Fair Lending   Technology   

How Short-Term Loans Could Break the Cycle of Debt

In 2015, the FDIC conducted its National Survey of Unbanked and Underbanked Households. The results showed that 7% of U.S. households had no interaction with the banking system.

An additional 19.9% of households were underbanked, with access to only basic financial products like checking or savings accounts, and relied on financial services outside the banking system. This translates to roughly nine million households that are unbanked and 26 million that are underbanked in the United States.

The majority of these households are low and moderate income consumers with limited or poor credit history. With banks wary of lending to them, payday lenders and other predatory loans fill these households’ credit needs. It’s an endless cycle of high-interest debt that prevents low-income consumers from building long-term wealth.

OCC Signals Change, Then Reneges

While the Office of the Comptroller of the Currency initially signaled they would greenlight banks to provide short-term, high-interest loans to compete with payday lenders, ultimately Comptroller Otting withdrew support due to its predatory nature, costs, and regulatory implications.

Alternative short-term credit services could be a conversation opener for banks providing new pathways for consumer education, credit and savings building, and improved financial positions. Creating additional access points to legitimate financial services and education fills a void in many of these communities and can help navigate away from predatory payday lenders.

If banks offered short-term lending and other services, they could enter markets that are untapped and provide economic opportunity and relief to a predominately LMI base. Banks can help these customers establish accounts, learn financial literacy and money management skills, and build wealth.

Nine million households are unbanked and 26 million are underbanked in the United States.

The Road To Financial Recovery

The big question to answer is: what should these loan products look like?

These loans are inherently high-risk with borrowers turning to payday lenders when banks turn them away. Banks need to review current product offerings and risk appetite to evaluate what products could be created and tailored to build a road to financial recovery for high-risk borrowers.

First and foremost, these products would need to meet all regulations and laws to provide borrower and bank with safe lending products. This would include conducting a risk assessment and setting minimum requirements for borrowers to qualify for credit. The products also need to be profitable in order for banks to continue offering these solutions to a larger community of high-risk borrowers. Small loans can be costly to underwrite and the profit margin might be too small to be viable.

The best potential solutions are hybrids that involve partnering with community organizations.

The best potential solutions are hybrids that involve partnering with community organizations, introducing education programs, and creating new products from the ground up.

Some ideas include:

  • Partnering with organizations that target LMI, underserved and underbanked communities. There are a number of organizations that provide financial literacy and empowerment programs, locally, and nationally.
  • Creating a savings vehicle for qualified customers to help build their credit – such as one that has a daily limit and no overdraft fees. This savings account should encourage wealth-building and money management. After a defined period of establishment, this could translate to loan eligibility.
  • Considering other innovative products that may function as credit, but also provide ways for the borrower to save and build wealth. For these consumers, the issue is not simply the need for a loan. Borrowers are often living paycheck to paycheck. If they keep falling behind, they amass debt. A line of credit that stabilizes income could mitigate the financial stress of living paycheck to paycheck, making loan repayment more likely.

Postal Services Meet Banking Services in High Need Areas

To address payday lending in the most underserved and underbanked areas, Senator Kirsten Gillibrand (D-NY) proposed a solution to maximize the existing infrastructure and services through the United States Postal Service (USPS). The Postal Banking Act legislation suggests making banking services available at all 30,000 USPS locations nationwide. While it may not appear a likely match at first glance, Gillibrand’s proposal would allow the USPS to provide financial products and services, including:

  • Small-Dollar Checking Accounts: Low-cost checking accounts for direct deposits, check cashing, and bill paying.
  • Small-Dollar Savings Accounts: Interest-bearing savings accounts that build wealth and could be used in combination with other federal, state, and local savings programs.
  • Small-Dollar Loans: Low-fee and low-interest rate micro-loans for customers.
  • Transactional Services: Debit cards, low-fee cash machines, online services, and bill payments.
  • Remittance Services: Domestic and international wire transfers.

The Postal Banking Act legislation suggests making banking services available at all 30,000 USPS locations nationwide.

Banks could make it possible to provide these products in conjunction with the Postal Service, either in conjunction with community organizations or through their own independent programs. Could banks be persuaded to join forces? Senator Gillibrand’s proposal aims to enable access to legitimate banking services in low-income areas by leveraging the USPS’s available resources.

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Stopping the Cycle of Debt

The end goal of payday lending competition and reform is to provide an exit strategy from the cycle of debt among high-risk borrowers. Banks have a responsibility to help low income consumers build their assets, learn valuable money skills, and get access to financial products within the traditional banking system.

Banks proactively initiating similar programs expand consumer confidence in the banking industry and in turn reach a new class of consumer formerly underserved by the traditional banking system. Ending the cycle of debt creates a new pipeline of potential customers, investors, and homeowners for banks that serve them.

Jessica Zeigerman

Compliance Professional, RiskExec

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