charging much lower fees; etc.  (“Many banks are hoping that wealth management can restore their fortunes”, Economist, May 19, 2012.)

In 2016, the net worth for a household in the top 1% bracket started at $10.4 million (” United States Net Worth Brackets, Percentiles, and Top One Percent”, https://dqydj.com/net-worth-brackets-wealth-brackets-one-percent/;“Here’s How Much Money You Need for Bankers to Think You’re Rich”, Suzanne Woolley, Bloomberg, May 23, 2018.)  Consider that one family with $5 million in investable funds can generate a $50,000 investment fee @1% (which is the fee often charged by bank wealth management departments for up to $100 million or more in investible funds), in addition to perhaps other products such as a mortgage, checking and savings accounts, car loans, student loans, credit cards, etc.  On the other hand, it would take 347 low income customers paying $12 a month for their checking accounts to generate the same fee of $50,000.  And the operating and branch costs to service one family compared to 347 would be substantially different.

In its last quarter, wealth management accounted for $434 million in Wells Fargo’s net income, close to 10 percent of the bank’s $5.5 billion overall profit. It plans to hire 5,000 or more employees to staff its various divisions and subdivisions, which include Wells’ Private Bank, which caters to “high net worth” clients with investable assets of $5 million to $50 million.

Among the San Francisco clients of Abbot Downing -“the boutique inside Wells,” said Mewha – are 18 billionaires and 25 other individuals or families with investable assets in excess of $500 million. Forty-three staffers are on hand to help them “to manage the full impact of unique wealth – addressing its financial, social and personal dimensions.” (“Banks cash in on services for wealthiest clients”, Andrew S. Ross, San Francisco Chronicle, September 7, 2013.)

But banks are not only targeting the top 1% these days.  Someone in the top 5% in 2016 had a net worth of at least $2.4 million or a household at the 90^th percentile had a net worth of $1,182,390.36.  They now have more significant available funds and wealth than before and there are many more of them.  With investible funds of perhaps $1.5 million for example, the investment fee would generate $15,000 plus other loan activity compared to the fees generated from 104 low income customers each paying $12 a month to maintain a checking account.  (And these 2016 numbers most likely have increased substantially by this time.)  This approach and attitude was demonstrated by Jamie Dimon recently who targeted a much lower amount of investible funds – $250,000:

At a Feb. 26 (2019) investor conference, JPMorgan’s chief executive officer, Jamie Dimon, said that the bank’s “biggest opportunity” is its wealthy customers. The number of Chase Private Client branches, located inside Chase storefronts, soared from just one in 2008 to about 3,000 today. JPMorgan has captured just 1 percent of the market catering to customers with at least $250,000 in assets, Dimon said.  “It’s not that hard to say, ‘Why not 10 percent?’” he said.

And many other banks are moving toward this “middle” high wealth market:

… In Asia and Latin America, where the numbers of very rich people are growing fastest, the big global investment banks are also stepping up their efforts to get deposits to fund their investment-banking and corporate businesses. That, too, will drive down margins for traditional wealth managers, forcing them to pay more attention to the merely rich rather than just the extremely wealthy.  … For HSBC the big opportunity is people with less than $5m to invest. “That is where you can get the intersection of the best economics [and] you can build the best industrial solution,” says Simon Williams, HSBC’s group head of wealth management. (“Many banks are hoping that wealth management can restore their fortunes”, Economist, May 19, 2012.) 

These changes, such as the number of Chase’s private client branches, have occurred or intensified in the last decade since the recession as the number of people with great wealth has grown considerably.  And it is particularly relevant in cities and metropolitan areas with greater levels of inequality where there is a lot of variation throughout the country.  (“Why wage gap is widening in California”, Margot Roosevelt, San Francisco Chronicle, October 11, 2019.)

There is sound financial reasoning behind this movement as the potential market is quite large.

According to Forrester Research, 40 million Americans have investable assets, not including their home, of $100,000 to $1 million. Others put the estimate closer to 50 million. “A lot of people who you wouldn’t expect are getting wealthy” said Jacks. “Anyone who disregards those folks will be left behind.”  (“Banks cash in on services for wealthiest clients”, Andrew S. Ross, San Francisco Chronicle, September 7, 2013.)

And Chase, among other banks, apparently has facilitated this concept by closing branches that are not performing adequately, mostly in lower income neighborhoods:

No major bank exemplifies the industry trend of leaving lower-income areas better than JPMorgan.  The biggest U.S. bank announced plans a year ago to spend billions to open 400 branches and boost lending in a national expansion that would extend the lender’s profile to new states for the first time in a decade.  In the 13 months through January (2019), JPMorgan has applied to open 185 new branches, with 71 percent of them in more affluent areas. The bank in that time has given notice to regulators of its intention to shut 187 branches. About half of those are in neighborhoods where household income is below the national median of $60,336, according to a Bloomberg analysis of regulatory and U.S. Census data…The median household income for all opening branches is $81,325 while the median household income for all closing branches is $61,524.  (“JPMorgan Leads Banks’ Flight from Poor Neighborhoods”, Michelle F. Davis, Bloomberg News, March 6, 2019.)

Chase is not the only bank following these trends.  (“Big Banks J.P. Morgan, Wells Fargo, and Bank of America Are Pulling Out of Lower-Income Neighborhoods”, Erik Sherman, Fortune, March 6, 2019. “Banks that Shun Risky Borrowers Offer Rosy View of U.S. Consumer”, Shahien Nasiripour, Bloomberg News, January 12, 2020.)

Recently, San Francisco’s Wells Fargo opened a handsomely refurbished space at its Montgomery Street headquarters for a select group of clients – those with a minimum of $50 million in liquid assets.  U.S. Trust, a subsidiary of Bank of America, is boosting staff in the Bay Area for clients with a minimum of $3 million to invest. Bank of the West, which opened its flagship “Wealth Management Center” on Market Street last year, is rolling out new services in the fall designed for those with investable income beginning in the $75,000 to $100,000 range.

The clients are referred to, respectively, as “ultra high net worth,” “high net worth” and “mass affluent.” While the overall U.S. economy remains stalled, client numbers are growing, as is the attention banks are paying to them – especially in the Bay Area.  “It’s a growth area for many of us, and a profitable one,” said Mary Mewha, regional managing director of Wells Fargo’s ultra high-net worth units, which the bank combined and renamed Abbot Downing last year.  And it’s growing fast here. “Look at the wealth-based factor,” said Marc Compton, managing director of U.S. Trust in Silicon Valley.   (“Banks cash in on services for wealthiest clients”, Andrew S. Ross, San Francisco Chronicle, September 7, 2013.)

Branch closures play a major role in the availability of banking services and generally have been occurring disproportionately in low income neighborhoods.  And they are expected to increase a great deal more in the coming years, most likely disproportionately in low income neighborhoods.  These branches do not perform as well as branches in middle and upper income neighborhoods because people with lower incomes create a smaller deposit base and use lower profit services, which are crucial to banks’ profitability:

Branches in low-income neighborhoods almost always perform well below industry standards. Take TD Bank’s location at 701 West Lehigh Ave. in North Philadelphia, which has just $38 million in deposits. By comparison, 11 of TD’s 21 branches in Philadelphia exceed $100 million. And that does not factor in the ability to cross-sell lending services and fee products, such as insurance and wealth management…

Matthew Schultheis, an analyst at Boenning & Scattergood, said when banks look to open a new branch, they tend to make a simple math decision based on average household income and business density, because those two factors almost always translate to how big the branch will become.  “Banks like to make money,” Schultheis said. “The extent to which they can make money involves largely deposits and loans as well as fee products.  (“The Bank Gap: Why the poorest Philadelphians are underserved by region’s banks”, Jeff Blumenthal, Philadelphia Business Journal, May 23, 2019.)

While Wells Fargo added branches, Citibank’s closures also have been substantial:

Citigroup has sold or shut more than 1,300 U.S. branches in the past decade, including its consumer-lending network, to concentrate on major cities.  Citigroup U.S. Branches: 2,183, operational in 2007.   812 operational in 2015…“We’ve gotten out of businesses where we don’t think that we are successful, and we’ve gotten out of businesses where we don’t see a pathway to getting the types of returns that we think is appropriate,” Citigroup Chief Financial Officer John Gerspach said in December.  (“Citigroup, HSBC Jettison Customers as Era of Global Empires Ends”, Yalman Onaran, quartz.com, July 26, 2016.)

It should be noted that the big banks have had perhaps 25% or more of their branches in low income areas (“How J.P.Morgan Plans To Beat Bank Of America In Low-Income Areas”, Kori Hale, Forbes, March 19. 2019), but the spread of bank closures likely will alter this proportion as they are closing more branches in low income neighborhoods than opening them.  This will lead to the spread of “bank deserts” in these neighborhoods – the lack of banking resources in low income areas.  This is occurring despite requirements in the Community Reinvestment Act (CRA) to invest in areas around bank branches and to assist low income neighborhoods.  Without access to banks, their capital and their products and services, neighborhoods, individuals, organizations and businesses suffer, sometimes withering away.

The amount of total bank assets in the U.S. has grown substantially since the great recession.  Bank assets have increased from around $6.6 trillion in 2007 to $11.3 trillion in 2016.  (“Branch Banks: Navigating a Sea of Industry Change:’ JLL Research, Banking Outlook 2017.)  This asset growth is another reflection of the enormous growth in income and wealth in the U.S. in the last decade.  However, at the same time as this enormous growth in bank assets has occurred, the actual number of banks and the number of branches has shrunk substantially over the last decade and a large percentage of bank closures has occurred in low income neighborhoods – 1,915 more branches in low income neighborhoods were closed than were opened between the years 2014 and 2018 alone.  (“JPMorgan Leads Banks’ Flight from Poor Neighborhoods”, Michelle F. Davis, Bloomberg News, March 6, 2019.)

This process continues despite ongoing changes in banks’ desires to increase or decrease customer deposits from branches or from electronic methods depending on market conditions.  (“You re Costing Your Bank Much More than You Think”, Casey Bond, gobankingrates.com, May 20, 2013;  “Citigroup, with limited options, hopes to lure deposits digitally”, David Henry, Reuters, July 8, 2018; “Why banks just don’t want your money”, Mark Garrison, December 17, 2015; “What’s Wrong With Big Banks? Too Many Lost Customers.” Jeffrey Pfeffer, May 17, 2013; “Citigroup, HSBC Jettison Customers as Era of Global Empires Ends”, Yalman Onaran, quartz.com, July 26, 2016.)

At the same time as the number of branches shrinks, especially in low income neighborhoods, the absolute number of banks also is shrinking:  “…since June 30, 2006, there are 2,767 fewer banks in the United States representing a 34% decline”, falling from 7,397 institutions to 4,630 on June 30, 2019.  (“Banking Future: Bigger Banks/Fewer Banks”, John M. Mason, Seeking Alpha, Nov. 18, 2019.)  There were almost 24,000 banks in the mid-1960’s.  Changes to state and federal banking laws, the overturning of the Glass-Steagall Act and other economic and technological forces have led to large numbers of mergers and consolidation of banking.

These policies have proven positive to banks’ bottom lines.

Roughly a decade after being burned by the most punishing financial crisis since the onset of the Great Depression, it’s increasingly clear that the nation’s largest lenders are targeting a narrower slice of consumers: The wealthy and those with excellent credit.

At JPMorgan Chase, which on Tuesday reported the most profitable year of any bank in American history, executives anticipate a paltry 1.76% loss rate on their $504 billion of household loans, filings show. Five years ago, the bank expected to lose almost $2 billion more on a loan portfolio that was $78 billion smaller. The rate of severely delinquent consumer loans at Wells Fargo has fallen for at least 22 consecutive quarters, while at Bank of America Corp. soured household debt has dropped 23 quarters in a row…”In the history of banking, we probably have the most pristine amount of credit,” Richard Hunt, chief executive officer of the lobbying group Consumer Bankers Association, said Wednesday during a CNBC interview.

Five years ago, 22% of Wells Fargo’s consumer loans with disclosed credit scores were held by borrowers below 680, while just 15% of loans went to consumers with FICO scores of at least 800, filings show. Now only 11% are below 680 and some 47% are held by borrowers with scores of at least 800, according to Sept. 30 figures, the most recent available…At Bank of America, the average balance of its checking accounts is “$7,000 plus and growing,” Chief Executive Officer Brian Moynihan said on the lender’s earnings call this week. (“Banks that shun risky borrowers offer rosy view of U.S. consumer”, Shahien Nasiripour, Bloomberg News,  January 17 2020.)

And all of these trends are expected to continue in the future and could both impact people with existing accounts and make it more difficult for people without accounts to obtain them.  The number of branches is expected to keep shrinking and both existing and new branches are likely to be smaller as they rely increasingly on mobile banking and other technology.  (“Branch Banks: Navigating a Sea of Industry Change”, JLL Research, Banking Outlook 2017.)  The number of banks may continue to shrink as concentration of banking assets further consolidates. And as banks rely more on the use of technology and mobile banking to serve their regular customers, they may further push away people who might not feel comfortable or who have less access to or understanding of the new technology.  All these forces will contribute to the increasing number and scope of banking deserts in low income neighborhoods in the future and making it more difficult for low income households and businesses to access affordable capital.

Besides cost and profitability, there are many other issues that make it difficult for mainstream lenders to make these loans.  Some other factors behind banks’ and credit unions’ reluctance to make these loans at scale could include:

• The difficult credit histories of many applicants also makes these loans difficult. Each different financial service (credit card, car loan, mortgage, personal loan) offered by a bank or credit union tends to have a different credit score floor that is acceptable.  But they all tend to be somewhere around 600 to 660, and occasionally as low as 580.  Regulators may have difficulty allowing a program at substantial scale to be targeted to people with credit scores of 400 to 600 which is where the greatest need is (and which constitutes CDF’s target market).  Demonstration programs may be adopted but large scale programs might be very difficult to implement.  This tension exists in all regulated institutions where the Community Reinvestment Act can create conflict with regulatory definitions of safety and soundness.
• Further, there also may be internal pressure to avoid these loans within the lender’s own lending and risk departments. These employees have to help create a strong portfolio and high profitability while trying to limit risk.  The loans to low and very low income people with bad credit are higher risk with the likelihood of lower profits (excluding overdrafts which are very profitable and generally are paid disproportionately by lower income people).  So there could be internal pressure from different parts of any bank that would push instead to reduce or eliminate these loans.
• Banks’ proportion of profits coming from lending and deposits is falling since banks have been allowed to conduct other services such as trading and fixed income investment when Glass-Steagall was partially repealed in 1999. So in addition to their looking for wealth management opportunities rather than small deposits, they also are increasing their earnings from trading and investment.

Citigroup says it’s leaner and safer today. But in serving those clients, the bank has bulked up on trading, a business that helped get it into trouble before. It doubled the amount of derivatives contracts it has underwritten since the crisis to $56 trillion. The company, which used to make most of its profit from consumer banking, now gets the majority from corporate and investment banking.

HSBC, which had an even bigger global retail footprint than Citigroup’s and advertised itself as “the world’s local bank,” also has retreated, quitting or planning to get out of consumer banking in more than half the countries it was in and jettisoning 80 million customers. Retail banking’s share of profit has dropped by half as commercial lending and investment banking filled the gap.  (“Citigroup, HSBC Jettison Customers as Era of Global Empires Ends”, Yalman Onaran, quartz.com, July 26, 2016.)

As a result, the large banks have been making increasing, record and spectacular profits this decade – now in the range of $20 billion to well over $30 billion each, annualized for 2019, for most of the large banks which have seen further enormous profit increases due to the economy and the U.S. tax law changes starting in 2018.  (“JP Morgan posts an earnings beat, but forecast on interest income disappoints”, Hugh Son, cnbc.com, July 16, 2019; “Bank of America beats analysts’ profit estimates on retail banking strength”, Hugh Son, cnbc.com, July 17, 2019.)  Moreover, they frequently choose further to try to increase profits by cutting jobs, paying dividends and buying back stock with their profits rather than conduct more traditional banking business.  (“U.S. Banks Win $21 Billion Trump Tax Windfall Then Cut Staff, Loaned Less”, Ben Foldy, Bloomberg, Feb 6, 2019.)  They also tried to avoid lower income, less profitable customers through the use of high fees, requirements for account minimums, and increased account denials due to increased competition and the need for higher efficiency. (“How the Other Half Banks”, Mehrsa Baradaran, Harvard University Press, 2015, pages 140-7.)

• Some banks – Wells Fargo, US Bank and several large regional banks in the south and Midwest – were making alternate payday loans several years ago until new regulations, political pressure and PR forced them out of this financial service in 2013-14. This type of lending creates reputational risk for banks and this reputational risk continues today for banks to be involved in this type of lending.  Nevertheless, more recently there has been a new effort to get them involved from a variety of sources including advocates and bank/credit union regulators which have modified regulations to encourage their participation in making these loans. (“CFPB Presses Banks, Credit Unions to Offer ‘Small-Dollar Loans’”, Yuka Hayashi, Wall Street Journal, Feb. 9, 2016; “How OCC can help banks disrupt the payday loan industry”, Nick Bourke, American Banker, May 23 2017; “Description: Core Lending Principles for Short-Term, Small-Dollar Installment Lending”, OCC BULLETIN 2018-14, Date: May 23, 2018; “Banks’ Secret Plan to Disrupt the Payday Loan Industry”, Ian McKendry, American Banker, May 6, 2016.)  But these loans would be different from the earlier loans when they made, in essence, payday loans.  Regulators and advocates want them basically to follow some form of the Consumer Financial Protection Bureau’s (CFPB) proposed structure for these loans rather than the methods they used earlier in this decade.

But there appears to be much less profit in this approach; it is more difficult and probably has higher costs.  For example, under the proposed new regulations, someone with a $2000 monthly income with 550 credit score would be allowed to borrow an amount that could be repaid with monthly payments of a maximum of 5% of income, or a $100 per month maximum payment.  This limitation would not allow a 36% loan of $300 to be repaid over 3 months; it would require a monthly payment of $106.06 which is over the $100 monthly payment limit.  However, this loan with the higher payments would generate $18.18 in interest.  Or, to get it to $100 per month with a 3-month term, the loan amount would be lowered to $291.35 with a monthly payment of $100 at a 36% rate.  This loan would generate $17.64 in interest.  Previously, banks made a $300 loan to be repaid in 2-4 weeks at rates of $10 to $15 per $100 borrowed.  These fees generated $30 to $45 in 2 weeks rather than much less interest over three months under the desired new structure for these loans.

While there has been a lot of encouragement for increased bank participation along with the changes from bank and credit union regulators to facilitate this hoped-for increased participation, US Bank(USB), which announced its program in September 2018, has been the only large bank to date to re-institute a form of the old loan program, although others may join it in the future after the regulatory issues are settled.  The program covers a loan amount up to $1,000 with a term of 3 months and a rate of $12 per $100 borrowed if the payments are automatic or $15 per $100 borrowed if they are not.  (“A major bank is offering payday-style loans. Will others follow suit?”, James Rufus Koren, Los Angeles Times, Sep 11, 2018.)  However, there are some issues with their structure, which does not fully conform to the CFPB guidelines:

• • The APR for the lower rate ($12 per $100 borrowed) is 71% rather than 36%.
  • The rate is too high for payday or small amount loans in a number of states.
  • The term is fixed at three months instead of being based on cash flow, which could produce longer repayment terms, but which also would take too much time and cost and therefore is not economically viable.
  • The 3-month loan term is too short for loans between $500 and $1,000 for many borrowers to repay affordably.
  • Borrowers need to have a USB account for 6 months before being eligible, so it is not workable for any immediate needs; moreover, someone has to qualify for the account and these requirements are not clear.
  • Loan underwriting criteria aren’t clear – is there a minimum credit score? Is there a minimum DTI ratio? Is there any kind of limit on the overall amount of debt? If any of these requirements is included, the program could exclude many needy applicants.  Similarly, the requirements for opening an account may not be not clear either.
• Many other efforts have been tried over the years such as the FDIC Small Loan Program for banks and San Francisco’s Pay Day Plus program with credit union partners. While they achieved some moderate success, none was able to reach scale or last very long or create much increased interest on the part of financial institutions to keep participating or on others to begin participating. In a book called “How the Other Half Banks”, (Mehrsa Baradaran, Harvard University Press, 2015, pages 152-3), Baradaran concludes that the banks were “begrudgingly” involved in the FDIC program to gain Community Reinvestment Act credit, were never interested in offering pricing and services other than the maximum involved, and that the loans had too much risk, especially for a service that just was not profitable.
• To originate these small loans given their cost structures, banks/credit unions could automate their systems like financial technology (fintech) companies in order to reduce costs. It is not clear if technological changes applied to loans for low income households would make the loans profitable, but they at least would assist banks in reducing costs and moving toward profitability.  But there has not been much of a visible movement to undertake this automation for many of their financial services.
• There has been a similar effort to encourage banks to open no-cost or very low-cost checking and savings accounts for low income households. The costs of maintaining a checking account vary by institutional size and type and are estimated to be between $250 and $400 annually (although these numbers can be a little lower and they vary by type and size of institution).  These costs include staff; fraud prevention; processing deposits and withdrawals; preparing and disseminating statements; printing; legal costs; maintaining branches, ATMs and phone service centers; maintaining a portion of deposits on reserve at all times; compliance; and all the associated auditing, accounting and bookkeeping costs.

That would seem to suggest the average checking account pays for itself, right? No. Averages don’t tell the real story.  Of all the financial institutions analyzed by StrategyCorps, we found almost 40 percent to be unprofitable – not covering what it costs to maintain them.  What do unprofitable customers look like? They tend to have very low debit swipes, about six times per month. They have practically no other relationship other than checking. Only 17 percent have more than one demand deposit account, only 23 percent have a savings account, only 1 percent have both a savings and a loan product, and 3 percent have a loan. The average balance is $812. Total annual revenue contribution for all unprofitable accounts is $92. Overall, unprofitable customers comprise only 2.7 percent of all checking-related revenue and 1.4 percent of total relationship dollars.  (“The Profitability of the Average Checking Account”, Tyler Spaid and Mike Branton, bankdirector.com, April 22nd, 2013.)

In this situation too, there is pressure on banks and credit unions to adopt programs and policies that possibly would result in operating losses.

• Finally, it is important to mention bank overdrafts (ODs) which, like pay day loans, cover shortfalls in small levels of cash availability for a short time period; they are both, in effect, short term loans. Although they, too, are relatively ignored in most policy discussions compared to pay day loans, they often are far worse in many ways:
  • They tend to have much higher average APRs, typically measured at over 1000%.
  • The average amount that is overdrawn to incur a $30 to $35 fee is about $40 compared to an average payday loan of $263 in California in 2013. As a result, the APR can be much higher.
  • Account holders cannot control them the way they can control pay day loans.
  • They may not be very transparent.
  • ODs can wreck someone’s credit while defaulted pay day loans do not, as payday loans apparently are not reported to the credit agencies.
  • A bank account holder with numerous ODs can be placed on ChexSystems, which impacts credit scores and keeps the person from getting a bank account for 5 years.
  • The banks make far more money in fees from ODs than pay day lenders make from their loans – roughly over $34 billion per year in all types of OD fees compared to about $7 to $9 billion in pay day loan fees, although only a slightly higher number of people use pay day loans (about 19 million compared to 15 million people who overdraft in 2011).
  • ODs can occur on any day and then continue to collect additional fees in the succeeding days. Payday loans at least allow up to 14 to 30 days to repay and the deadlines are known by the borrowers.
  • There also is the vexing question for banks offering payday loan alternatives whether this product would compete with the revenues from overdrafts.

There have been some measures of people called multiple over-drafters – those people who overdraft a minimum of six to ten or more times a year – and whose fees comprise the majority of the OD fees that are paid. Generally, those people tend to be far worse off with a checking account and over-drafting multiple times than getting pay day loans. They often pay a few thousand dollars a year in OD fees.  They also are predominantly poor.  (“How the Other Half Banks”, Mehrsa Baradaran, Harvard University Press, 2015.)  Yet there is not nearly the same emphasis or focus on overdraft fees as there is on pay day loans despite how much more damaging they can be.

Another observer had this general comment about the participation of banks and credit unions:

Along with reforming payday lending, Cordray is trying to jawbone banks and credit unions into offering small-dollar, payday-like loans. Theoretically, they could use their preexisting branches, mitigating the overhead costs that affect payday stores and hence enabling profitable lending at a much lower rate. This is the holy grail for consumer advocates. “What everyone really wants to see is for it to come into the mainstream of financial services if it’s going to exist at all,” Cox says.

This idea has been around since at least 2005, when Sheila Bair, before her tenure at the FDIC, wrote a paper arguing that banks were the natural solution. But that was more than a decade ago. “The issue has been intractable,” Bair says. Back in 2008, the FDIC began a two-year pilot program encouraging banks to make small-dollar loans with an annualized interest-rate cap of 36 percent. But it didn’t take off, at least in part because of the time required for bank personnel, who are paid a lot more than payday-store staffers, to underwrite the loans. The idea is also at odds with a different federal mandate: Since the financial crisis, bank regulators have been insisting that their charges take less risk, not more. After guidelines issued by the FDIC and the Office of the Comptroller of the Currency warned of the risks involved in small-dollar lending, Wells Fargo and U.S. Bankcorp stopped offering payday-like loans altogether.

A more nefarious theory is that banks currently make a lot of money on a payday-lending alternative that already exists—namely, overdraft protection. One study done by the Consumer Financial Protection Bureau found that most debit-card overdraft fees are incurred on transactions of $24 or less, and yield a median fee of $34. Why would banks want to undercut such a rich source of profits?

As for credit unions, although a few have had success offering small, short-term loans, many struggle with regulators, with reputational risk, and with the cost of making such loans. “We are all cognizant that we should do it, but it is very challenging to figure out a business model that works,” says Tom Kane, the president of the Illinois Credit Union League. In any event, the credit-union industry is small—smaller altogether, Kane points out, than JPMorgan Chase, Bank of America, or Wells Fargo alone. “The scale isn’t there,” he says.  (“Payday Lending: Will Anything Better Replace It?”, Bethany McLean, The Atlantic, May 2016 Issue.)

Credit unions also have been part of the discussion and have made a number of efforts to address this issue.  They have made market rate loans in some cases.  They have run demonstration programs with lower rates.  In a few instances, they have been involved in offering smaller loans at scale, although it is not clear what their underwriting was or if they were reaching people substantially below credit scores of 600.  (“Faith-based credit unions offer an alternative to big banks, payday loans”, Katelyn Ferral, January 4, 2019; “New credit union will provide alternative to payday loans for residents in KC’s urban core”, John Pepitone, FOX – 4 WDAF (Kansas City, Missouri), February 23, 2018; “Think there’s no good alternative to PAYDAY LOANS?: WELL, THINK AGAIN, Mike Calhoun, ; Special To The Washington Post, July 1, 2016 Friday; “Seattle Metropolitan Credit Union opens Beacon Hill branch to serve the ‘financially abused’”,  Ashley Stewart, creditunionjournal.com, February 16, 2017; “Mendo Lake Credit Union a Saving Grace for the Underserved”, Natasha Chilingerian, Credit Union Times, February 24, 2016;  “New Era for Payday Lending: Regulation, Innovation and the Road Ahead”, Federal Reserve Bank of Dallas, Kevin Dancy, September 2016.)

There are already some experimental alternatives going on to replace payday loans. One program run through credit unions is called the Payday Alternative Loan, where a customer can borrow between $200 to $1,000 at 28 percent interest and an application fee of $20. But interest in the program has been limited. The federal regulator for the PAL program estimates only 20 percent of credit unions provided such loans and loan originations were only $123.3 million last year, a drop in the bucket compared to the roughly $7 billion the mainstream payday lending industry did in the same year. (“If payday loans go away, what will replace them?”, Ken Sweet, July 07, 2016, The Associated Press.)

Other reports have found credit union loans to be less desirable than payday loans.  The reasons vary from inconvenient credit union hours and locations, time limits on membership requirements, reporting to credit bureaus, savings deposit requirements, tighter underwriting – minimum employment tenure, minimum income requirements, credit checks, etc.  (“Are Payday Lending Markets Competitive? Victor Stango, Regulation, Fall 2012.)

Nevertheless, credit unions could provide an important partner in addressing these issues in the future.  The culture and mission of many credit unions would encourage their participation.  And they offer excellent loan terms to qualified borrowers.

Some Other Possible Solutions – the U.S. Post Office and Fintechs

The U.S. Postal Service has more recently been proposed as a solution to the banking needs of low income households and solving the financial issues facing the USPS at the same time.  While this program is not impossible, it is fraught with major concerns that do not seem to have been considered in public materials to date.  For example, no actual economic feasibility analysis has been prepared to date – the main analytical focus has been on the revenue possibilities not on the net revenue issues.  So there is no definitive answer about the actual impact of providing financial services on the financial condition of the USPS or how much new services would assist unbanked patrons.  In addition, there are practical issues such as the possible need for separate customer lines; higher salaries for unionized postal workers compared to the check cashing industry’s lower salaries which would impact the economic feasibility of the program; hours to be opened that need to extend into the evenings and weekends beyond the normal post office hours; the need to train postal staff to recognize bad checks which is a crucial but difficult and time-consuming matter; etc.  There also are major policy issues such as determining what the loan underwriting would be; how would the loans be priced – various different rates would either create a cost to low income borrowers or the USPS; what kinds of checks would be cashed; etc.  Without an in-depth analysis of this possibility, it is unlikely to determine if it can be a real solution.  (See “The Post Office and Financial Services for the Unbanked: Some Practical Matters”, Dan Leibsohn. April 2014, communitydevelopmentfinance.org.)

Financial technology companies (fintechs) offer another possibility as noted above.  Fintechs now make more personal loans than either banks or credit unions.  Fintechs automate their systems, usually completely.  They use formulas (algorithms) to analyze the collection of massive amounts of personal data and then make automated loan decisions.  They create these decisions by looking at some types of personal data that banks do not use or have thought much about using.  Through automation, they are able to lower their costs substantially and offer somewhat better rates.  And, with automation, they can offer very rapid decisions to applicants.  They have few if any brick and mortar stores as they depend almost completely on an online presence and technology for their operations.

It has been CDF’s experience that many households will not be comfortable using this technology at this time and we have defined our own goal for the use of technology as finding a balance between complete fintech automation and complete high-touch lending, as we also need to automate some parts of our process to reduce our costs in order to be competitive and reach scale.  Furthermore, most fintechs are interested in higher income customers who offer a much more lucrative future.  Most of these companies have high floors for acceptable credit scores unless the applicants have a very high earning potential.  Many of them likely use algorithms that would not work with low income people with bad credit; new algorithms would need to be created.  Even those startups that purport to be offering solutions for the unbanked do not get too deeply into the arena as they maintain underwriting limitations that do not allow them to serve people who are more deeply mired in debt and bad credit.

And it still may not be clear if these startups will be economically viable.  They follow a more traditional venture capital model that is concerned with creating market share and they place less attention on losses and sometimes on economic feasibility at the earlier stages of development.  As a result, there often are what appear to be very large losses.  So, in many cases, there is no clear indication that these companies will offer an economically viable alternative later in their development.

There also are issues associated with online lending in general.   As noted above, online lending can lead to its own version of overspending and creating debt traps.  The Cleveland Fed study noted above found that the online loans “do not go to the markets underserved by the traditional banking system” and “resemble predatory loans in terms of the segment of the consumer market they serve and their impact on consumers’ finances.”

Consumer Financial Protection Bureau Solutions

The CFPB developed entirely new regulations for smaller short term loans when President Obama was in office.  Under President Trump, new regulations were written.  The overall process has been stalled and no final rule has been approved.  Here, the core issues addressed by the initial proposal will be described.  While this rule may or may not end up passed in this form, the effort has helped to define future conditions that may serve as standards for the industry.

• The lender must establish the borrower’s ability to repay in some fashion. For example, the lender could verify after-tax income, borrowing history through viewing a credit report, and other key budgetary costs such as rent, medical costs and food. Generally, the lender must determine if the borrower can fully repay the loan while still satisfying all other major financial obligations so that the borrower will not need to re-borrow.
• The loan has to be affordable to the borrower:
  • The present rates must be lowered substantially to be more affordable – 36% plus an affordable origination fee or follow the NCUA’s Payday Alternative Loan program guidelines;
  • The monthly payment cannot be greater than a maximum of 5% of monthly income for payment;
  • There must be a longer loan term for repayment that is affordable for the borrower – up to two years;
  • The loan should be amortizing rather than a bullet, single repayment in a short time period.
• The borrower cannot re-borrow or roll over immediately – there must be a cooling off period.
• The borrower cannot have more than one loan outstanding at the same time.
• There are limits on the number of times that the lender can use ACH to gain repayment.

Still Other Proposed and Implemented Solutions

Addressing debt is one large part of assisting low and very low income households which are unbanked or underbanked and have bad credit.  In addition, many other methods have been implemented and proposed to assist this population.  Below is a partial listing of the most frequent products that have been put into practice in addition to many other suggestions that have been made.

• Major core programs
  • Bank On – new accounts for unbanked households
  • Asset building
  • Consumer protections
  • Financial literacy training/coaching
  • Savings accounts
  • Savings accounts for 1^st graders
• Other related ideas for California include:
• Increase cash assistance through CalWORKs.
• Expand efforts to promote awareness of the CalEITC.
• Expand and promote free tax preparation services for CalEITC recipients.
• Increase participation in CalFresh, which provides vital food assistance to

low-income Californians.

• Continue to increase payment rates for subsidized child care providers,

including license-exempt providers.

• Others look at more complete structural changes (For example: “Struggling to stay afloat. Real costs measure in California”, 2018. United Ways of CA.)
  • Preserve and Expand Subsidized Health Coverage
  • Maximize Current Income Supports
  • Invest in Post-Secondary Education
  • Give Income Supports a Longer Tail
  • Integrate and Naturalize Immigrants
  • Increase Housing Stock and Prioritize Help for Renters
  • Make Work Pay
  • Rethink Work, Jobs, and Links to Income

These are all very important ideas and recommendations.  There is little to argue about most of them or their value.  However, they do not offer relatively immediate debt relief or assistance and they don’t offer any answers for immediate cash needs.  They are long term at best and they frequently require large funding from the public sector and other sources.  Some of them are dependent on political solutions, which may have questionable likelihood of gaining needed support.  But they nevertheless should be pursued with great effort as they are part of the long term solution.  They are all very important parts of any overall program and are necessary in helping people move forward with their financial lives.  But they are not sufficient.  More assistance and program development is absolutely necessary.  And this assistance needs to be targeted at supporting the immediate needs of people who are struggling and should not have to wait until more long term answers are implemented.

One major example of additional immediate assistance needed and that can be implemented rather quickly are direct lending programs that offer fair and affordable loans to people needing this support.  However, rarely, if ever, is access to affordable capital listed as an option when the topic of the unbanked is discussed except in the framework of encouraging banks and credit unions to participate in this lending.  This issue does not seem to be fully recognized or well understood.  Payday loans tend to be the main focus with the goal of eliminating this existing financial service and rather than replacement with a superior product.

 

This actual lending is hard, messy and difficult.  There aren’t many clear decisions.  It calls for tough choices.  Some worthy applicants have to be denied.  Some applicants don’t want to bother with the loan process, which can be burdensome, or with making necessary changes to their lifestyles.  Mistakes in underwriting judgment result in loss of crucial funds.  Borrowers go through difficult personal times that are painful to witness.  People that seem trustworthy can try to scam the program.  These issues are very true of CDF’s lending and loan process.  But these processes have been successful and are important to continue as we have witnessed the immense impact on people’s lives that is possible when the lending is combined with financial coaching.

 

This type of lending also represents a way to address poverty.  It can create debt that is affordable and manageable for some and it can help others get out of debt completely.  By reducing or eliminating debt, borrowers can then take the large savings from well-structured debt and use it help get out of poverty in many other ways.

This is not to criticize these other approaches.  They are very important and can be extremely helpful.  But, by themselves, they are not adequate, they are not sufficient.  The existing programs now do not get at the core of the issues facing the unbanked and underbanked.  To completely address the full range of issues, a wider range of programs and approaches is needed, including making personal debt capital available and affordable.

This lack of success even with a massive investment of money, time and effort can be tracked.  Nationally, 6.5% of U.S. households were unbanked in 2017 according to the 2017 FDIC Survey of Unbanked and Underbanked Households.  This percentage was a decrease from 2009 when the rate was 7.6% (and from 8.2% in 2011).  Nevertheless, this 2017 percentage still represented 8.4 million U.S. households consisting of 14.1 million adults and 6.4 million children, a very large number and one which now exists during excellent economic times.  The numbers for 2009 and 2011 reflect the possibility of a regression from today’s numbers if present economic conditions worsen.

The numbers of underbanked households were even higher.  In the report, “underbanked” was defined as a household in which at least one household member held a savings or checking account in an insured institution while also using one or more alternative financial services or institutions – such as check cashing, payday loans, money orders, international remittances, tax refund loans, pawn shops, auto title loans, rent-to-own services, etc. – in the preceding 12 months.  By this definition, in 2017, 18.7% of U.S. households was underbanked – representing 24.2 million households comprised of 48.9 million adults and 15.4 million children.  These numbers represented a decrease from 20% of U.S. households in 2013.

In total, 25.2% of U.S. households was either unbanked or underbanked in 2017.  The total number of unbanked and underbanked households was 32.6 million households comprised of 63 million adults and 21.8 million children.

In contrast, the number of “fully banked” households (defined as households with an account and not using any alternative financial services in the past 12 months) totaled 68.4% of U.S. households, an increase from 68% in 2015.

It is important to note that the percentages of African American and Hispanic households in the unbanked and underbanked categories were significantly higher than the overall averages. These numbers have remained steadily high decade after decade.  In 2017 for example, 16.9% of African American households was unbanked in addition to 14% of Hispanic households.  It also is important to note that these numbers were recorded during the time of a large economic recovery that has reached many people formerly left out.  If that is the case, the question arises about what impact this economic recovery has had on the numbers of unbanked and underbanked as compared to these other programmatic efforts.  It also raises questions about what will happen when the economy experiences a downturn.

The impact of existing programs in assisting with these changes to date is exemplary and should be applauded.  Conditions might have been much worse without them.  And an expanded lending program by itself will not have an extensive impact on these numbers although it should create significant gains.  A much greater commitment of resources is needed for lending and the other programs as well.  And a greater vision is needed to address the deep-rooted problems facing this population.  All the existing programs and proposals are very important and useful, but they are not sufficient by themselves.  Additional types of assistance are needed.  I have written elsewhere about larger programs to address these issues including combining public sector, bank and nonprofit programs: “A Non-Predatory Financial Services Program for the Unbanked” and “A Non-Predatory Financial Services Hub Description”.  Both are available on our website at communitydevelopmentfinance.org.  Here, I will focus on lending programs to meet the needs of the unbanked and underbanked.

Designing a Realistic Program to Meet the Requirements of All Parties – Existing Conditions

Some form of alternative lending programs needs to be added to existing programs and proposals in order to create a fuller complement of programs.  What would this type of program look like?

There is a prevailing specific approach and set of recommendations.  The issues associated with payday loans typically are classified in the following manner:

The following five payday lending practices contribute to the creation of a debt treadmill for borrowers:

• • Lack of underwriting for affordability.
  • High fees.
  • Short-term due date.
  • Single balloon payment.
  • Collateral in the form of a post-dated check or access to a bank account.

The consequence of not repaying a payday loan is that the check used as collateral will be deposited or ACH transaction debited, which puts lenders “first in line” to be paid (rather than being “just another bill”).3.  Because the payday loan is tied to the borrower’s payday, the lender can be reasonably sure the check will clear. Most borrowers will simply run out of money to cover their expenses before the end of the month, often taking out more payday loans (and paying more fees) to pay for the expenses. (“The State of Lending in America and its Impact on U.S. Households”, Center for Responsible Lending, 2013, page 162.)

Some of these are key issues and have been incorporated into the proposed regulations from the Consumer Financial Protection Bureau.  For example, proposed regulations from the CFPB include limiting the loan to a monthly payment not greater than 5% of the borrower’s income along with an interest rate cap of 36%, a longer term and amortization.

In addition to the rates and loan structure, there is another key ingredient stated outright or implied in most of these proposals:

Alternatives to pay day loans must stand on their own merits. The question is not whether a loan is cheaper than traditional payday loans; it is whether it is affordable enough to be used sustainably by borrowers. The point of reference is the borrower’s well-being, not the cost of the most extreme products on the market. Any loan that is unaffordable is not a genuine alternative. Public policy needs to focus on eliminating harmful forms of credit, not expanding the array of dangerous products available to consumers…The point of reference must be the impact on the consumer, not the lender’s economics.  (“Stopping the Pay Day Loan Trap”, National Consumer Law Center, June 2010.)

These are all totally legitimate issues and concepts to structure an alternative payday loan program.  However, it also is extremely unlikely that this type structure could be implemented in a way to achieve a scale necessary to address the problem.  While legitimate and understandable, this overall approach seems flawed.  First, according to this narrative, because pay day loans are very predatory, they must be eliminated and outlawed – either outlawed outright or by creating legal restraints that make continuing the programs impossible.  Then, alternatives must be provided that do not account for the economic viability of the lender; only the affordability of the loan to the borrower must be considered.  Almost all of the description of the issues is from the borrower’s perspective and there is little attention paid to the lending costs and issues.  So, if the proposed loan structures are implemented but not economically viable, payday loans will effectively be eliminated and there will be few or no alternatives for many borrowers.  If one starts with the proposition that access to credit (not only payday loans but many other types of credit as well) is crucial to low income people just as it is to people with higher incomes, then a balance must be found that allows access to credit on a large scale that is economically viable for lenders as well as being affordable and reasonable to borrowers.  Otherwise, the government will need to provide access to credit or provide enormous subsidy and income support.  And that type of long term approach is not viable in today’s political and economic environment.

It probably is unlikely that the existing proposals can be viable in the long run when they

• Propose the effective elimination of pay day loans.
• Restrict the development of new products to ones that work for borrowers but are not economically sustainable for lenders.
• Advocate for banks and credit unions to make appropriate loans.
• Propose lending options that do not work economically for banks and credit unions.
• Support access to credit options needed for people who are lower income, higher risk and do not ordinarily qualify without extra, or extraordinary, effort.
• Not address the need to deal with the whole range of non-mainstream financial services products that serve low income people.

 

Therefore, CDF approaches these issues from a slightly different perspective:

• Access to credit is absolutely essential, but often restricted and problematic in low income neighborhoods and for many unbanked and underbanked households.
• The existing lending alternatives often are problematic or even predatory.
• Many legislators and administrators would like to end pay day loans and similar products but they do not offer, or try to find, any kind of an adequate alternative.
• Banks and credit unions are the desired institutions to replace these financial services.
• The desired replacement of these predatory products by bank/credit union products or by the U.S. Post Office is very unlikely to occur on any meaningful scale.
• Existing products and services should not be eliminated until adequate alternatives are available.
• To reach the necessary scale without massive subsidies, alternatives need to balance economic viability with providing fair, affordable financial services to low and very low income households with bad credit.
• New alternatives and approaches are needed that address the entire range of financial products and services in the Dual Financial Economy.

Designing a Realistic Program to Meet the Requirements of All Parties – A New Proposal

There needs to be a program that balances the needs of lenders and borrowers while it complements the excellent existing programs and infrastructure that has been created. Neither perspective can capture all the ideal issues that have to be addressed to create a program that will meet the needs of all parties and be viable and achieve scale.

The following is an outline of the types of strategies and programs that can complement the efforts needed to create a viable program and that balances the needs of borrower and lender:

Strategy #1: Keep working on the full range of all programs and approaches as described above.  There are many efforts, both local and national, that have worked to improve the lives of so many people.  The new program should support these efforts and build a complementary effort to strengthen and expand these existing programs.

Strategy #2: Affordability and Loan Structure

The fees and rates charged for loans for low income people with bad credit are often far too high and unnecessary for financial feasibility.  These rates and terms can be reduced to be much more affordable levels for low income people.  Generation of a larger scale should allow further rate reductions.  Likewise, the loans must not be structured to keep borrowers trapped in them due to their inability to pay off short term loans.

Strategy #3: Sustainability

The amount of capital needed to address these lending issues is enormous.  For example, there were 10.2 million payday loans made in California in 2018 from 1.62 million borrowers totaling $2.8 billion.  While many of these loans were rolled over during the year and do not represent new capital or the total capital required, the amount of capital needed still is massive.  And the operating expense for providing this capital is likewise extensive.  And this structure exists for just one type of loan in one state – payday loans, albeit a very large state with a large usage of this particular product.

To reach the fee levels proposed by many would require financial institutions to operate these programs at a loss.  And this would be a large scale loss if the program is implemented at a scale large enough to address the problem.  Or, it would require a very large amount of subsidy to assure break-even or a small profit for the lenders.  However, there is not enough subsidy available to make this program work on a large scale requiring massive levels of support.

Therefore, a program that addresses these needs must be sustainable for the most part.  It needs to charge fees to bring in income to cover costs.  Some subsidy will be needed for the development and startup period and occasionally for operations or other purposes, but subsidy unlikely will be the core element of the financing needed for this program.

Strategy #4: Scalability

The number of people needing assistance is very large as is the amount of capital needed.  So any program must be scalable.  Sometimes small scale efforts can be successful, but they may not be amenable to large scale implementation.  Large scale is a key issue for the new program.

Strategy #5: New Network

The so-called fringe banking industry has a deep network to be able to reach potential clients and customers.  They have stores and kiosks in low income neighborhoods which often are otherwise banking deserts.  They have a huge online presence and large marketing budgets.  And they utilize lead generators to bring in other borrowers.

Any alternative program needs a competing network.  Fortunately, one already exists but has not been tied together.  There are large numbers of nonprofit organizations working in these neighborhoods.  Likewise, there are many public agencies with equally deep ties in the neighborhoods along with churches and other religious institutions with extensive relationships and ties to neighborhoods.  This potential network needs to be connected to help identify people who need these new services and then to help them complete the paperwork and address any follow-up issues.  A small fee could be paid to the individual members of this network for each loan application submitted.  Creation of this network should lower risk and losses as well since the borrowers would be referred by agencies that already have relationships with the applicants.

Strategy #6: Technology

Fintechs have developed exceptional technology to make their lending possible on a very large scale.  However, their technologies and its uses will not be immediately or fully translatable to low and very low income people who are unbanked/underbanked with bad credit.  Their algorithms are designed for an entirely different population and most likely would result in rejection of many or most of the people who could, and need to become, borrowers.  In addition, they automate everything, including the loan decisions compared to the high-touch needed by many customers.  Also, these lending programs do not include direct financial literacy assistance.  Finally, it has been our experience that our borrowers, at this time, are not likely to be able to use the computer or phone to apply for loans – and therefore, the importance of the proposal to develop the network described in Strategy #5 above to assist with the loans can be seen.  But the technology can speed up the process and lower costs – both necessary elements of a large scale, sustainable approach.  A balance needs to be found between full automation and the existing high-touch approach to make this approach workable.

Strategy #7: Address the full range of financing needs

The primary focus of public policy has been placed on payday loans and the issues they raise.  But this program needs to address many other lending approaches far beyond payday loans: consumer installment loans, rent-to-own, pawn loans, auto title loans, subprime credit cards, etc. as well as non-debt and non-predatory sources.  The entire range of financial institutions serving low income people needs to be challenged and replaced.  The debt traps that they create need to be removed and assistance in reducing debt to manageable levels is a core element of this program.

Strategy #8: Financial Coaching

Many borrowers definitely need some form of financial coaching.  People interested in small loans like payday loans will not enter a financial coaching program when alternatives – even high cost alternatives – are available.  However, they will enter such a program when larger amounts are involved.  CDF requires that anyone who wants to be considered for a larger consumer installment loan must come to our store for a coaching session, which is really an underwriting session from our perspective; we review bank statements and credit reports, and we prepare a very detailed budget in order to determine cash flow which in turn allows us to set an appropriate loan term.  For a larger program, this meeting could occur through technology solutions such as Skype and other communications methods.  A call center of well-trained coaches/underwriters could be created.  While this step will add to costs, it likely would reduce losses as well.

Strategy #9: Implementation

There are many possible ways to implement this type of strategy.  It could be serviced entirely online.  It could be serviced completely as a back-office operation without any physical presence.  It could be serviced out of one or more brick and mortar stores.  It could be a combination of storefronts and online presence.  It also could be serviced out a re-imagined Financial Hub.

Financial Hubs would combine programs of the public sector, banks/CUs, and nonprofits and would offer services far beyond loans.  It could have financial services such as those offered by CDF now in its store: check cashing, money orders and money transfers, other check cashing services available in these stores, and of course a range of different types of loans.  To complement these services, a bank or credit union could operate one or more of the available teller windows and offer a range of banking services with very low operating costs for the institutions compared to creating and maintaining a branch.

The Hub also would offer extensive financial coaching and literacy training staff.  Other financial services could be co-located as well, such as small business lending and technical assistance services; perhaps a CDFI lending office; workforce training and development activities such as a tech training center along with job placement services; housing programs such as first-time homebuyer programs or anti-foreclosure programs; private sector businesses such as insurance and/or perhaps a real estate company, or export/import services if there are many immigrants in the neighborhood.

The Hub also could offer an ideal location for social justice activities.  For example, a consumer protection agency office could be stationed there, a location where some solutions could be immediately available for individuals seeking assistance.  Other programs that assist people with leviable debt, youth banking, ex-offender re-entry programs, etc. could be located in the Hub.  Separate programs often exist for them, but participants in these programs often have huge financial needs, almost greater than more typical customers. Locating in the Hub could allow more of their needs to be addressed.

It should be noted that implementation of these plans will require subsidies – grants, government contracts, donations, etc. especially during the startup period and early years.  Government frequently subsidizes a variety of social services for people in need and with income supports or other resources – healthcare, case management, workforce training, homelessness, etc.  However, government rarely subsidizes financial services programs beyond financial coaching.

Nevertheless, it is clear that some subsidies are needed.  There is a huge gap in access to safe and affordable financial services similar to the gaps faced by low income people for social services.  While there are some banks in low income neighborhoods of some cities, they tend to offer inadequate services.  They don’t reach enough people.  And many of the people that they do reach are not provided with fully bankable products and services.

Moreover, many of the alternative financial services that can reach this population with lower prices and other assistance also will need to have some subsidy in order to deliver affordable products to customers, although not at the level needed by social services.  Social services typically are fully subsidized but some financial services can generate revenue and, as a result, need proportionately less subsidy.

In addition, subsidy for an alternative financial store would generate very traceable savings to people in the neighborhood through reduced prices and financial coaching – and that leads to a multiplier effect.  The amount of savings, cumulative over time, likely would be many times the amount of subsidy spent and probably would return the amount of subsidy quickly.  And the savings that would be generated would result in more money spent in local stores to help local owners and help retain jobs in the neighborhood while assisting the recipients of the savings to have more funds for other necessities, savings, etc.  (CDF estimates the level of annual savings to its customers to be between $175,000 and $225,000; cumulatively, the total is approaching $2 million since we opened.)  So there are extensive benefits to providing some strategic subsidy to financial service providers.

Community Development Finance has worked on these issues for the past few years as it has gained experience through its own lending to help guide its plans for creating solutions.  CDF has developed a plan to implement these approaches that has included all of these strategies. (Please see the CDF website, communitydevelopmentfinance.org, for papers with a much fuller description of these programs: “A Non-Predatory Financial Services Program for the Unbanked” and “A Non-Predatory Financial Services Hub Description”.)

Conclusion

Debt issues are a major obstacle for many low and very low income people, especially those who are unbanked or underbanked and have bad credit.  These issues extend far beyond payday loan issues.  They are part of an entire institutional financial framework that serves low income people with bad credit; it features several different financial services with high rates and fees and it can trap people and make it very difficult for them to move out of poverty.  This can be termed a dual financial economy and it is this entire range of financial services which needs to be addressed, not just payday loans and check cashers.

Most of the most desirable solutions have not worked fully or even partially in some cases in the past and are unlikely to be successful by themselves in the future if any scale is to be achieved.  A new lending approach needs to be developed that would complement the excellent existing approaches and expand their impact.  This new approach should offer much lower fees and rates; be sustainable with only relatively small amounts of subsidy; be scalable; create a new network to assist potential borrowers; adapt technology to lower costs and speed the process while maintaining some direct contact with applicants; address the full range of necessary financing needs; include financial coaching; and create a new framework for implementation on scale.

New approaches are possible and should be developed that can provide solutions to the financial services issues facing low and very low income people who are unbanked/underbanked and have bad credit.

 

APPENDIX

Interest Earnings on Small Dollar, Short Term Loans

Loan Amount              Rate                 Term                Interest Payment

$260                            18%                 3 months          $7.84

$260                            18%                 6 months          $13.84

$260                            18%                 12 months        $26.80

 

$260                            36%                 3 months          $15.76

$260                            36%                 6 months          $28.00

$260                            36%                 12 months        $53.44

 

$500                            18%                 3 months          $15.07

$500                            18%                 6 months          $26.56

$500                            18%                 12 months        $50.08

 

$500                            36%                 3 months          $30.31

$500                            36%                 6 months          $53.80

$500                            36%                 12 months        $102.76

 

$1,000                         18%                 3 months          $30.14

$1,000                         18%                 6 months          $53.18

$1,000                         18%                 12 months        $100.16

 

$1,000                         36%                 3 months          $60.59

$1,000                         36%                 6 months          $107.52

$1,000                         36%                 12 months        $205.52

Community Development Finance.  2014