Nontraditional lending is booming — payday, bill-pay and auto-title loans for consumers; merchant advances and unsecured loans for small businesses — it now represents hundreds of billions of dollars worth of click-through credit for tens of millions of borrowers each year.
There’s a reason for that.
According to an FDIC survey, nearly one-third of all U.S. households are either unbanked (having no relationship with any bank) or underbanked (having limited eligibility for traditional banking products and services). Small businesses are also fast becoming alternative financial services (AFS) converts as many continue to have difficulties accessing traditional credit products.
AFS loans are typically smaller in size and they remain outstanding for only brief periods of time — from a few days to several months. As such, the amount of interest-related dollars that lenders are able to earn is limited. Often the loans are also unsecured (uncollateralized), which means they would have little if any recourse should the borrower default.
So the alternative lenders’ dilemma is: how to charge enough to keep the lights on and their benefactors (venture capitalists and private equity firms) happy without squandering the goodwill of their customers, and of course, running afoul of the law.
Fortunately for the AFS lenders, the financial stars and planets are perfectly aligned at this time: interest rates are low, yield-hungry investors are abundant, regulatory oversight is slight, and statutory usury limits vary from jurisdiction to jurisdiction.
Despite that, some have decided to reach for more.
Is the Cost of AFS Loans Justified?
These loans are often structured in ways that encourage debtors to re-borrow the same amount or more soon after—a practice known as round-tripping. Loan costs are also typically divided into components of interest rates and fees – amounts that may seem modest when compared with the small amounts being financed. For example, a one-month loan that carries a 5 percent rate of interest plus 15 percent in fees is actually the equivalent of borrowing at a more than 200 percent annual rate of interest.
The reason for the split-pricing approach is this: interest is interest and fees are, well, something else. And because the fees are something else, the prevailing view is that they should fall outside the purview of the state regulators and their usury calculations, which means: the sky’s the limit.
Increasingly, however, states are taking a closer look at these tactics. In fact, some have begun to take forceful issue with companies they believe to be engaged in deceptive and predatory practices.
But the reality is, AFS loans do cost more to transact and they do carry more risk. So the rates arguably should be higher than for larger denomination loans to more creditworthy borrowers. But how much is too much, and how can borrowers be better protected from unscrupulous loan companies?
Tackling the Issues With AFS Lending
In a recent interview, Richard Cordray, the director of the Consumer Financial Protection Bureau, spoke about the difficulties federal agencies face in regulating entities that are subject to a state-by-state patchwork of conflicting usury limits.
He’s right and perhaps these three suggestions will assist in curtailing some of the more abusive practices.
To start, lenders that operate in multiple states should be federally regulated. Their loan products should be properly described, rates and terms fully disclosed and all of them compliant with newly enhanced consumer and small business protections. Those that exclusively operate in a single state should be similarly regulated by that state.
Lenders should be compelled to express the cost of their products in Annual Percentage Rate (APR) format — a methodology that translates interest rates and fees into a single metric — so that prospective borrowers will be able to compare and contrast rates and terms more easily. The calculation should also reflect how the taking of a security deposit and/or the premature commencement of a loan will negatively impact interest.
Finally, these APRs should become the universal standard for setting all statutory usury limits as they pertain to small-denomination loans for consumers and small businesses alike.
As long as universal access to fairly priced and reasonably structured credit remains elusive, borrowers who are unable to qualify for a better deal will pursue alternative solutions. The key is to keep the greed in check and the financing channels open. Sensible regulations that are assiduously overseen would help.
This is an op-ed contribution to Credit.com and does not necessarily reflect the views of the company or its affiliates.