Who deserves a loan? Is there an answer more fundamental than, someone who is likely to pay it back? The challenge is figuring out who that might be. Finding the answer can cost you. Not finding the answer can cost, too, for it means economic opportunity lost, for individuals and for the nation overall.
Consider short term, small dollar loans. These can be the most expensive for a lender to make, precisely because of the cost of identifying the good risks. Lenders report that analyzing borrower risk, together with basic costs of making, processing, and collecting repayment can run to several hundred dollars per loan. When the loan itself is for only a few hundred dollars, how does the lender earn sufficient profit to stay in that market?
Fortunately, there are lenders who offer short-term small dollar lending solutions. Their approaches vary, as do the borrowers.
Proposed restrictions at federal, state, and local levels would restrain many credit-worthy borrowers. Examples are annual rate caps on loans tailored to be repaid within a few months. Those who propose such mismatched restrictions should explain how in the real world they will not exclude people from access to credit who have access—and use it—today. It should be obvious that if these loans with government mandated restrictions could be offered profitably, someone would do so and absorb the market. That is not happening. Such bad public policy to control credit access is unfair toward a large segment of the population being served today.
Think of an ex-convict struggling to get on his feet. Bringing people into the economic mainstream is good for them and for the community, but how does one get started? Robert Sherrill, after 5 years in a federal prison, was able to get a small dollar loan from a specialized small dollar lender. He used it to start a commercial janitorial company, which now has a couple dozen employees. Sherrill also works to encourage others to reenter the mainstream.
This story is one of millions of small dollar borrowers, who make a up a $100 billion plus segment of the economy. What do they use the money for? Like Robert Sherrill, it may be to start a business. Often, it is to keep a business going. There are the self-employed, whose lawn service equipment has suddenly broken down. A $400 dollar loan can be the difference between working today or not. Another loan can get the car repaired to get to work. There are dental bills, a temporary job loss, the need to visit family across the country, a leaky roof, replacing a furnace in the winter or an air conditioner in the summer. How often can these expenses wait?
The biggest source of small dollar loans is credit cards. Lenders spread their costs across the ongoing relationship with the borrower. There are tens of millions, though, who do not want or cannot qualify for credit cards. According to the Federal Reserve, “Relatively small, unexpected expenses, such as a car repair or replacing a broken appliance, can be a hardship for many families without adequate savings.” That report goes on to say that nearly 40% of adults would have difficulty covering a $400 emergency expenditure. What is the source of credit for this significant segment of the population?
Several firms offer loans averaging more than $3,000, repayable over more than two years. Those help some but do not reach many others. Another focused on lending to people with low credit scores but, hard hit by the recession, raised loan levels to amounts approaching $10,000 and repayment periods ranging from 2 to 5 years, a product beyond the necessity and sometimes the reach of people who seek a few hundred dollars, often in a hurry. How do we serve those people, with very real needs?
Fortunately, a number of alternative financial service firms specialize in fitting short-term small dollar credit to borrowers who might otherwise be left out. Making use of Internet technologies, they make loans in amounts below a thousand dollars, repayable over a few months. Such lenders can be the last resort for non-prime customers. These short-term loans are in small amounts tailored to the borrower’s need, financed by fees, with rates explained in clear and understandable terms.
As a typical customer wrote, ,“They were amazing and helped me when I needed it most. They were able to approve me in a timely manner and got me out of an emergency. Thank you!” That was a market and public policy success.
Unfortunately, there are proposals that would make it harder to serve these borrowers, such as by imposing annual interest rate caps on loans customer-tailored for use and repayment in months. Public policy should encourage serving these good loan risks, attracting more providers, not chasing them away.