In the aftermath of the great recession, more Californians than ever have turned to payday lenders; their number nearly doubled from 2006 to almost 2 million borrowers in 2011. This trend is alarming, given that payday loans are one of the most expensive and onerous forms of credit in existence, and that those most likely to use payday loans are often least able to afford them.
Here’s how getting a loan from a payday lender works. With proof of identity and income, a borrower writes a post-dated check for the loan amount plus interest and leaves the store, cash in hand. Most payday lenders charge the maximum amount allowed by law: in California, a payday advance of $300 usually carries a 460 percent annual percentage rate, roughly 35 times higher than a credit card and 85 times higher than an auto loan or subprime mortgage.
Unlike banks, payday lenders make no attempt to adjust interest rates based on the “riskiness” of the borrower. Instead, the extraordinarily high interest rate is based on the short-term nature of the loan, usually two weeks. Payday lenders say their short-term loans are primarily for financial emergencies, but close to half of payday customers in California use at least one payday loan per month. In fact, the industry makes most of their profits from repeat, long-term borrowers who take out six or more loans annually.
Our research has shown that payday lenders provide loans to individuals underserved by banks: those who aren’t financially sophisticated (read: little formal education) or those that need quick cash (read: poor). In other words, payday lenders provide short-term funding to those seen as too risky by banks based on interest-rate caps and concerns about profitability. Yet, larger banks have been more than willing to offer products like overdraft fees and direct deposit advances, which generate significant revenue by charging relatively high fees, not unlike payday loans.
But what if there were an alternative way to provide profitable small-dollar loans? There is – and California is leading the way.
In October, Gov. Jerry Brown approved the pilot program for Increased Access to Responsible Small Dollar Loans, an extension of a 2010 pilot program. Under the 2010 program, for-profit companies developed profitable business models that benefited borrowers instead of trapping them in a cycle of high-interest debt. For example, Menlo Park-based Progreso Financiero focuses on underserved Latino communities, extending loans of $3,500 or less at a fraction of the interest payday lenders charge and allowing borrowers to repay in small installments over a period of many months.
Today, Progreso Financiero actually reports successful repayment to credit bureaus. Now prudent borrowers who previously lacked any credit history can attain things many of us take for granted, like getting a credit card or even renting an apartment.
Additional startups entering this market can also serve as a beacon to show established financial institutions such as community banks how to operate profitably in the space. Unlike larger institutions, community banks lack the scale and technology to process large amounts of data, but now newer companies can do the work for them.
Los Angeles-based ZestFinance uses 70,000 variables to calculate a borrower’s risk, showing that a borrower calling in to say they will miss a payment is actually more likely to repay a loan; whereas someone not maintaining a consistent cell number is a red flag. With a more nuanced type of assessment, community banks will be able to better assess the true riskiness of a potential customer.
These efforts show early promise. Recent policy changes and private-sector innovations have put the under-banked within reach, and community banks already have the ability to make more lending decisions based on personal factors, not just numbers. But if better alternatives to payday lending are to truly develop, community banks need to step up to the plate. For the economic well-being of the 2 million Californians using payday loans, we hope they’ll take a swing.
Priscilla Hamilton and Donald Markwardt are research analysts at the Milken Institute, a Santa Monica-based think tank. With James Barth, they are the authors of “Where Banks are Few, Payday Lenders Thrive.”