This year is providing a growing opportunity for mainstream financial institutions to offer affordable small-dollar loans while proving to be a difficult one for predatory lenders. First, Illinois passed legislation closing a gaping loophole in payday lending regulation. Now, the Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law by President Obama on July 21st, has the potential to significantly increase the number of affordable small-dollar loans available to consumers. Title XII of the Act "encourage[s] initiatives for financial products and services that are appropriate and accessible for millions of Americans who are not fully incorporated into the financial mainstream." Specifically, the Act will incentivize financial institutions to offer low-cost, small-dollar loans that serve as safe alternatives to payday loans.
Rather than regulating high-cost payday lenders, the Dodd-Frank Act seeks to provide financial incentives to institutions to offer more competitively priced small-dollar loan products through loan loss reserve funds, technical assistance funding, and other programs and grants to promote financial access and education. The Act authorizes the Secretary of the Treasury to establish grants to eligible entities to provide low-cost small-dollar loans. In this case, eligible entities include any federally insured depository institution, state, local or tribal government entities, community development financial institutions (CDFI) and 501(c)3 organizations. In order to receive a grant, the loan provider must offer financial literacy and educational opportunities to each small-dollar loan consumer.
The Act also includes several provisions that are exclusive to CDFIs. A CDFI is a financial institution that expands the availability of credit, investment capital, and financial services in economically distressed communities. The new legislation allows for the creation of loan loss reserve funds in order to help defray the costs of any defaults. Concerns regarding defaults are one of the primary obstacles cited by bankers who have expressed interest in starting a small-dollar loan program. However, after offering small-dollar loans for two years, the charge-off ratios were in line with industry standards for unsecured loans to individuals and charge-off rates compared favorably with credit cards. In order to qualify for the grant, the CDFI must offer a small-dollar loan program that offers loan amounts of $2,500 or less, to be repaid in installments with no pre-payment penalties, as well as any other requirements established by the fund administrator. Not all payday loan alternatives are created equal. Therefore, it is necessary to define the parameters of the eligible loan programs in a way that creates products that are truly safe, reasonable, appropriate, and accessible for consumers.
One tool to help create a consumer-friendly product is the template proposed in the FDIC's Small-Dollar Loan Pilot Program. According to the FDIC, the essential elements of safe, affordable and feasible product design include:
•Loan amount of $2,500 or less;
•Term of 90 days or more;
•APR of 36% including fees;
•Streamlined underwriting with proof of identity and income;
•Credit report (but not necessarily score) to determine loan amount and repayment ability.
This two-year pilot program, completed in the fourth quarter of 2009, included 28 participating banks that made more than 34,400 small-dollar loans with a principal balance of over $40 million, all with an APR of 36% or below, including any fees.
Three banks headquartered in Illinois participated in the FDIC study: Community Bank - Wheaton/Glen Ellyn, Lake Forest Bank & Trust, and State Bank of Countryside. Lake Forest Bank was able to earn a small profit on the loans and intends to develop long-term relationships with performing borrowers. Losses on their small-dollar loan product were no higher than those on other consumer loans. Lake Forest Bank reported one of the most successful changes made to its program was reducing the minimum loan amount to $250 to accommodate borrowers who did not need large amounts of credit. Also on the state level, the Illinois Asset Building Group (IABG), a diverse statewide coalition invested in building the stability and strength of Illinois communities through increased asset ownership and asset protection, is working to promote alternative small-dollar loans in Illinois. For more information, see the IABG brief Alternative Small-Dollar Loans in Illinois: Creating Sound Financial Products Through Regulation and Innovation.
With 2010 just half over, there are even more changes on the horizon for the alternative small dollar loan landscape.
This article was coauthored by Hannah Weinberger-Divack, a VISTA working at the Shriver Center.