Small Money Lending and the U.S. Economic Climate

Over the past years, Americans’ access to credit has declined. Banks have been forced to tighten lending and credit standards time and time again since the financial crisis either in attempt to protect their own capital or in response to regulatory pressure. At the same time, Americans saw their savings largely wiped out. About 1 in 3 Americans live paycheck to paycheck and 54% of checking accounts are in poor standing. With savings at record lows, income stagnant, and income inequality rising, credit scores have been on the decline. Without access to credit, more and more people are resorting to payday loans, pawning their possessions, or incurring bank overdraft fees.

Currently, there are a few main categories of small money lending people turn to when faced with unexpected expenses (think medical bills and other emergencies). Title loans are one such commonly taken loan. The borrower allows the lender to put a lien on his/her collateral (usually a car) and must also give the lender a hard copy of the title to the property. If the borrower fails to pay off the loan in time, the title to the property is then transferred to the lender. In a sense then, title loans work similarly to pawning except they are usually for more money, the borrower has more time to pay them off, and important pieces of property the borrower usually uses regularly are the collateral. If the lender is good at selling the collateral without steep discounts, title loans can be very safe for a lender.

Payday loans are another popular, and perhaps most well-known, non-prime loan category. Payday loans are notorious for their high interest rates and opaque rules. Their loan payments are processed through the automatic clearing house (ACH), under which the borrower usually gives the lender authorization to withdraw payments. When a borrower is unable to repay a payday loan on time, they are allowed to roll over the loan for high fees. Often, these fees are also automatically withdrawn and the borrower can end up paying more than the original value of their loan in fees before they realize. The borrower is allowed by law to revoke ACH authorization from the lender but most borrowers are not told this and misinformation is common.

A common thread with the most well-known forms of non-prime loans is the lender’s means for collection are unusually powerful. Either the borrower makes payments in time or the lender dispossesses the borrower of a car or paycheck after paycheck. In a sense, the risks of making such a loan are artificially reduced and lenders are not incentivized to accurately assess the borrower’s ability to pay. Not all small money lenders are so irresponsible or outright malicious but the current environment does allow the bad actors to thrive.

With the plethora of data available today, it’s at first glance difficult to imagine why new entrants with more reasonable risk assessment tools have yet to disrupt the small money lending industry. Peer to peer lending platforms once made headlines but have yet to seriously make impact. One of the reasons is regulation is simply too confusing. The financial services industry is one of the most heavily regulated industries and is also in a state of philosophical confusion. It’s simply too difficult for new entrants to navigate the current system.

Another reason may be that small money loans are incredibly illiquid and difficult to value. A portfolio of title loans could become a portfolio of used cars in a month. If a payday loan borrower keeps rolling the loan over, the lender has no idea when the loan will reach maturity. Even worse, if the borrower is well versed in his/her rights and rejects the predatory automatic withdrawals, the lender and the borrower would need to settle the loan in court. All of these make for high-maintenance, undesirable financial products. A startup making such loans simply could not enter the hyper growth expected these days.

Maybe it’s a good thing that payday and title loans are such ugly financial products though. As the Consumer Finance Protection Bureau is working to simplify regulation around small money finance and regulate to protect borrowers, the market could see new entrants. The hope is that loan counts will increase while lending will simultaneously become more responsible. At the same time, traditional capital markets won’t develop the same voracious appetite for these loans as they had for mortgages or junk bonds that caused those respective markets to overheat. Then, maybe those relying on such loans may finally escape the cycles of bad debt they all too often get trapped in.