As unemployment claims across the US surpass three million, many households are facing unprecedented income drops. And COVID-19 treatment costs can be substantial for those who require hospitalization, even for families with health insurance. Because 46 percent of Americans lack a rainy day fund (PDF) to cover three months of expenses, either challenge could undermine many families’ financial security.

Stimulus payments could take weeks to reach families in need. For some experiencing heightened financial distress, affordable small-dollar credit can be a lifeline to weathering the worst economic effects of the pandemic and bridging cash flow gaps. Already, 32 percent of families who use small-dollar loans use them for unexpected expenses, and 32 percent use them for temporary income shortfalls.

Yesterday, five federal financial regulatory agencies issued a joint statement to encourage financial institutions to offer small-dollar loans to individuals during the COVID-19 pandemic. These loans could include lines of credit, installment loans, or single-payment loans.

Building on this guidance, states and financial institutions can pursue policies and develop products that improve access to small-dollar loans to meet the needs of families experiencing financial distress during the pandemic and take steps to protect them from riskier forms of credit.

Who has access to mainstream credit?

Credit scores are used to underwrite most mainstream credit products. However, 45 million consumers have no credit score and about one-third of people with a credit score have a subprime score, which can restrict credit access and increase borrowing costs.

As these consumers are less able to access mainstream credit (installment loans, credit cards, and other financial products), they may turn to riskier forms of credit. In the past five years, 29 percent of Americans used loans from high-cost lenders (PDF), including payday and auto-title lenders, pawnshops, or rent-to-own services.

These forms of credit typically cost borrowers significantly more than the cost of credit available to consumers with prime credit scores. A $550 payday loan repaid over three months at a 391 annual percentage rate would cost a borrower $941.67, compared with $565.66 when using a credit card. High interest rates on payday loans, typically paired with short repayment periods, lead many borrowers to roll over loans repeatedly, ensnaring them in debt cycles (PDF) that can threaten their financial well-being and stability.

Given the projected length of the pandemic and its economic impacts, payday lending or balloon-style loans could be particularly risky for borrowers and lead to longer-term financial insecurity.

How can states and financial institutions increase access to affordable small-dollar credit for vulnerable families with no or poor credit?

States can enact emergency guidance to limit the ability of high-cost lenders to increase interest rates or fees as families experience increased distress during the pandemic, like Wisconsin has. This may mitigate skyrocketing fees and consumer complaints, as states without fee caps have the highest cost of credit, and a large number of complaints come from unlicensed lenders who evade regulations. Such policies may help protect families from falling into debt cycles if they are unable to access credit through other means.

States can also strengthen the regulations surrounding small-dollar credit to improve the quality of products offered to families and ensure they support family financial security by doing the following:

• defining illegal loans and making them uncollectable
• setting consumer loan limits and enforcing them through state databases that oversee licensed lenders
• creating protections for consumers who borrow from unlicensed or online payday lenders
• requiring installment payments

Financial institutions can partner with employers to offer employer-sponsored loans to mitigate the risks of offering loans to riskier consumers while providing consumers with more manageable terms and lower interest rates. As lenders search for fast, accurate, and cost-effective methods for underwriting loans that serve families with poor credit or limited credit histories, employer-sponsored loans could allow for expanded credit access among financially distressed workers. But as unemployment continues to increase, this may not be a one-size-fits-all response, and financial institutions may need to develop and offer other products.

Although yesterday’s guidance from the regulatory agencies did not provide specific strategies, financial institutions can look to promising practices from research as they expand products and services, including through the following:

• limiting loan payments to an affordable share of consumers’ income
• spreading loan payments in even installments over the life of the loan
• disclosing key loan information, including the periodic and total cost of the loan, clearly to consumers
• limiting the use of checking account access or postdated checks as a collection mechanism
• integrating credit-building features
• setting maximum fees, with those with poor credit in mind

Financial institutions can leverage Community Reinvestment Act consideration as they ease terms and work with borrowers with low and moderate incomes. Building relationships with new consumers from these less-served groups could provide new opportunities to connect communities with banking services, even after the pandemic.

Expanding and strengthening small-dollar lending practices can help improve families’ financial resiliency through the pandemic and beyond. Through these policies, state and financial institutions can play a role in advancing families’ long-term financial well-being.