What do payday, account-advance, bill-pay and auto-title loans have in common?
Three things, it seems: They’re underwritten to value collateral over cash flow; they’re designed to encourage repetitive borrowing; and their cost is so high, it’s as if the lenders want their borrowers — a demographic that includes recent college grads, working class and working poor — to default.
Collateral vs. Cash-Flow
Credit underwriting for traditional lending is governed by the 5 Cs of credit: capital, capacity, collateral, conditions and character. In a nutshell, capital represents financial worth — what you own versus what you may owe against that; capacity measures the extent to which you have enough cash running through your household to support the additional borrowing; collateral is the asset you agree to pledge in return for the financing you need to buy it (or, in the case of auto-title loans, the cash to pay your bills); conditions refer to the health of the economic environment in general and your ability to withstand changes to that; and character means credit history — in particular, how well you’ve handled however much of that you may have been granted in the past.
The question is, how should these Cs be ordered when a person’s credit is being evaluated for a loan? In particular, which should take precedence in the credit-underwriting process: excess cash-flow or collateral that’s anticipated to always be worth more than the loan balance?
Here’s a hint: Because these loan products are designed to appeal to borrowers who are short on cash, lenders that are interested in booking many high-priced transactions as fast as possible may be inclined to sacrifice capacity in favor of a bulletproof collateral position.
Repeat Customers vs. Repetitive Borrowing
If you had the chance, what kind of business would you prefer to run: One where your customers choose to work with you over and over again, or one where they have no choice but to do so? OK, let me ask that in a slightly different way: Which is more likely to stand the test of time?
Loan products that help borrowers to overcome financial difficulties or to take advantage of an opportunity are constructive. The companies that offer these are probably in it for the long run, too. The opposite, of course, is obvious — and unfortunate, especially for customers who are ensnared.
The culprit is an innovative group of specialty-finance products that are, in effect, “cash-flow accelerants.” Payday, bill-pay and account-advance loans are designed to make available today what would normally arrive tomorrow — less a healthy helping of interest and fees that are deducted from the loan’s proceeds. Consequently, consumers and small businesses that sign up for these may think they’re doing a one-time deal to get out of a tough spot, when in fact they’re setting themselves up for costly encores.
That’s because the full amount of next week’s payroll or next month’s accounts receivable now belongs to the lender, and the borrower is left with a cash-flow hole that’ll need to be filled with — you guessed it — another loan. That the APRs for these transactions often exceed triple-digits means that debtors will, over time, pay more in interest and fees than the value of the average loan they’ve taken out.
The High Price of High Risk
A fundamental truth of finance is this: The higher the risk, the higher the reward will need to be. But how high is too high, especially when the combination of rate and structure can mean the difference between successful repayment and default?
I ask because I worry about the destabilizing impact that costly loans can have on financially-tenuous households and small businesses — particularly those that resort to trading big equity positions for a modicum of cash, relatively speaking. Auto-title loans are a good example, not least because borrowers stand to lose that and more (when the car is repossessed) if they were to default.
Yet the lure of big profits is precisely why so much venture capital and private-equity money is flowing into this sector of finance. It’s also why investors clamor for shares of stock when these entities reach IPO size.
What Needs to Be Done
There’s been much talk about the plight of borrowers who’ve been victimized by certain of these products and the companies that offer them. Whether that leads to new legislation or added regulation to limit their more harmful aspects, such as that which the Consumer Financial Protection Bureau may be contemplating — a national usury limit that’s APR-based would be a great place to start — it’s important to understand and address the reasons why there is persistently high demand for these products: too little access to more fairly priced financing, inadequate financial-literacy education and growing wage disparity, for example.
In the meantime, it would help if the disclosures for these potentially hazardous specialty-financing products were as blunt as a surgeon general’s warning on a pack of cigarettes.