A Playbook for Small-Dollar Credit

With growing pressure on the payday lending industry and deposit advance on its way out, many are starting to wonder what's next in consumer credit. The need that drives millions of people to seek out small loans isn't going away. As more products recede, what will take their place?

According to the Center for Financial Services Innovation's 2012 Financially Underserved Market Size Study, subprime consumers spent an estimated $41.2 billion on small-dollar credit in 2012. We estimate that 15 million consumers use at least one of five common products – payday, pawn, auto title, nonbank installment and deposit advance. About a third of them regularly spend more than they make. For these borrowers, credit probably hurts more in the long term than it helps in the immediate term.  

For the other two-thirds of consumers, credit is a reasonable option: for smoothing a timing mismatch between paychecks and when bills are due; for covering an unexpected emergency; or for financing the purchase of larger durable.  Yet high-quality loan products that meet their needs are hard to come by. Some consumers have no credit history or a tarnished one, and therefore can't qualify for credit cards or lines of credit. Others simply need to borrow smaller sums than many lenders make available.

There is a tremendous opportunity for lenders to fill this gap. But the uncertainty about the regulatory rules of the road, combined with the steep reputational price of getting it wrong, are keeping too many good actors on the sidelines. Well-intentioned lenders don't have a playbook to follow.

Over the last six months, CFSI convened nearly fifty lenders, alternative data providers, consumer advocates, nonprofits and academics to create that playbook. The Compass Guide to Small-Dollar Credit defines the key characteristics of high-quality loans of less than $5,000, providing a roadmap for lenders to develop products that meet consumers' needs responsibly and profitably.

The guide provides detailed advice and examples organized around the life cycle of a loan, from marketing and underwriting to consumer communications and collections. Three key themes emerge:

It's not just about price. A lot of attention has been paid to price as the main gauge of a high-quality loan. While price is an element of quality, it is only one piece of the puzzle. In fact, one could argue that the biggest problem with the typical payday loan isn't the price, but a structure that requires full payback in two weeks, which frequently leads to multiple rollovers and an ever-increasing annual percentage rate.  Defining a quality loan requires moving past polarizing conversations centered on an artificial annual percentage rate litmus test. 

Ability to repay is paramount. High-quality lenders must have confidence in the borrower's ability to repay the loan before extending credit. This represents a big change from the status quo, in which lenders substitute rigorous underwriting with proximity to the source of repayment.

Of course, underwriting for the ability to repay is hard to do, especially for very small loan amounts. Gathering and verifying data about potential borrowers can be costly and time-consuming, and existing data may only paint a partial picture of a potential borrower's financial life. But access to new data sources and more cost-effective delivery channels should enable more lenders to underwrite responsibly while still delivering loans at reasonable prices. In the meantime, there is more work to be done to create proxies for assessing a borrower's ability to repay that can enable lenders to make good bets efficiently and economically while ensuring that meaningful numbers of consumers can qualify.

The solution is not one-size-fits-all. Our research shows borrowers have a variety of needs for small-dollar credit. Meeting those needs isn't as simple as replacing payday loans with slightly longer term, less expensive loans. Yes, for some borrowers, such as those facing an unexpected expense or making a planned purchase, an installment loan might be the best option. But there is also a need for lines of credit or credit cards for consumers with variable cash flow. The market needs standards that apply across multiple product types and lender categories. 

Defining a high-quality small-dollar loan is a first step, but it is by no means the most difficult. Lenders face real challenges and trade-offs as they put these guidelines into practice. Regulators, too, are facing their own balancing act as they begin to write rules that protect consumers from bad practices while allowing sufficient space for market innovation.

The Compass Guide to Small-Dollar Credit offers lenders a playbook to follow. Lenders who put it to the test will find a hungry and growing market, and an opportunity to reap first-mover benefits in market share and customer loyalty.  

Jennifer Tescher is the president and CEO of the Center for Financial Services Innovation. Beth Brockland is director of the Compass Principles initiative at CFSI.