Why low-interest payday loans could scale

January 8, 2012
Megan McArdle responds to my post about consumer lending in Missouri by expressing skepticism that it's possible to lend to people with bad credit unless you do so at extremely high interest rates.

Megan McArdle responds to my post about consumer lending in Missouri by expressing skepticism that it’s possible to lend to people with bad credit unless you do so at extremely high interest rates. She gives a number of reasons why this might be the case, all of which are entirely plausible.

For one thing, she says, the risk of default is high — and particularly invidious when you’re lending money out for short periods of time. Think of it this way: what happens when you lend 100 people \$500 each, for one year, at 10% interest, with a 10% default rate? You start the year with \$50,000. You end it with 90% of the loans paid back — that’s \$45,000 — and another \$4,500 in interest on those loans, for a total of \$49,500. And you also have \$5,000 of defaulted loans, which are worth say 25 cents on the dollar. Which means you make a total profit of \$750.

On the other hand, what if the term of the loan is six months, but the 10% default rate stays the same? Then after six months you’ve got \$45,000 back, plus \$2,250 in interest, for a loss of \$2,750. And if you run the same program again in the second half of the year, you’ll lose another \$2,750. Instead of being down \$500, you’re down \$5,500. Yes, you’ve now got \$10,000 in defaulted loans rather than \$5,000. But even so, you end the year with a loss of \$3,000.

The point here is that defaults aren’t evenly distributed: instead, they’re highly front-loaded. If you haven’t defaulted in the first six months of a one-year loan, you’ll probably pay it off: the probability of default is always highest at the very beginning. And so if you lend for shorter periods rather than longer periods, you have to increase the interest rate you charge, just to make up for the fact that the default rate is not going to fall. Which is the opposite way round to how yield curves normally behave.

On top of that, notes Megan, small loans are labor-intensive: the fixed costs of processing such things are high as a percentage of the principal amount, and the kind of people who take out such loans are, in the parlance of retail banking, “high touch”. These are not the sort of customers who apply on line and repay their loans through online-banking balance transfers.

And so Megan comes to her conclusion. “Credit unions lack expertise and skill in this sort of loan”, she writes, and payday lenders tend not to be particularly profitable, which means that

the reason that the credit unions aren’t putting them into cheaper loans is that they can’t. The cost of an unsecured loan to someone with terrible credit is high because those loans go bad very frequently, resulting not only in the loss of funds, but in considerable overhead expended on collection.

All of this is perfectly reasonable. But I’d point out three arguments pointing in the other direction.

Firstly, what payday lenders are really selling is convenience, at least as much as it is loans. Check cashers, payday lenders, and the like do not keep typical banking hours: they’re open late, they’re open at weekends, and they are generally found in small storefront locations which would not be suitable for a fully-fledged bank branch.

This is entirely rational — you want to be where your customers are, and you need to be able to reach your customers when they’re not working any of their jobs. But at the same time, it’s expensive. And in general, credit unions are already paying for the cost of their overheads, before they start offering any kind of payday loan. So while payday lenders have to cover a lot of overhead from the proceeds of just one product, credit unions have to cover just the marginal cost of the payday loans, which is a great deal smaller. After all, their staff and real estate is already being paid for. If you went up to a payday lender and said that you’d cover the cost of their real estate and their labor, you can be sure that either their rates would come down or their profits would go up.

Secondly, credit unions have a significantly lower cost of funds than payday lenders do. Most importantly, they can take deposits, which pay little or no interest. Payday lenders, by contrast, tend to be small organizations which are largely unregulated. When they borrow money, they have to pay up for doing so.

And thirdly, credit unions are non-profits. There’s only one reason to set up a payday lending shop: to make as much money as possible. Credit unions, by contrast, exist to serve their shareholder-members. If those members need payday loans, then it behooves the credit union to find some way of giving them those loans, even if they’re not particularly profitable.

There’s a pretty strong argument that credit unions should offer payday loans at zero marginal profit — the customers who ask for them are among the credit union’s neediest members, and pretty much by definition they’re also least able to afford expensive financial products. A case could even be made for extending payday loans at a small loss, just because the cross-subsidy is attractive to the membership as a whole. Think of it like an insurance policy: if you join the credit union, then you know that if you ever do fall on very hard times, it’ll be there to help you through them.

Which brings me to the Salary Advance Loan offered by the North Carolina State Emloyees’ Credit Union. Megan wonders whether it’s only possible because state employees’ paychecks are particularly reliable, but the structure of payday loans makes them all relatively safe: they’re fully collateralized by the money coming at the next payday. You can only get one of these loans if you’re employed, and you can demonstrate how much your next paycheck is going to be.

The NCSECU product is very well put together. It involves financial counseling; the creation of a savings account; and a modest interest rate of either 5% or 7%. It lacks the convenience of most payday loans: the credit union surely has shorter office hours than most payday lenders, and the product is more complicated. But the interest charged is so much lower that taking out one of these loans is always going to be a better idea than going to a payday lender who might charge upwards off 400% APR.

And I can’t help but think that with a bit of goodwill, other credit unions across the land could follow suit — even (especially!) those which aren’t specifically designed to cater to a low-income or underserved population. The non-profit business model is a very powerful one in financial services: just look at Vanguard. And I suspect that a lot more credit unions could push the envelope of what they offer, if only they had the will to do so.

Are low-interest payday loans from credit unions “a game changer that will revolutionize payday loans”, in Megan’s words? Probably not — but if they’re not, I think it’s more about credit unions’ willingness to provide these things than it is about their ability to do so. The product exists, and it works. The problem is making it scale.