If Payday Loans Go Away, What Replaces Them?

by Alex Johnson 0

The quick answer? No one knows.

For the slightly longer answer, let us turn to the New York Times:

The lenders who advance poor people money on their paychecks charge exorbitant interest rates that often snare the most vulnerable customers in a cycle of debt, the industry’s critics have long said.

Yet even consumer advocates who loathe the industry admit it fulfills a need: Providing small amounts of cash quickly to people who can’t qualify for credit cards or a bank loan. Roughly 12 million Americans take out a payday loan each year, spending more than $7 billion, according to the Pew Charitable Trusts.

But with proposed new regulations from the Consumer Financial Protection Bureau predicted to cut deeply into the industry, experts and consumer advocates are trying to figure out what will replace it.

According to the NYT’s sources, there are a couple of potential replacements for traditional payday loans:

SAME BIRD, NEW FEATHERS: The simplest answer is the industry will survive, and keep doing what it is doing by changing the nature of the loans it provides.

Nick Bourke, a researcher at Pew who has spent more than five years looking at the payday lending industry, says the industry is already making adjustments in the wake of new regulations. When Colorado effectively banned traditional payday lending, the industry moved into high cost installment loans that are paid over a few months instead of all upfront in a few weeks.

This evolutionary change to payday seems very likely, as it has already happened on a state level in response to regulations.

PAWNING: Another possible beneficiary may be pawnshops. A 2015 Cornell University study found that states that banned payday loans saw more activity at pawn shops

This seems like a less-than-ideal outcome, from a consumer protection standpoint.

BANKS TAKE OVER: Consumer advocates and the CFPB have been quite public in saying the best solution would be for traditional banks, which are highly regulated, to take over payday lending. Banks have plenty of locations, easy access to funds, and can make loans at much lower interest rates and still be profitable. But banks have been cool at best to the idea. Payday loans are seen as a risky and expensive. The costs for underwriting and processing them would eat into profits from the high interest rates they carry.

CREDIT UNIONS: There are already some experimental alternatives going on to replace payday loans.

One program run through credit unions is called the Payday Alternative Loan, where a customer can borrow between $200 to $1,000 at 28 percent interest and an application fee of $20.
There’s also a program being tried in Atlanta, run by the credit agency Equifax and the National Federation of Community Development Credit Unions, that will provide payday loan alternatives that would come with lower interest rates as well as financial counseling to help people avoid borrowing in an emergency again.

Banks and credit unions taking over is clearly the preferred path for regulators when it comes to satisfying “legitimate” small dollar credit needs. However, it is also clear that many banks and credit unions (particularly smaller community institutions cited as examples in the article) lack the automated loan underwriting and processing technology to cost-effectively serve high risk small dollar credit applicants.

Interestingly, a lack of efficient underwriting and processing capabilities is also one of the primary reasons that traditional banks and credit unions have long underserved verticals like small business lending and debt refinance. Alternative lenders have exploited this efficiency gap to grab significant market share in these underserved markets. Recently, banks have shown a desire to build out more sophisitcated online lending platforms to profitably compete in verticals like small business. It will be fascinating to see if payday lending becomes a priority in banks’ online lending renaissance.

Overview by Alex Johnson, Director, Credit Advisory Service at Mercator Advisory Group

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