It is time more credit unions stepped into the space that predatory payday lenders have taken over. Payday lenders often plant themselves right next to mainstream financial institutions - offering complementary loan services that credit unions could be providing at a lower cost, according to a new Filene Research Institute study, "The Impact of Two-Tiered Banking: How Credit Unions Can Bridge the Divide." Many credit unions deny small-dollar loans to consumers with limited credit histories who may be good candidates. And some consumers choose payday lenders over credit unions because they want convenient hours and shorter wait times.
Unfortunately, we pay a huge price when consumers use payday lenders instead of credit unions. A study last year by the Insight Center for Community Economic Development found that payday loans drained $943 million and 14,000 jobs from the U.S. economy in 2011. The Center for Responsible Lending demonstrated that the structure of payday loans, including interest rates of 400-500% annually and short-term repayment schedules, results in long-term debt traps.
While the $44 billion-per-year payday loan industry will not disappear overnight, widely available credit union loans can stem its most harmful effects, especially if the loans improve on the payday loan structure by offering convenience combined with longer, more affordable repayment schedules and low interest rates.
A number of credit unions already offer such loan products to consumers with limited access to credit. However, most credit unions have concerns about internal capacity and loan losses, and lack information about best practices that can reduce risk. We believe that wide-scale credit union adoption of these products is possible with a combination of persuasive messages, encouragement from leaders, financial incentives, a viable model, and technical assistance for startup.
State advocates have a strong role to play in encouraging credit union adoption. They can approach individual credit unions to promote expanded loan products within the context of nonprofit mission and responsiveness to community. They can also ask key leaders to promote a statewide model, including the state treasurer and credit union league, the National Credit Union Administration, and the Consumer Financial Protection Bureau.
Financial incentives can also play a key role in statewide adoption. Loan loss reserves, which are funds set aside to fully or partially reimburse a credit union from losses due to defaults, can be pooled for a state or region and administered by an intermediary. The pool can be funded by grants or low-interest loans from state or local government, foundations, or faith-based groups. Each loss can be reimbursed at a rate of 50% or higher in the first year, and then reduced or eliminated after credit unions gain confidence in building scale and mitigating losses. Government and large corporations can also be encouraged to move their deposits to designated Low-Income credit unions to incentivize credit union participation.
There is evidence these strategies are effective. The Pennsylvania Credit Union Association launched a successful statewide small-dollar loan and savings product, Better Choice, using loan loss reserves from the Pennsylvania Treasury. The reserves were withdrawn several years later, and only a small number of credit unions left Better Choice. The Better Choice loan, which is offered at 65 credit unions in 178 locations, is a 90-day loan of up to $500 with a $20 origination fee, 18% annual interest, no credit reports - and a default rate under five percent. Optional financial counseling, along with a required savings account of 10% of the loan, helps consumers stay on track.
Additional credit union loan products, now in testing or implementation phases in credit unions across the country, can be adopted by credit unions at scale. Intermediaries are needed to provide strong program leadership, training and technical assistance toward implementation. We must not forget the value of incentives and influence in this equation.
Finally, national advocates can work on two provisions in the Dodd-Frank Act that were designed to incentivize wide-scale adoption of small dollar loans, but were never funded. One provision would have given grants to eligible entities to provide small dollar loans and financial education, and another would have provided loan loss reserve funds. To resuscitate these provisions, advocates could prepare a policy brief for the Treasury, encourage a private-public funding partnership for loan loss reserves, or advocate for appropriations after demonstrating the effectiveness of a pilot program.
Of course, not everyone can pay back a small-dollar loan, and not everyone should be given one. And some consumers will continue to prefer payday lenders unless policies are enacted that restrict their presence. But many consumers who can afford loans are denied the services they need and left in the hands of predatory lenders. Credit unions, as nonprofits with a commitment to their communities, are the right ones to bridge the divide.
Aimee Chitayat is a Senior Consultant to the Insight Center for Community Economic Development. Henry A. J. Ramos is its CEO.