Prospects Rising for Lower-Cost Small-Dollar Loans

The nation’s three federal bank regulators—the Federal Deposit Insurance Corp. (FDIC), the Federal Reserve Board, and the Office of the Comptroller of the Currency (OCC)—are working together to find ways to improve access to small-dollar loans, raising hopes that more banks could offer affordable small installment loans that cost about six times less than payday loans.

To date, most banks have not offered small installment loans in part because of concerns that without explicit approval, they could be subject to future regulatory action. An announced agreement on rules for such lending could substantially boost the market for affordable alternatives to payday and similar high-cost loans.  Twelve million American adults use payday loans annually. Average borrowers earn about $30,000 per year, and most use costly payday loans to cover ordinary living expenses over the course of months, not unexpected emergencies over the course of weeks. Bank regulators are examining ways to make less burdensome alternatives more widely available.

“We gathered a lot of valuable information through this process, particularly about how banks structure their small-dollar credit products, how they underwrite those loans, and how they use technology to service them,” said FDIC Chairman Jelena McWilliams at the Community Development Bankers Association peer forum and membership meeting in June. “We are using the feedback we received to formulate guidance that can help institutions develop small-dollar loan programs that meet their business needs and are safe, accessible, and understandable to consumers.”

Like the regulators, the National Credit Union Administration (NCUA) also has committed  to improving affordable loan options, taking a first step toward that goal by finalizing a small change to its  Payday Alternative Loan program in September. 

That action follows new guidance last year from the OCC that paved the way for U.S. Bank to begin offering new small installment loans with prices markedly lower than payday, auto title, and other high-cost loans.

These loans feature terms that are largely in line with The Pew Charitable Trusts’ published standards for safe and affordable small-dollar loans. The three-month loans are repaid in equal installments and feature payments that don’t exceed 5 percent of a borrower’s monthly income. They cost $12 for every $100 borrowed, which translates to an effective annual rate of 71 percent— about six times lower than typical payday loan rates. For example, a $400, three-month loan from U.S. Bank costs $48, compared with about $350 from a payday lender.

When Pew surveyed payday loan customers about numerous possible reforms, the most popular was enabling banks and credit unions to offer small loans at significantly lower prices than those charged by payday lenders. Research by Pew—and U.S. Bank’s actions—demonstrate that banks and credit unions have such a large comparative advantage that they can offer loans at prices that are six to eight times lower than payday lenders and still make a profit. The annual percentage rates have to be higher than those on credit cards, of course, but neither the public nor the payday loan borrowers Pew surveyed see that as unfair as long as APRs do not exceed double digits. Effective annual percentage rates for payday, pawn, auto title or rent-to-own loans can top 300 percent.

This kind of small-dollar loan product offered by banks and credit unions to their checking account customers would likely be accessed through mobile and online banking platforms. According to the FDIC’s most recent National Survey of Unbanked and Underbanked Households, 93.5 percent of Americans have bank accounts, which means most would have access to such services. In addition, technological innovation has enabled automated underwriting and loan origination, with applications processed via mobile or online banking and the proceeds deposited into customers’ accounts the same day. That saves banks money and time, and can help consumers borrow more quickly from banks than they can from payday lenders. These small installment loans could be made without borrowers leaving home or disclosing information to a third party, such as a payday lender, which improves their safety. If these loans were to become widely available, millions of borrowers now using payday and other high-cost loans could save billions of dollars annually.

Michael D. Thompson is a vice president at The Pew Charitable Trusts, overseeing work ranging from building fiscally sound government budgets to protecting public safety, consumers, and health.