Keep Payday Lending Safe, Legal, and Rare

Keep Payday Lending Safe, Legal, and Rare

Nothing seems to get bankers, consumer advocates, and government regulators so riled up as payday lending. The short-term non-bank loans taken out by millions of consumers a year

Prisoner to the payments

Prisoner to the payments

are the focus of government studies and consumer reporting. But clearly, there’s a demand, and if we are creating personalized banking experiences for each and every consumer, there must be room here somewhere.

It’s easy to dismiss this financial vehicle as predatory and harmful, but it opens up the question: what should these borrowers do?

When you start to look at the data, you find that the story isn’t so simple and the pejoratives used to describe the industry and its customers don’t quite fit.

I’ve completed an initial analysis on the data reported by the Consumer Financial Protection Bureau (CFPB) in the United States and have drawn some conclusions about the behavior of the typical payday loan borrower. From those conclusions, we see what these borrowers need and we have an glimpse into how to provide it.

Keep Payday Lending Safe

It’s clear there’s a need for short-term borrowing – either as an emergency funding source or because of poor cash-flow management practices. The trick is to provide for short-term financing without trapping consumers in a never-ending downward predatory spiral.

The way to do that is to finally admit to ourselves one simple truth: these are not short-term loans. At least not the 14-day or 30-day ones that people think they are.

Data collected and reported by the CFPB in their report, CFPB Data Point: Payday Lending, shows that the typical payday loan borrower “rolls over” their loan multiple times – sometimes up to 11 or more times. This means that the financial need here is not until the next paycheck; it’s a long-term financial need.

Let’s finally admit it: these are not short-term loans.

Now what “rollover” means is different from state to state. Many states allow borrowers to roll their loan into a new loan immediately while some states require a “cooling off” period with the intent of preventing long-term borrowing.

The data indicates that these efforts are futile.

The CFPB reports almost no difference in rollover sequences between states with and without cooling off periods. In states with no restrictions, 84% of loans are rolled over within 14 days. States with a waiting period see 81% of loans rolled over while states that allow no rollovers see 83% of loans renewed. This is essentially no difference.

States with rollover restrictions see no change in payday loan renewals compared with those that have no such restrictions

Payday Loan Renewal by State Rollover Restriction (Source: CFPB)

Therefore, the conclusion is crystal clear: payday loans are longer-term borrowing vehicles.

Let’s start treating them as such.

The data tells us that consumers treat payday loans as 12-month loans. In fact, in some cases, consumers “self-amortize” by reducing the principal balance themselves each rollover. That doesn’t happen in every case, but in most cases, consumers do not increase the principal balance of their payday loans.

Now, perhaps this is because the transaction fees and interest eat up any opportunity to do so, but the data indicates that many consumers reduce their principal balance over time.

Less than 20% of payday loan borrowers actually increase the loan principal, and a plurality of borrowers paid monthly (around 40%) actually leave the principal loan amount unchanged. Compare that with only approximately 34% of monthly-paid borrowers who pay off the loan the first time and we can see that consumers are using payday loans to finance long-term needs.

These borrowers are perfect for one-year term loans.

But the fact that borrowers are able to “self-amortize” or at least do not increase the principal shows that payday loans are typically not needed for monthly, recurring overspending. These loans represent one-time, emergency funding that takes a consumer almost a year to payoff given their income.

That makes this market ripe for traditional, one-year amortized loans.

But what about defaults? Won’t those make this population unprofitable?

According to CFPB data, the default rates for payday lending is less than 15%. In some segments even as low as 6%.

But when we dig further into the default data, we can see where the problem lies. Defaults are concentrated in two major groups:

  1. Borrowers who increase the principal balance over the course of several loans, falling victim to their own “Ponzi scheme,” and
  2. Borrowers who cannot make even the first payment.

Default Analysis

By turning payday loans into amortized loans, we eliminate the “balance increasers” from the population. They represent about a third of all defaults.

Turning our attention to the other group, we have classic Early Payment Defaults (EPD). We know where EPDs come from. There are two root causes for EPD: bad underwriting and bad affordability estimates.

Bad underwriting is due to the lack of focus in this area. Payday lenders make so much money, there is little desire to have underwriting beyond the basics of identifying the consumer. If a bank were to take this function over, better underwriting and some basic credit guidance would help reduce defaults.

But bad affordability is a bit of a misnomer. Remember that payday loan borrowers that miss their first payment are held by consumers who – for whatever reason – cannot roll over that loan. This may be because of the “cooling off” periods mandated or because some other information changed that didn’t allow the borrower to rollover.

So they are required to pay off the entire loan. Not the first payment of a one-year term loan, but the entire loan upfront. Basically, state regulations or the structure of the loan itself is what has made the loan “un-affordable” for that first payment.

Defaults could decrease by up to 50% by improving underwriting and fixing the “affordability gap.”

Share of borrowers by change in principal loan amount between first and last loan, by sequence length (weekly, bi-weekly, twice per month paid borrowers)

Share of borrowers by change in principal loan amount between first and last loan, by sequence length (weekly, bi-weekly, twice per month paid borrowers) (Source: CFPB)

So affordability as we typically understand it is out of whack. If we amortized the loan, the consumer would only be required to come up with the first payment – not the entire loan. That could represent a 90% discount off the required payment (assuming a $350 loan at 29.9% interest for one year.)

That kind of change would drastically affect affordability.

I estimate that defaults could decrease by 50% in this group by simply improving underwriting standards and fixing the “affordability gap.”

Keep Payday Lending Legal

Even with all of this data, regulators and consumer advocates completely miss the point. Since we have consumers with short-term financing needs that the traditional banking system either refuses to provide or cannot provide because of regulation, they force consumers into the “non-banking” system to meet this need.

The fact is that these short-term loans should be available through credit unions and banks – even for customers with low credit – or no credit scores. Many banks will choose not to participate in this market. That’s fine. But many will want to and should be able to.

Generally speaking there are three things standing in the way of this happening:

  1. A lack of understanding of the consumer need.
  2. A lack of consumer data that would make underwriting this portfolio possible.
  3. A lack of support from government regulators looking to minimize (not manage) portfolio risk.

Lack of Understanding

Most bankers would dismiss this opportunity to serve the “underbanked” or “unbanked” because they feel like 14-day or 30-day loans just aren’t worth it. But the data shows us that this isn’t the case.

These loans can be profitable with a small origination fee and reasonable interest rate. Clearly, the interest rate would be higher than collateralized loans, but the business case can still be made. Even with an origination fee, the overall out-of-pocket expense for the borrower would be much better than what they experience in the payday lending space.

With a little work, these loans can be made profitable for standard banking institutions.

With a little work, these loans can be made profitable for standard banking institutions.

Furthermore, these kind of “cash loans” are common in developing economies like Eastern Europe and Asia-Pacific. They do not represent some “boogeyman” of the banking industry. Even in economies that have almost no credit bureau data, banks are able to make profitable and non-predatory cash loans available to the consumer.

Lack of Data

This population of borrower will have credit blemishes or in some cases, no credit history at all. Being able to underwrite thin, poor, or no file customers will be critical for success. Traditionally, bureau data has had a bit of a blind spot here, although they are doing great work to fill in the gaps.

Access to alternative credit data and scoring will be critical to support an underwriting process for these loans. The good news is that there are many choices out there.

Lack of Support

Of course one big barrier that needs to be overcome is the fear from regulators. By forcing banks to minimize risk rather than manage it, regulators have unknowingly pushed these consumers into the arms of the very people they rail against. One of the unintended consequences of portfolio risk management is to make “safe” lending to the underbanked population almost impossible.

Regulators are unknowingly pushing these consumers into the arms of the very people they rail against.

The CFPB should consider this in their analysis of the industry. Don’t cut off payday lending if there’s no where else to go. Consumer advocates are concerned about “outrageous” APRs for these loans. But compare them to the alternatives. It’s not like the need goes away when the funding vehicle does. Consumers still have to make a payment on their credit card, or cover a check from their account, or pay their utility bill.

Keep Payday Lending Rare

Obviously short-term lending to cover emergencies is unavoidable for many consumers. But the fear among financial professionals is that short-term and payday lending is prolific because consumers cannot manage their money.

There are two reasons why a segment of consumers need these short-term loan vehicles: macroeconomics and financial literacy.

There very little I can say about macroeconomics. And frankly, I don’t want to get into it. I think it’s reasonable to assume there will always be a portion of the population which is living at the  bottom of economic society.

But the financial literacy component can be addressed.

Typically, when payday lending is discussed I often hear the consumer dismissed with the comment that one wouldn’t need a payday loan if they could just manage their own money. Or even better, “just don’t spend more money than you have!”

Show me where we teach consumers how to do the kind of advanced cash flow forecasting necessary to balance the funds availability between checks, cards, online bill pay, automated withdrawals, and the wide variety of deposit availability rules.

I think this misses the point. Point to where in college – let alone in high school – where we teach people how to manage their finances. What we’re expecting consumers to do is manage cash flow – something that even accountants do only with great difficulty for businesses. I would argue that managing cash flow in a family is much more difficult.

In addition, banks don’t make this any easier. Combine different timing of debit and credit card transactions, online bill payment, checks, and deposit funds availability and this is a truly complex problem. Given that most of these consumers manage their finances with a balance inquiry at the ATM, it’s no wonder that the average consumer experiences overdrafts, cash flow problems, and a lack of savings. It was much easier when there were only checks to worry about.

Blaming this on the consumer when the banking industry has made this even more difficult is not productive.

Pairing unsecured, one-year term loans with a PFM tool will help fill the cash need gap and bring new consumers into the banking system that might otherwise be permanently shut out due to bad financial decisions.

The answer is a robust personal financial management (PFM) solution.

We're essentially asking consumers to do advanced cash flow forecasting on their spending and savings goals.

We’re essentially asking consumers to do advanced cash flow forecasting on their spending and savings goals.

Drop the pie charts and so-called “surprising results” about how much money is spent at Starbucks and start forecasting cash flow. If we want to make a positive impact on consumers, we’ll help them know when their money is gone – even before their balance is at zero. Right now, PFM is failing to provide enough value.

Short-term loans for this segment of the population should be bundled with a good PFM solution to help consumers manage their payments and expenses. This isn’t a new idea. The company TandemMoney tried this several years ago only to be shut down because of the threat of regulatory problems. Again, a place where regulation may be squashing innovation.

The fact is, consumers need better cash flow management advice. We can’t expect them to do this on their own. We don’t teach it, and we make it difficult. If we want expensive and potentially predatory borrowing to be rare, we have to make it that way through better financial literacy.

There’s Room for Short-Term Lending

If bankers are serious about their talk of reaching out to the underbanked or unbanked, this is an obvious place to start. Create a safe, legal, and rare way for consumers get to small, short-term amortized loans to bridge emergency funding – especially for those consumers with thin, poor, or no credit. It can be done with the right data and analytics infrastructure, supported by reasonable risk management policies.

More to Come

We’ll be publishing our full report, The Business Case for Short-Term Unsecured Lending, in the next few weeks outlining what a robust data and systems framework should look like for short-term lending. We’ll be including data vendors, underwriting procedures, and a decisioning framework to show how a lender can set up a responsible and profitable infrastructure for short-term lending.

In addition, we’ll show a typical portfolio profitability analysis along with statistical evidence to back up how to make such an investment a good one.