In this four-part series, Andrew Morrison, a NILA member from Sun Loan Company, deliberates on wrong-footed policymaking, unintended consequences and the importance of safe, affordable small-dollar credit…..
PART 2: IT’S STRUCTURE THAT MATTERS, NOT RATE (ATR NOT APR)
As we saw in Part 1 it is obviously not rate, then, that determines whether a loan is good or bad, which makes all those attempts to regulate based solely on rate so hard to understand. What is it that makes a loan likely to be harmful or beneficial? In a word, the answer is “structure”.
The most important aspects of a ”good” small-dollar loan are the tests of the ability to repay (ATR) during the loan process, and having the loan repaid in equal installments of principal and interest, without balloon payments at the end. These are the classic features of a Traditional Installment loan (TIL), which is why TILs are so often referred to as “safe and affordable.”
Other important positive features include reporting loan performance to the credit bureaus, allowing a responsible borrower to improve their credit score; and licensing and auditing of loan offices by state authorities, with the power to take action in the event of a valid customer complaint (the all-important right of redress).
Finally, a borrower should consider what is being risked, in the event they default on the loan. Have they pledged as collateral something they need to maintain their essential quality of life? Have they given the lender access to their bank account through an ACH?
All of these factors matter more than the APR of the loan, which comes into play as a tool for comparison, only if all other factors are equal.
When it comes to testing the ability to repay, or underwriting, clearly the best way is to do a full budget, examining the borrower’s actual monthly income and expenditures. Failing that, there are various methods and algorithms employed by companies to determine whether the loan will be repaid. Pew Charitable Trusts likes to use a general rule of thumb to indicate affordability, that payments of principal and interest should not exceed 5% of a borrower’s Gross Monthly Income. Their analysis shows that the vast majority of TILs fall within this.
Another important consideration, cited by the Center for Financial Services Innovation (CFSI), is that a successful outcome for the borrower be aligned with a successful outcome for the lender, and vice versa. (The possibility of a loan product being “predatory” exists only when those interests are not aligned.) Because traditional installment lenders do not securitize or sell their loans, it is true that, if the borrower loses, the lender loses too, and vice versa.
Incidentally, this alignment totally invalidates the thinking of those consumer advocates, whose plan for helping consumers seems to consist of ways to hurt lenders. If lenders and their customers’ interests are, in fact, aligned, there is no place for this kind of outdated, negative, zero sum thinking.
Hurting lenders also hurts borrowers.
