On March 26th of this year the Consumer Financial Protection Bureau issued a proposal under consideration for possible rulemaking to “end the debt trap” caused by high cost payday loans, title loans, and certain high-cost installment loans. LendUp is in full support of reigning in the more nefarious practices associated with subprime lending, and ending the debt trap associated with some incumbent small dollar, short-term credit products.
Solving the problems in the small dollar, short term lending industry was one of the principal reasons we created The LendUp Ladder. The LendUp Ladder replaces a broken product with one that rewards customers who are responsible with lower rates and credit building opportunities over time; protects struggling customers with a safe product that features built-in transparency; and features flexible payment schedules that work for customers and change if their needs change with no hidden fees. But the proposal goes well beyond “ending the debt trap”. It effectively eliminates the product entirely. Though this is a complicated industry, I think there is a simpler approach than removing the last life line of credit from millions of working class Americans with few to no options.
I have two suggestions below, but first a little context:
There is a $45B market for consumers who only need to borrow about $200 to fix their car, pay their monthly cell phone bill, or buy a prescription. This market is not served by the mainstream financial market. This is the industry of last chances for 12 million Americans. But the industry has a major problem - a revenue model where the company wins when the customer fails; where a borrower can pay thousands of dollars in fees for borrowing a few hundred over the course of just a few months for their inability to repay ontime. That does not happen to the majority of borrowers; but it does to a few, and that must change.
When someone tells me that they have the solution to low income or credit challenged consumers’ “debt trap” problem, there are several things I commonly hear. But each of these “solutions” has problems that prevent it from realistically solving the $45B per year problem faced by consumers:
They should save more!
We agree, but if potential short term loan customers don’t have savings, this does not solve their problem today. We do believe financial service providers have a collective responsibility to teach financial literacy including topics such as interest rates, consumer rights, borrowing, budgeting and saving. That is why we created an accessible and understandable financial literacy series, which we make available to everyone, including modules on how to save and budget. See our YouTube page, which includes videos on these topics, here.
They should ask their family!
The reality is that this is unfeasible for many consumers, as their family or friends may not have money to lend them. It is not scalable, not dignified, and certainly can’t fill the $45B annual demand for short term loans.
They should go to a bank!
Banks generally do not make small loans. This is because of their old, expensive legacy software and underwriting systems, high overhead costs, and increasing compliance costs that make small loans unprofitable. Plus they are held to an arbitrary 36% APR restriction, which makes a fixed cost loan for a short period of time seem exhorbitantly expensive. For example, charging someone $15 to borrow $100 for a two weeks is an annualized percentage rate of 390%, even if it is only $15 on an absolute dollar basis. So instead they offer to lend a minimum of $1,000 at “only an 18%” interest rate, which means a borrower looking for $100 instead has to borrow $1,000 and pay $180 in absolute dollars - this is not only not the product the consumer wants, it is a product that is 12 times as expensive.
How do we fix this?
Ok, so what do we do? We cannot simply shut consumers out of an existing legal, extensively used, and generally well-liked credit option without proposing a solution in its place.
The simplest approach to just “end the debt trap” is to stop the places where consumers can get “trapped” by not allowing rollovers and refinancings that turn a short term loan into a long term obligation. These are the only real “traps”, and take care of almost all the bad headlines I can find on a Google search for the “problems with payday lending”. Narrowly tailoring any rulemaking to truly ending the “debt traps” makes the product less expensive so that consumers will pay less, and business will be forced to align their economic incentives with their customers, as they can only make money when consumers can pay them back (and not through a string of refinancings or roll overs). However, the proposal is not narrowly tailored and, in my opinion, there are two major problems that I believe will adversely impact the industry as well as those consumers who most need small dollar, short-term credit.
Don't Punish Responsible Borrowers
The first major problem relates to the frequency and timing limitations on consumer access to short-term loans, even for those consumers using the product responsibly and paying off their loans in full. These limitations do not lead to a change in demand, they actually lead to a higher cost of credit for consumers by driving them to street corner loan sharks, or options with potentially fewer consumer protections, and would deprive consumers who use credit responsibly of an array of safe and regulated credit options.
Solution: We should exclude limitations from users who borrow and pay responsibly, and instead reward them for their responsible behavior.
Create Ability to Pay Requirements that Work
The second major problem relates to the ability to repay requirements as proposed. The proposal effectively puts all independent and neighborhood brick and mortar lenders out of business, which, in some cases, are the only lenders that exist in the community - especially in ‘bank desert’ areas of urban America and small, rural communities. This hints that only large brick and mortar and online lenders will remain, which while easier to regulate, comes at the expense of the consumer. As written, the ability to repay requirements for online lenders would impose significant costs on both the consumer and the lender in time and money. But worse still, the income documentation provisions of the proposal disproportionately impact elderly, women, minority, and low-income applicants -- some of the very people the proposal is designed to protect. Applicants without a documented source of income - such as stay at home moms, or those earning money informally (baby-sitting, selling food, performing tasks or odd jobs for neighbors) would all be shut out from small dollar, short-term credit by this proposal entirely.
Even if applicants have the proper income documentation available, accessing it and submitting it to a licensed, online lenders isn’t as straightforward as it may seem - especially for lower income individuals.
The two most common ways online lenders ask for income documentation is via online submission (something that shouldn’t be taken for granted, given the availability of internet along with requisite hardware to scan income documentation in low income communities and an average current price for a smartphone of $254) or fax machine (a dated technology that is hardly convenient for the borrower or the lender). Alternatively, applicants could mail their income documentation, wait several days for a lender to receive and process it, and then finally receive their funds. If they wanted to submit it more quickly, applicants could overnight it at their own expense, upwards of $25. These funds are generally needed to solve an urgent need, so speed is critical.
Solution: Follow the example of the credit card industry. Allow for income verification with a reasonable degree of accuracy. Modeled income looks at a customer's job, company, and location to determine if his self-reported income is reasonable. If it deviates too far from a reasonable band, it can be verified with additional customer submitted documentation.
Alternately, the federal government and payroll providers could allow access to their income data through a secure API to properly vetted and credentialed companies, which would allow lenders to accurately verify income data in real time.
This Proposal Makes Life Harder for Those It's Supposed to Protect
Proposals like this have a disproportionate impact on low income communities and make the challenges of living on a low income even more severe, with no statistical justification it improves customer success. We should allow consumers in low income communities the same conveniences as wealthy Americans to apply online for sources of credit.
Together, the proof of income and ability to pay aspects of the proposal, as is, would harm consumers, stifle innovation, and reduce access to credit to consumers who need more options.
We need to protect struggling consumers from financial harm and educate them, instead of removing access and choice. We need to reward responsible borrowers with better options, not worse. As written, the proposal would turn short-term, small-dollar credit into the only segment of the financial services market where paying back on-time means you have fewer options instead of more.