Why small dollar credit is not underwritten and why policy makers can’t force it.

Loan AppWhen you compare traditional credit and short-term credit options, you will find very few things in common. Other than both having terms of payment, everything else is very different, including the regulations that control them. One of the most significant contrasts between the two types of credit is what is involved in the credit approval process. One financial CEO even joked of short-term credit approval requirements, “All you need is a pay stub, a bank account and a heartbeat.” This general lack of requirements and underwriting has brought waves of scrutiny in recent years about whether short-term, high cost loans provide financial value to the consumer (i.e. does the loan benefit the consumer’s financial well-being).  These loans are intended to be short-term in nature but often turn into longer-term financial vehicles for many consumers. Extensive research shows that consumers of short-term, high-cost loans often have few alternatives for quick access to small loans which can make them a prime target for unregulated products that promise quick cash and few credit checks, and it is becoming increasingly obvious that the short-term credit industry needs regulations.

Traditional Credit

Credit assessment for a traditional consumer loan requires that a consumer submit information about their income along with a review of their credit reports and credit scores. Lenders assess a consumer’s risk profile to determine how much they can afford to borrow based on current income, liabilities (short-term, long-term, revolving, etc.) and credit history.  Terms of a credit contract (e.g., an interest rate and a monthly payment) are established based on this assessment. This entire process can take anywhere from a couple of days to a couple of weeks, and is carefully analyzed by loan experts.  This evaluation comes with a significant cost to the lender and is often not practical for small, short-term loans.

Small-Dollar Credit

The payday loan approval process is quite different and is significantly faster. Lenders typically only check to see if borrowers have a bank account and steady income, and many lenders claim they can get borrowers their money the same day they apply. This evaluative process doesn’t give short-term credit lenders a very accurate appraisal of their customers, and may lead to high default rates.  There is no consistent, accurate way for a lender to know how many loans a borrower already has, and if any of those loans have already defaulted or been rolled over. This general lack of information leaves both lenders and borrowers exposed to risk. However, this business model does allow for traditionally credit strapped consumer to obtain small dollar credit when traditional creditors will typically reject the request.

Why is there no underwriting?

ficoBanks and other financial services rely heavily on FICO credit scores to establish whether or not individuals are an acceptable risk in providing credit. These scores are based on data provided by the 3 major US credit bureaus, and include factors like debt, credit limits and credit histories. Unfortunately, these credit bureaus are very restrictive on the types of data they will accept, making it difficult for the tens of millions of American adults with no credit history to build a healthy financial profile with the major credit bureaus.  These consumers face additional hardships as banks and credit card companies have tightened their loan requirements since the 2008 recession, requiring higher credit scores in order to obtain access to credit.

PRBCThis current credit system offers very limited options for the underbanked. One organization, the PRBC (Pay Rent, Build Credit) made a strong effort to help them achieve easier access to financial services, but eventually fell short of their objective. The PRBC’s goal was to use non-traditional forms of payment history to help individuals without a credit history build credit. They built a database that would store individual’s rent payments, utility payments, cell phone bills and even prepaid cards to try and establish a credit history.  The PRBC even went as far as to secure partnerships with FICO, the National Credit Reporting Agency, and the National Association of Mortgage Brokers, but major lenders never adopted the PRBC’s reporting and it was eventually sold to new owners in 2008 with little to show for its efforts.

Since then, FICO has partnered with multiple other alternative credit reporting companies with varied success. Alternative credit reports can contain many different kinds of information including; demographic information, utility and rent payments, criminal history, how often you change addresses and if you hold any professional licenses. Many of the major lenders still do not trust these new credit reports because there is no obligation for them to report and their information may be scattered at best. Some experts also believe that payday loans recorded in these alternative reports could hurt consumers no matter their payment history. Some believe lenders may view using payday loans as a risky behavior because of their high interest rates, and that they could penalize borrowers regardless whether or not they paid their loans back on time. Alternative credit reports present very different information than traditional credit reports, and how this information will be interpreted is still a mystery.

A customer base that is primarily without credit history, a demand for quick access to money and the cost associated with underwriting has made it difficult to incorporate into the small dollar credit industry. These pressures, coupled with the refusal of major lenders to accept nontraditional forms of credit history, make underwriting for the small dollar credit industry not feasible and the need for regulation even more prevalent.

 

References:

http://www.cashamerica.com/Files/Annual%20reports/Cash_America_2013_Annual_Report.pdf

http://www.philadelphiafed.org/community-development/publications/conference-summaries/Underbanked_Summary.pdf

http://tuitionmanagementsystems.com/understanding-and-aiding-the-unbanked-and-under-banked/

http://www.ibisworld.com/media/2013/05/16/how-banks-regulators-can-better-serve-the-underbanked/

http://www.nwcua.org/community-impact/member-resources/anthem/bank-on-oregon-hopes-to-serve-unbanked-under-banked-consumers-across-the-state

http://files.consumerfinance.gov/f/201403_cfpb_report_payday-lending.pdf