OPINION: Small-Dollar Installment Loans Belie One-Size-Fits-All Regulatory Scheme

Small-dollar loans are a form of unsecured credit that serves consumers who may not have access to other forms of credit. At least 25 percent of U.S. households are unbanked or underbanked, according to the FDIC. Among the unbanked, 27 percent borrow through small-dollar loans, rent-to-own agreements, pawn shops or refund-anticipation loans, a figure that rises to 40 percent among underbanked. In 2013, 12 million American households borrowed $46 billion in small-dollar loans. Yet traditional lenders such as consumer banks have avoided these products due to the different economics of small-dollar loans.

Policymakers in Congress and with the Consumer Financial Protection Board (CFPB) have grappled over weighing the benefit and harm to consumers from small-dollar loans and the need for an appropriate form of regulation. Unfortunately, much of the current congressional and regulatory public-policy climate is shaped by antiquated data and outdated assumptions that compare the costs of different forms of credit. A more complete understanding of the issue would identify the economic causes motivating these products.

CFPB’s analysis of single-payment loans, typically due in two weeks, shows that a small number of consumers repeatedly roll over their loans. More recently, installment-loan products have entered the small-dollar market. To provide a more complete picture of the market than anecdotes or consumer-opinion surveys, we recently completed a study of actual data on the growing installment market. We examined loans made between January 2012 and September 2013 in 16 states by four companies, licensed in accordance with state laws. The data sample comprises 55 percent storefront loans and 45 percent online loans. The typical (median) loan amount is $900, to be repaid over six months. The median gross annual income of borrowers is $35,057.

Our findings are revealing. Firstly, the ratio of loan payment to borrower income by itself is a poor metric for predicting whether the loan is paid off or not. Secondly, regulation imposing an upper limit on payment-to-income ratio is likely to reduce access to credit for a large majority of current borrowers, without a large improvement in loan payoff rates. For example, a regulatory requirement that caps payment-to-income ratio at 5 percent would reduce the volume of credit between 55 percent and 93 percent. A limit of 10 percent will decrease credit by 26 percent to 68 percent without any increase in loan payoff rate. Thirdly, less than a quarter of consumers borrow again within a short period of time. Those who do are more likely to repay their loans and are offered lower interest rates, suggesting that some repeat borrowers utilize the opportunity to borrow again based on their track record of payments.

Like any form of credit, some consumers choose small-dollar loans while others prefer other forms of credit. The products available reflect both consumer demand and the economics of lending within regulatory constraints. Efforts to regulate small-dollar loans should not be motivated solely by a desire to make them look more like other credit products. Congress must ensure this does not happen. Differentiated credit products allow consumers the freedom to choose products that best serve their needs. Some take smaller loans that are more affordable, while others choose larger loans after weighing their financial needs against their ability to pay. A regulation that prohibits lending based on simple affordability criteria risks substantial reductions in credit availability to a population that often has few available alternatives.

A cost-benefit analysis of the proposed regulation requires weighing the cost of reduced access to a financially underserved segment of the population against the benefit of a higher loan payoff rate and lower incidence of indebtedness. As judged by consumers themselves, the tradeoff is clear: They have chosen to take out the loan, presumably in the belief that doing so will make them better off. Limiting the payment-to-income ratio to 5 percent would reduce the incidence of loans that are not paid off less than 1 percent, but impose costs on 86 percent of current borrowers, who will not be offered the same credit on the same terms that they now obtain.

Raising the permitted ratio can reduce these costs, but it also reduces the benefits, because payment-to-income ratio alone is a poor predictor of the likelihood of repayment.

As policymakers confront the ever-changing consumer-loan industry, particularly small-dollar lending, it is imperative that Congress monitor and ensure that any CFPB regulations rely upon data that accurately reflects consumer realities rather than the anecdotal impressions of a few. The consequences for millions of hardworking Americans can be significant and severe.

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Howard Beales, Ph.D. is a professor of strategic management and public policy at The George Washington University School of Business. Anand Goel, Ph.D. is a director at Navigant Economics.

This article appeared in print in the March 31st, 2015 edition of Hamodia.