When I recently came across a NCUA proposal To expand its alternative loan policy, it was evident that there was growing interest among credit unions to expand payday loan alternatives. This interest is driven not only by higher margins, but by a growing awareness of making financing affordable for a segment that historically relied entirely on in-store payday lenders.
I’ve been researching this segment for over three months now to see how we can bring transparency and choice to this segment, and the statistics have surprised even a seasoned consumer credit professional like me. This article is an attempt to help you better understand these borrowers and shed some light on what credit unions should think about before making a foray. Let’s start with some statistics so that you can understand this segment of borrowers.
Payday loan (single payment) in store
Who is the consumer? According to the Center for Responsible Lending and a 2018 Alternative Financing Trends report from Clarity Services, the average borrower on a payday loan earns $ 2,500 per month ($ 30,000 per year) and is very likely to be employed in the retail, quick service restaurants, government, retail banking or business services. Their average age is 39 years with 68% or more of applicants in the 30 to 60 age group.
Why is this segment paying so much to borrow so little? The popular perception is that most of these borrowers need the cash to face some sort of emergency. But in reality, for this segment, emergencies don’t have to be a big hospital bill or an emergency auto repair. The majority of borrowed dollars are used to meet day-to-day financial obligations such as rent, children’s school fees, and car payments. Almost all borrowers intend to repay the same day they receive their next paycheck. However, on average, only 8% of their salary is available for loan repayment. As a result, they fail to make the lump sum payment and rely on the next loan to help pay off the previous loan. The industry calls this “loan sequencing” and unfortunately it is quite common.
Why are they not served by traditional lenders? The majority of these borrowers belong to the subprime segment. According to the CFPB, about 20% of Americans are either “invisible credit” or “unscorable credit”.
Invisible credits or non-notable credits are those on which the national credit bureaus (Experian, Transunion and Equifax) do not have sufficient data or data. Due to this lack of information about their credit records, traditional scoring models (like the popular FICO model) cannot rate the credit reports of these borrowers. These scores are an important part of lending decision making in the majority of traditional banks and credit unions. As a result, as soon as a borrower of this 20% reaches a traditional institution, he is unable to make a credit decision in his favor – resulting in a decline. In addition to the 20%, there are a significant number of borrowers in the lower end of the credit spectrum that traditional lenders do not have the risk appetite to lend. It is these two main groups that are turning to borrowing from payday lenders.
Market Shift: From Showcase Payday Loans To Online Installment Loans
Fintech meets borrowers online: Technology has long been used as a means of bringing efficiency where inefficiencies exist. In this particular case, fintech lenders are able to meet the financial needs of this segment in a channel of their choice – mobile and digital. Going online has not only helped fintech lenders avoid expensive storefronts; they were ready to give up volume margins, thus bringing supply-demand dynamics to this underserved segment. A lower cost footprint for lenders and good competition meant better rates and better products for borrowers. Better products also implied that there would be no lump sum payments (monthly payments now include interest and principal) and better loan terms (one to two years). This perfect combination of better products, better rates, and the ability to serve the consumer in their preferred channel all contribute to the rapid growth of the online installment loan category.
Some studies, including the 2018 Alternative Financing Trends from Clarity Services, have shown that online installment loan dollars grew at a breakneck rate of 580% from 2013 to 2017 (55% CAGR). A shift from traditional storefronts to online fintech lenders has been a blessing in disguise for these borrowers. Even traditional in-store lenders are seeing their market share shift to their online lending platforms, and some of them are ready to offer a differentiated (and competitive) product on their online platform.
But there is still a long way to go to make financing accessible and affordable for these consumers. Currently, some of the online fintech lenders include OppLoans.com, PayOff.com, SpotLoan.com, and RiseCredit.com.
Regulatory changes: Many states have capped interest rates, but in-store payday lenders almost always price their loans at those capped rates. Some states started lowering the caps in order to make these loans affordable, which deterred these lenders because they haven’t historically assessed the risk, and they got out. In short, borrowers in some states are now underserved. In 2016, CFPB began to assess the role of alternative data sources and how they can play a role in assessing the credit risk associated with this segment. Since then, he has made decisions to encourage lenders to assess the risk and price of risk (instead of using caps) and to determine the ability to pay before lending. While some of these directions may be overruled by the new administration, they have caught the attention of traditional banks and credit unions.
Political initiatives: The original policy and recent NCUA proposal is a classic example of how traditional institutions are starting to think about serving these underserved consumers. This is a welcome trend and one which I hope will lead to a drastic change in the number of lenders willing to serve this segment.
Where do traditional institutions fit?
As policy initiatives take shape, traditional lenders will open up to this segment, and it is important that they first understand how to assess risk for these consumers. Keep in mind that dark or non-notable credits make up the majority of this segment, and national credit bureaus cannot help lenders quantify risk. This created an opportunity for alternative data sources to bring efficiency where inefficiencies existed. While these consumers do not have any outstanding loans or loan payment history on their credit reports, they still pay monthly rents, monthly phone bill payments, and insurance payments, for example. . Alternative data sources such as FactorTrust and Clarity Services have become the gatekeepers of this payment history as well as alternative data sources for lenders who wish to assess risk for this segment. And not surprisingly, FactorTrust was acquired by an NCRA, Transunion and Clarity Services by another, Experian.
The charge rate for payday loans has always been as high as 32%, so it is not for the faint of heart. But this level of default is the result of unhealthy lending practices, including not assessing credit risk. The new generation of fintech lenders are able to assess risk and ability to pay using the alternative data sources described above.
Credit unions should note that scoring credit using these alternative data sources is very different from the methods used for traditional borrowers, but it’s not rocket science either. As long as the financial institution has an appetite for risk, these new sources of data can enable it to assess risk and turn it into a profitable business.
Deepak Polamarasetty is President and Co-Founder of CreditSnap Inc. You can reach him at [email protected]