Implications for Lending Practices and Policy
Around two-thirds of short-term borrowers seek to cover bills that come before payday or simply earn too little to cover basic household expenses, with around one-third of borrowers taking out loans for an unexpected expense.1 Having a lower-cost alternative to high interest loans can keep these households from losing their bank accounts or having their electricity shut off. Addressing this issue is important for lower-income households in Cook County, as well as the 39 percent of Black households and 32 percent of Latino households in Cook County without a savings account.2
Most people have an aversion to high-interest debt regardless of income, numeracy, or financial literacy.3 People choose high-interest debt most likely because they know they can get approved quickly when they don’t know where else to go, don’t have a clear sense of how it compares to other types of debt, underestimate payments needed to get out of debt, or overestimate their ability to pay the debt off in the future.4 Nearly half of payday loan borrowers in one large-scale study couldn’t remember their APR and most thought the dollar cost for one month was the dollar cost for three months of borrowing.5
Ensuring that there are clear, affordable alternatives that improve financial health over time can help build a virtuous cycle of economic growth across the region. We believe our findings, combined with broader research around borrowing behavior, can help lenders and policymakers design better products and public policy around the rules of play in consumer lending.
“I’m a former banker. I hated having to turn away people.…I think we need to talk about different products for people with different backgrounds and income so that they have an option. Where is the product for those people?” —Ashley, age unknown, Woodlawn
Beneficial Community Lending Practices
Banks, community development financial institutions (CDFIs), credit unions, financial technology (fintech) firms, and local nonprofits could keep customers longer, increase uptake of new products among existing customers, and open new markets by offering alternatives to predatory loans in low- and moderate-income communities. This could simultaneously be incredibly useful for building financial health in these communities. Unfortunately, many times these products aren’t well marketed or have complicated applications and slow and opaque approval processes. The following practices can ensure products are both attractive to customers and build economic stability in underserved communities.
Clear, Simple Loan Eligibility and Quick Processes
Both our research and that of others has shown that people consistently choose more expensive loan products because they know they qualify and will receive the money within a day or two. People will not choose lower-cost alternatives unless it is crystal clear that they compare favorably with the products they are accustomed to using, especially in communities that do not trust traditional financial institutions. Clearly stating, in simple terms, who is eligible; providing a short, simple application process; and creating a one-to-two-day turnaround will help replace high-interest loans with better alternatives.6
Tech-Enabled Alternatives to Credit Checks
Merchant websites have a number of ways of assessing risk for payment plans that do not involve credit checks. Offering alternatives to credit checks can make low-interest loans more accessible to Black and Latino communities where avoidance of taking on credit is common, credit scores tend to be lower,7 and affordable financing can be harder to find.
Just-in-Time Financial Education
Most people do not understand compound interest well, have anxiety about math that hinders computation, and overestimate their ability to pay back debt, so building knowledge about how debt can be used responsibly could be hugely beneficial.8 Because most people quickly forget what they have learned about finance, financial education programs have shown almost no impact on behavior.9 Bite-sized financial lessons and coaching at times of decision can help. For example, giving people quick summaries of good versus bad debt when they are making financial decisions has been shown to help them make better financial choices.10
Choices Shown in Real Dollars and APR
Multiple studies have found that people routinely take out higher-interest loans when cheaper credit is available.11 When thousands of payday borrowers were shown the cost in dollars of their loan over two weeks, one month, two months, and three months compared to the same costs using a credit card, the amount borrowed went down by 24 percent and future borrowing went down by 11 percent.12
Default Choice Architecture Used for Good
People are likely to take the default option offered to them, even if it is more expensive.13 Socially conscious lenders can flip this on its head to make the default option the choice that is most optimal for the customer’s financial health. This could include automatic enrollment and small deposits in a savings or simple investment account.14 Smart defaults based on customer attributes or adaptive defaults based on previous consumer choices can help make sure this approach meets consumer needs.15
Repayment Time Improved
Breaking debt down into smaller amounts for specific items leads people to allocate 19 percent more money to repayment, and starting with the smallest debt first can make people more likely to follow through on debt pay-down plans.16 Including this element in lending apps, online account interfaces, or bills could help improve consumer credit usage and repayment.
Temporal Framing to Increase Savings
Pairing small, low-interest loans with an automatic savings or investment program that shows the contribution in daily or weekly payments is more likely to increase uptake, using the pennies on the dollar principle.17 A nonprofit loan program could put a portion of the interest payment in a savings account, for example, rather than simply giving out a savings planner, which is less likely to work.18
Loans that Improve Credit with Regular Repayment
Offering small dollar credit-builder loans that report on-time payments to credit bureaus can be helpful for underserved communities. Nonprofits or credit unions can also use choice architecture to offer two or three clear repayment options, with the one that is financially best for the consumer selected as the default.19
Overdraft Fees Replaced with Small, Short-Term Loans
While overdraft fees can be very lucrative, banks and credit unions can close fewer accounts and hold onto customers longer by offering an alternative.20 Creating a regular, low-interest line of credit under $250 for account holders that is available until payday, and that can be automatically approved based on customer payment and deposit history, could help build customers’ financial health.21 Since people make more shortsighted choices when money is tight, reminding people right after payday to take action to avoid a pattern of shortfalls may improve financial stability.22
Policy Considerations
Solve for Multiple Problems
Any policy solution that eliminates high-interest loans but doesn’t help people make ends meet is a partial solution. Incentivizing banks, credit unions, fintech, and nonprofits to provide low-cost help for regular expenses that come before payday and for financial emergencies is essential to improving financial health in low- to moderate-income neighborhoods. Only providing financial education when people simply don’t make enough money has limited impact.
Enact Federal Caps and Guidance
Having a patchwork of banking regulations in 50 states makes it harder to protect consumers, leaves them vulnerable to gouging, and makes it difficult to enforce safe lending policy in the Wild West of online and nonbank lending. The federal government should enact a cap of 36 percent APR on lending and enforce the cap across the board. This includes regulating interest rates and fees for pawnshops and other high-interest lenders that people may turn to when payday loans aren’t available.23
Require Honest Lending
Federal regulations should require a standard, simple table of actual borrowing costs for all loans across the country. Use lessons learned from the 2009 Credit Card Accountability Responsibility and Disclosure Act to improve immediate consumer information, in simple language, about payments and the total cost of paying off loans over time compared to other types of credit.24 The language should clearly describe how costs increase if the borrower borrows more or rolls over a loan.
Expand Programs to Meet the Size of the Problem
Programs such as the CDFI Fund Small Dollar Loan Program are important, but the annual funding in Illinois alone represents a tiny fraction of the small dollar loan market and most CDFIs focus on other types of loans.25 While credit unions and other CDFIs are an essential resource, credit unions are greatly limited in scope and the number of total CDFI awards each year is dwarfed by the size of the need. Not only is additional funding necessary, but creative solutions that leverage different sources of capital are also sorely needed. Creating new funding sources that allow for collaboration among nonprofits, CDFIs, credit unions, fintech, employers, and state agencies could make a difference. Expand funding for community-based solutions similar to Capital Good Fund, the Kansas Loan Pool Project, Ko’olau Federal Credit Union, Common Wealth Charlotte, Common Wealth Athens, and the UPI Loan Fund.26
Create Incentives for Financial Institutions
Using tax policy and the Community Reinvestment Act to incentivize financial institutions to provide affordable, short-term capital in low-income neighborhoods with limited banking options could also increase financial stability.
Regulate and Harness Fintech
Fintech and online banking have the potential to improve banking access and solve problems mainstream banks do not, but they also have great capacity for harm. It can be incredibly difficult to enforce state caps on interest rates and other laws with the explosion of online financial services. The federal government must enact clear guidelines and require a federal registry and common data reporting for online lending.27 Regulation of online financial services should be approached in a way that allows for creative solutions to old problems.
Make Artificial Intelligence a Force for Good
Artificial intelligence (AI) could be a powerful tool for educating consumers, if regulated well. With the right protections in place, generative AI that only draws from confirmed, accurate sources could provide consumers with useful, just-in-time financial advice.28 However, there is just as much, if not more, capacity for spreading inaccurate or predatory information, so this requires well-informed, well-reasoned regulation at the federal level.
Integrate Financial Health Concepts into Government Programs
The government could integrate elements into safety net programs to help build healthier financial practices. For example, increasing savings and investment account amounts allowed for benefits recipients and integrating just-in-time financial education into current activities could both help if framed in appealing language. Individuals receiving government benefits like food stamps (SNAP) or the Special Supplemental Nutrition Program for Women, Infants, and Children (WIC) could receive a small automatic matching deposit in a savings account, since people are more likely to save when it is automated.29 Since people tend to overspend what they see as windfall, reframing tax refunds and connecting them to recurring, semi-regular expenses people may overlook could help build financial stability. Combining government messages about savings with messages about the relative cost of low-interest savings versus paying off high-interest debt when people receive funds could also help build healthier habits.30
Recognize that Lending Policy Doesn’t Exist in a Vacuum
Policymakers can help reduce reliance on high-interest lending products by enacting policies that alleviate financial pressure on families. For example, expansions in Medicaid have been directly linked to reductions in high-interest loan uptake.31 Reinstating the expanded monthly Child Tax Credit or policies that improve access to well-paying jobs can reduce the need for loans.
New America
Citations
- For more, see Nicholas Bianchi and Rob Levy, Know Your Borrower: Four Need Cases of Small-Dollar Consumers (Chicago, IL: Center for Financial Services Innovation, December 2013), source.
- Celik, Greene, Chege, and Fontes, Financial Health Pulse 2022 Chicago Report, source.
- Adam Eric Greenberg, Abigail B. Sussman, and Hal E. Hershfield, “Financial Product Sensitivity Predicts Financial Health,” Journal of Behavioral Decision Making 33, no. 1 (January 2020): 15–26, source.
- Fernandes, Lynch, and Netemeyer, “Financial Literacy, Financial Education, and Downstream Financial Behaviors,” source; Marianne Bertrand and Adair Morse, “Information Disclosure, Cognitive Biases, and Payday Borrowing,” The Journal of Finance 66, no. 6 (December 2011): 1865–93, source; Jack B. Soll, Ralph L. Keeney, and Richard P. Larrick, “Consumer Misunderstanding of Credit Card Use, Payments, and Debt: Causes and Solutions,” Journal of Public Policy & Marketing 32, no. 1 (April 2013): 66–81, source; Hal E. Hershfield, Abigail B. Sussman, Rourke L. O’Brien, and Christopher J. Bryan, “Leveraging Psychological Insights to Encourage the Responsible Use of Consumer Debt,” Perspectives on Psychological Science 10, no. 6 (November 2015): 749–52, source; and Adam Eric Greenberg and Hal E. Hershfield, “Financial Decision Making,” Consumer Psychology Review 2, no. 1 (2019): 17–29, source.
- Bertrand and Morse, “Information Disclosure, Cognitive Biases, and Payday Borrowing,” source.
- For useful details about how to restructure processes and instructions for loans see Caetano et al., Increasing Applications for Small Dollar Loans, source.
- George, Newberger, and O’Dell, “The Geography of Subprime Credit,” source.
- Greenberg and Hershfield, “Financial Decision Making,” source; and Greenberg, Sussman, and Hershfield, “Financial Product Sensitivity Predicts Financial Health,” source.
- For example, see Fernandes, Lynch, and Netemeyer, “Financial Literacy, Financial Education, and Downstream Financial Behaviors,” source.
- Greenberg, Sussman, and Hershfield, “Financial Product Sensitivity Predicts Financial Health,” source.
- Bhutta, Goldin, and Homonoff, “Consumer Borrowing after Payday Loan Bans,” source; Sumit Agarwal, Souphala Chomsisengphet, and Cheryl Lim, “What Shapes Consumer Choice and Financial Products? A Review,” Annual Review of Financial Economics 9, no. 1 (November 1, 2017): 127–46, source.
- Bertrand and Morse, “Information Disclosure, Cognitive Biases, and Payday Borrowing,” source.
- N. Craig Smith, Daniel G. Goldstein, and Eric J. Johnson, “Smart Defaults: From Hidden Persuaders to Adaptive Helpers,” SSRN Electronic Journal (2008): source.
- Philip Fernbach and Abigail Sussman, “Teaching People about Money Doesn’t Seem to Make Them Any Smarter about Money—Here’s What Might,” MarketWatch, October 27, 2018, source.
- Smith, Goldstein, and Johnson, “Smart Defaults: From Hidden Persuaders to Adaptive Helpers,” source.
- Keri L. Kettle, Remi Trudel, Simon J. Blanchard, and Gerald Häubl, “Repayment Concentration and Consumer Motivation to Get Out of Debt,” Journal of Consumer Research 43, no. 3 (October 2016): 460–77, source; and Alexander L. Brown and Joanna N. Lahey, “Small Victories: Creating Intrinsic Motivation in Task Completion and Debt Repayment,” Journal of Marketing Research 52, no. 6 (December 2015): 768–83, source.
- Hal E. Hershfield, Stephen Shu, and Shlomo Benartzi, “Temporal Reframing and Participation in a Savings Program: A Field Experiment,” Marketing Science 39, no. 6 (November 2020): 1039–51, source; and Greenberg and Hershfield, “Financial Decision Making,” source.
- Bertrand and Morse, “Information Disclosure, Cognitive Biases, and Payday Borrowing,” source.
- Hershfield, Sussman, O’Brien, and Bryan, “Leveraging Psychological Insights to Encourage the Responsible Use of Consumer Debt,” source.
- Consumer Financial Protection Bureau, “CFPB Research Shows Banks’ Deep Dependence on Overdraft Fees,” press release, December 1, 2021, source.
- Patrick L. Hayes, “A Noose around the Neck: Preventing Abusive Payday Lending Practices and Promoting Lower Cost Alternatives,” William Mitchell Law Review 35, no. 3 (2009): 1134, source.
- Greenberg and Hershfield, “Financial Decision Making,” source.
- Bhutta, Goldin, and Homonoff, “Consumer Borrowing after Payday Loan Bans,” source.
- Greenberg and Hershfield, “Financial Decision Making,” source; Agarwal, Chomsisengphet, and Lim, “What Shapes Consumer Choice and Financial Products?” source; and Soll, Keeney, and Larrick, “Consumer Misunderstanding of Credit Card Use,” source.
- CDFI Annual Certification and Data Collection Report (ACR): A Snapshot for Fiscal Year 2020 (Washington, DC: U.S. Department of the Treasury, October 2021), source.
- M. A. Caplan, “Communities Respond to Predatory Lending,” Social Work 59, no. 2 (April 1, 2014): 149–56, source; UPI Loan Fund, “New Arizona Nonprofit Offers Low-to-No Interest Loans for Qualified Individuals,” press release, PRWeb, October 20, 2020, source; and Sheila Bair, Low-Cost Payday Loans: Opportunities and Obstacles (Baltimore, MD: Annie E. Casey Foundation, June 2005), source.
- Jessica Silver-Greenberg, “Major Banks Aid in Payday Loans Banned by States,” New York Times, February 23, 2013, source.
- Abigail Sussman, Hal Hershfield, and Oded Netzer, “Consumer Financial Decision Making: Where We’ve Been and Where We’re Going,” Journal of the Association for Consumer Research 8, no. 4 (October 2023), source.
- Agarwal, Chomsisengphet, and Lim, “What Shapes Consumer Choice and Financial Products?” source.
- Hershfield, Sussman, O’Brien, and Bryan, “Leveraging Psychological Insights to Encourage the Responsible Use of Consumer Debt,” source.
- Heidi Allen, Ashley Swanson, Jialan Wang, and Tal Gross, “Early Medicaid Expansion Associated with Reduced Payday Borrowing in California,” Health Affairs 36, no. 10 (October 2017): 1769–76, source.