A study released last week by the Pew Charitable Trust made some interesting points about the nature of traditional installment lending and its regulation.
We welcome Pew’s assertion that installment loan payments create a pathway out of debt and, critically, are affordable for borrowers, generally falling below a (somewhat arbitrary) figure of 5 percent of monthly income.
We also applaud Pew’s finding that installment loans cost much less than other non-bank small dollar loan products “three to four times less expensive than using credit from payday, auto title, or similar lenders.”
Likewise, the finding that installment lenders can enable both lenders and borrowers to benefit echoes a point we have been making for years – only if the interests of borrower and lender are aligned, can demand be fulfilled through sustainable loans, made in a competitive environment.
The study’s focus is on how state laws governing the industry could be improved, and here some of our views and beliefs diverge with those of Pew.
Annual Percentage Rates (APR)
The study’s position on Annual Percentage Rates (APR)is that there is a discrepancy between the stated APR and the so-called “all-in” cost of the transaction, meaning that the total cost is less than transparent. This may be true, but we would point out that lenders are obliged to disclose APR as defined in Federal Truth in Lending Act (TILA). It would be illegal to do anything else. Besides, TILA disclosure is already as transparent as can be, itemizing all costs and disclosing “Total Cost of Credit” including ancillary products, alongside APR. “All-in” APR, then, serves only to muddy the waters. Redefining APR under TILA is a something only the Federal Government can accomplish.
Renewals and Refinancing
The study says that reducing the number of loan renewals or refinancings can be achieved by requiring origination fees to be folded into the overall cost, rather than earned upfront, a move that effectively raises the interest rate. This assumes that refinancings are mainly lender driven, when, in all cases, the borrower has a clear choice and the decision-making power, with no guarantee that their lender will agree to refinance. The wider problem here is that it ignores basic behavioral economics (usually a strong suit for Pew). If the aim is to reduce the number of refinancings, then making refinancing more attractive to borrowers is unlikely to achieve this!
The reality is that borrowers value renewals as a way to manage total debt. They understand thatby paying off their loans, they are effectively unlocking a pool of credit that they can choose to tap as needed. This allows them to borrow precisely what they need and no more, something that should not, counter to what the study implies, be seen as a bad thing. Structurally, a refinanced installment loan will always be better for the customer than either a revolving line of credit or a credit card with minimum payments. Both of those other options are more likely to lead to chronic indebtedness. Generally, the longer the loan, the lower the APR, but the more likely that a borrower will need to borrow more at some point. With an installment loan, at least, when that happens, borrowers still have a clear pathway out of debt.
Voluntary Credit Insurance
The study says that pricing on loans should be raised so it is no longer critical for the sustainability of the loan product to offer voluntary credit insurance. We agree that this makes sense, though there is an uncredited assumption in the study that insurance products have little value – something we vigorously dispute. Credit insurance allows borrowers to voluntarily increase their financial resilience – and we know savvy borrowers value that.
The study contains some misleading conclusions, about how credit insurance significantly raises the cost of loans. This assumes that the loan could have been made without the insurance. The reality is, as Pew recognizes elsewhere, that APR caps mean that fees and interest earned in some states are inadequate to attract capital for lending. The additional income generated from borrowers who choose to purchase insurance provides acts as a revenue source which allows lenders to serve demand. The alternative is a credit desert.
The study’s recommendation that credit insurance function like any other insurance policy with monthly charges rather than an up-front assessment, fails to take into account its very nature. In car insurance, for example, monthly payments will continue to be paid by the insured until the policy is cancelled, even in the event of a total loss or write off of the insured vehicle and associated claim. In credit insurance, on the other hand, in most cases, we can assume insurance payments would cease along with payments on the insured loan, leaving the borrower in a situation of needing to access insurance without having paid for it.
To DOWNLOAD the study, visit Pew Trusts.
NILA welcomes the work of Pew in furthering thinking about the nature and regulation of installment loans. We look forward to continuing the debate with them with the shared aim of ensuring that safe, affordable, well-regulated credit is available for those that need it, where banks will not provide it.