A Payday Lending Primer: Loan Sizes, Credit Invisibles and More

When I recently came across an NCUA proposal to expand its alternative lending policy, it was evident there is an increasing interest among credit unions to expand into payday loan alternatives. That interest is not just driven by higher margins, but by an increasing awareness about making financing affordable for a segment that has historically relied entirely on storefront payday lenders.

I have been researching this segment for more than three months now to determine how we can bring transparency and choice to this segment, and the stats surprised even an experienced consumer lending professional like me. This article is an attempt to help you understand these borrowers better, and shed some light on what credit unions should think about before making a foray. Let’s begin with some stats so you can understand this segment of borrowers.

Storefront Payday (Single Payment) Lending

Who is the consumer? According to the Center for Responsible Lending and a 2018 Alternative Financing Trends Report by Clarity Services, the average payday loan borrower earns $2,500 per month ($30,000 per year), and is highly likely to be employed in retail, quick serve restaurants, government, retail banking or business services. Their average age is 39 with 68% or more 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 money to deal with some sort of emergency. But in reality, for this segment, emergencies are not necessarily a huge hospital bill or an emergency car repair. The majority of the borrowed dollars go toward meeting day-to-day financial obligations such as rent, kids’ tuition and auto payments. Almost every borrower’s intent is to repay the very day they receive their next paycheck. However, on average, only 8% of their paycheck is available to make any loan repayment. As a result, they fall short on making the balloon payment and rely on the next loan to help repay the prior 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 map to the subprime segment. According to the CFPB, about 20% of Americans are either “credit invisibles” or “credit unscorables.”

Credit invisibles or credit unscorables are those that National Credit Reporting Agencies (Experian, Transunion and Equifax) either do not have any or enough data on. Given this lack of information on their credit files, traditional scoring models (like the popular FICO model) cannot score the credit reports of these borrowers. These scores are an important part of loan decision-making at the majority of traditional banks and credit unions. As a result, as soon as a borrower from this 20% reaches a traditional institution, it is unable to make a credit decision in their favor – leading to a decline. In addition to the 20%, there is a significant number of borrowers in the lower range of the credit spectrum whom traditional lenders do not have the risk appetite to lend to. It is these two primary groups that lean toward borrowing from payday lenders.

Market Shift: Storefront Payday Loans to Online Installment Loans

Fintech Meets Borrowers Online: Technology has long served as a means to bring efficiency where inefficiencies existed. 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 not only helped fintech lenders avoid expensive storefronts; they were willing to give up margins for volume, thereby bringing supply demand dynamics to this underserved segment. A lower cost footprint for lenders and good competition meant better rates and better products for the borrowers. Better products also implied there would be no balloon payments (monthly payments now included 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 rapid growth in the online installment loan category.

Some studies, including the 2018 Alternative Financing Trends by Clarity Services, showed online installment loan dollars growing at a breakneck pace of 580% from 2013 to 2017 (55% CAGR). A share shift from traditional storefronts to online fintech lenders has been a blessing in disguise for these borrowers. Even the traditional storefront lenders are seeing a share shift to their online lending platforms, and some of them are willing to put a differentiated (and competitive) product on their online platform.

But more needs to be done in order to make financing accessible and affordable to these consumers. Currently, some of the online fintech lenders include OppLoans.com, PayOff.com, SpotLoan.com and RiseCredit.com.

Regulatory Changes: Several states have interest rate caps, but storefront payday lenders almost always priced their loans at these rate caps. Some states started reducing the caps in order to make these loans affordable, and this created disincentives for these lenders as they have not historically priced for risk, and they exited. Long story short, borrowers in some states are now left underserved. In 2016, the CFPB began evaluating the role of alternative data sources and how they can play a role in evaluating the credit risk associated with this segment. Since then it has made some rulings to encourage lenders to evaluate risk and price for risk (instead of using the caps), and to determine the ability to pay before lending. While some of this guidance may be rolled back by the new administration, it did get the attention of traditional banks and credit unions.

Policy Initiatives: The NCUA’s initial policy and recent 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 that I hope will lead to a dramatic shift in the number of lenders willing to serve this segment.

Where do Traditional Institutions Fit in?

As policy initiatives take shape, traditional lenders are going to open up to this segment, and it is important that they first understand how to evaluate risk for these consumers. Remember, credit invisibles or credit unscorables form majority of this segment, and National Credit Reporting Agencies cannot help lenders quantify the risk. This created an opportunity for alternative data sources to bring efficiency where inefficiencies existed. While these consumers did not have outstanding loans or loan payment history on their credit reports, they are still making monthly rent payments, monthly phone bill payments and insurance payments, for example. Alternative data sources like FactorTrust and Clarity Services became the gatekeepers of this payment history as well as alternative data sources for lenders that want to price for the risk for this segment. And not surprisingly, FactorTrust was acquired by one NCRA, Transunion, and Clarity Services by another, Experian.

The charge-off rate in payday lending has consistently been as high as 32%, so this is not for the faint hearted. But that level of default is a result of unhealthy lending practices – including not evaluating credit risk. The new crop of fintech lenders are able to evaluate the risk and ability to pay using the alternative data sources described above.

Credit unions should note that credit evaluation using these alternative data sources are 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 data sources can allow them to price for the risk and make this a profitable enterprise.

Deepak Polamarasetty is President and Co-Founder of CreditSnap Inc. He can be reached at deepak.polamarasetty@creditsnap.com.