By Mitchell D. Weiss
There are lots of cash-strapped consumers out there who, for all practical purposes, are closed out of many traditional credit product offerings because of the high default risk they're presumed to represent. But that doesn't mean the financial services industry hasn't figured out ways to profit from their plight. After all, the "unbanked" and "under-banked" demographic, as it's known, is huge -- estimated to comprise more than a quarter of all U.S. households -- and its need for financing is acute, especially during tough times.
So the industry has created a slew of pricey specialty loan products that were designed for lower-income borrowers with poor credit. I'm talking about payday, bill-pay and refund anticipation loans, insurance-premium financing, structured settlement and private student loans.
But are the risks associated with these credit products truly so great that they justify the outsized rewards the lending institutions earn for marketing them? Let's take a behind-the-scenes look at how these financings are structured and you can decide for yourself.
Payday Loans (aka Account Advance Loans)
Many companies pay their employees in arrears --- this week's paycheck is based on the previous week's hours. They're also likely to pay every other week or twice-monthly. So it's not unusual for a low-income earner to feel the pinch in between payrolls, hence the creation of the payday or account advance loan.
As long as the borrower's employer is a bona fide company that can confirm its employee's continuing earning status, and as long as the payday lender is able to gain control over its borrower's next payroll deposit, the lender will have effectively ensured the repayment of its loan. The borrower, however, might not fare so well. That's because the cash-flow "hole" he's created for himself by trading next week's paycheck for this week's cash is likely to provoke a recurring need; at least until he's able to generate enough extra cash-flow to bridge the gap on his own. In fact, according to a report by the Center for Responsible Lending, the typical payday borrower remains indebted for two or more years for a loan that was intended to span one or two weeks.
And the reward for what turns out to be a very tightly-managed risk? The typical account advance lender loan charges more than 600% APR (annual percentage rate) for the service.
Consumers who live from paycheck to paycheck often run short. However, as long as the borrower's checking account activity is consistent -- predictable payroll deposits every other week, comparable-dollar utility, cable and cellphone payments every month -- and as long as the borrower agrees to a preauthorized Automated Clearing House from that checking account, the bill-pay lender will then have virtually managed away its risk when it covers one of the borrower's monthly cellphone payments.
The bill-pay lender's reward? When you combine the processing fees and interest, the APRs can approach 200 percent.
Refund Anticipation Loans
Payroll tax over-withholding is not uncommon for low-income earners (and others) who may lack the financial literacy education that would help them to understand the math behind the process. Consequently, those who live with unforgiving budgets may be strongly tempted to take advantage of the quick cash-hit a tax refund advance represents.
From the lender's perspective, as long as the tax return was properly prepared and filed, and provided that it can secure the refund once it's been issued, it'll have effectively offset the risk of nonpayment by swapping the credit of the low-income borrower for that of the U.S. Treasury -- the issuer of the tax-refund check.
The refund lender's reward? According to the National Consumer Law Center, the APRs for these loans range from 100 percent to 200 percent.
Insurance Premium Financing
Auto insurance premiums can be expensive, especially for those living in major urban areas. And while many insurance carriers offer payment plans for their policy premiums, some don't. Enter the insurance-premium finance companies. The loans are typically structured with a down payment that's at least equal to the non-refundable portion of the total annual premium: the up-front money the insurer gets to keep even if the policy is canceled right away. The balance is then spread out over fewer months than the policy is designed to cover. That way, in the event of a payment default, the lender is able to cancel the policy before the remainder of the premium has been "earned" by the insurance carrier and pay itself back with the refund. As a result, the risk is once again very tightly managed, if not completely eliminated.
In return, the borrower pays an interest rate that's usually much lower than for payday, bill-pay or refund anticipation loans, which seems like a pretty good deal -- that is, as long as the payments are made on time with checks or ACH drafts that are backed up with sufficient funds on deposit. Otherwise, the high fees the finance companies charge for late payments and bounced checks can easily escalate the overall cost for these nine or ten-month loans to the mid-double digits or more.
Structured Settlement Loans
Hardly a day goes by without a structured settlement loan commercial that features a campy mini-opera or a little dog planting a money tree. The pitch is, you're entitled to a future stream of payments -- whether from a court settlement, annuity or some other source -- but you need the money now. High risk? Not so much. That's because the lending decision has less to do with the borrower's creditworthiness than it does with the entity that has agreed to remit the payments in the first place.
The reward? According to a transaction sampling published by the Bankruptcy Law Network, APRs can approach the mid-double digits.
Private Student Loans
Generally speaking, students who borrow for their education don't have payroll checks, tax refunds, prepaid insurance premiums or structured settlements to pledge as collateral in exchange for the money they need. As such, you'd probably conclude that student loans are actually the riskiest of this group of loans, right? Well, yes, unless you consider that except in extreme circumstances (as measured by the Brunner test), these loans are virtually impossible to discharge in bankruptcy. So the question becomes, what's a fair price to charge for a loan that sticks to your personal credit like gum to the bottom of a sneaker?
According to the government, it's 3.4 percent if you can demonstrate financial hardship and 6.8% otherwise. The private lenders, however, feel differently. I do a fair amount of pro bono counseling work at the university where I teach, and the students and alums I help are struggling with private student loan debts that carry interest rates as high as 15 percent. To give you a sense of the impact this kind of rate differential can have, borrowing $10,000 at 15 percent for 10 years is the same as borrowing $16,400 at 3.4 percent for same duration. Is it any wonder why more and more students are moving into their parents' basements after graduating college?
Ideas to ConsiderFace it, the financial services industry isn't likely to reform or discontinue these high-priced lending products on its own --- there's just too much money at stake. Therefore, it's up to those who need these specialty loan products to learn how to avoid the worst of the deals and limit the damage from the ones they end up selecting. A few suggestions:
- Payday loans and bill-pay loans are not only very expensive but they also have the very real potential of becoming the kind of debt traps I described before. You're actually better off taking a credit card cash-advance, even if it comes with a 25% interest rate plus a 5% fee (which is what my own credit card company charges). The APR calculates to a little less than 35%, if the loan were to be paid off in 12 months -- far less than for either of the alternatives. This simple APR calculator, courtesy of Efunda.com, can help with the math.
- Insurance-premium financing can make sense if you're careful about not missing a payment or bouncing a check. Otherwise, the fees will eat you up alive. If you're obtaining your insurance coverage through an intermediary (insurance agent or broker), double check that the carrier doesn't offer a less costly service of its own.
- Structured settlement loans can also make sense provided that the interest rate is low enough, you're prepared to live without the monthly payments you would have otherwise received and you're disciplined enough not to fritter away the cash once you get your hands on it. Online calculators such as this one, courtesy of Zenwealth, can help you decide.
- When it comes to financing higher education, try to limit your borrowing to the programs the government has made available to students and parents. In addition to lower rates of interest, the feds also offer the most repayment flexibility -- which is particularly important in times of economic difficulty.
This story is an Op/Ed contribution that originally appeared on Credit.com and does not represent the views of the company or its affiliates. Mitchell D. Weiss is an experienced financial services industry executive, entrepreneur and adjunct professor of finance at the University of Hartford. He is also the author of the recently published College Happens: A Practical Handbook for Parents and Students and Life Happens: A Practical Guide to Personal Finance from College to Career-2nd Edition.