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June 27, 2012

Providing affordable credit to underbanked consumers

June 27, 2012

The availability of small-dollar credit to low- and moderate-income (LMI) households was a major focus of the 7th Annual Underbanked Forum, hosted on June 13-15 by the Center for Financial Services Innovation (CFSI). Small-dollar credit refers to consumer loans under $2,500 (and are typically less than $500). The forum’s discussions highlighted two opposing business models for offering small dollar credit—one focused primarily on profit and one focused on customers.

The first model, normally associated with “alternative financial services” providers (payday lenders, pawnshops, rent-to-own stores, etc.) but also distressingly evident among mainstream institutions, is to extract fees and charges from LMI consumers who have difficulty managing credit. Intentional choices in product design and targeting stack the deck against borrowers, making timely repayment an unlikely prospect and resulting in lender profits. A prominent example is Internet payday lending, the most rapidly growing segment of the small-dollar credit market. Recent CFSI survey data indicate that fully 40 percent of borrowers do not make timely repayment on “very short” term loans—products with repayment periods of one month or less, such as payday loans, pawn loans, and deposit advance loans (taken out against an upcoming direct deposit to one’s bank account).

A contrasting model works off the premise that loan products can be designed to enable repayment and thus avoid the debilitating cycle of loan rollover and borrower dependency. With such products, repayment is rewarded, as the borrower’s record of payment is reported to credit agencies. Structural safeguards prevent misuse, and loan terms are transparent to the borrower. Lender risk is reduced to an extent that APRs of 36 percent or lower—less than one-tenth the effective rates for payday loans—become viable. These innovative products are offered by firms such as Tandem Money, ZestCash, BillFloat, Lending Club, and Progreso Financiero. The Tandem Money product, for example, is a creatively structured line of credit, with the loan amount conditioned on a borrower using their own savings to meet a portion of their financial need.

The emergence of this customer-focused small-dollar credit paradigm is an important market development, given the large number of newly underbanked consumers. Most underbanked households (81 percent) can be found in metropolitan areas. A legacy of the Great Recession has been the number of previously banked consumers who ended up making late payments or defaulting on loans, bringing down their credit scores and shutting them out of mainstream credit products. Many of these consumers are creditworthy, as evidenced by a recent Equifax analysis showing that more than one-quarter of the underbanked consistently make on-time bill payments. Add in their consistent payment history on utility and rent bills and 18 percent of those conventionally regarded as high risk are reclassified into a lower-risk category. Many of these consumers spend less than they earn every month, but they are vulnerable to unexpected financial shocks, such as car repairs or medical expenses.

Whether the consumer-empowering business model can make headway against its predatory counterpart remains to be seen. One encouraging sign is the extent to which mobile technology may enable the emerging lenders to reduce their marketing, underwriting, and servicing costs. Equifax has found that, among the underbanked, 29 percent have used mobile banking in the past year for deposits, payments, remittances, and other fund transfers. As evidenced by the growth of Internet payday loans, however, technology is also increasingly exploited by predatory lenders. A key question is whether innovative customer-centered product development in this market can keep pace.

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