By Dan Gorin
Close up photo of male hands holding bill and pen and female hands hugging him while they doing home finances together online on a laptop computer in the kitchen.

Most of us have been there at one time or another: facing an unexpected expense or an abrupt drop in income or contending with poor planning. Five years ago, I had a credit card on autopay. The day before the payment was due, I realized the payment was occurring two weeks earlier than expected. I was going to be almost $1,000 overdrawn.

I panicked. How did I let this happen? The funds I was planning to use wouldn’t be available for more than a week.

What could I do? Hunt for a quick, costly loan? Stop payment on the check? Pay an overdraft fee?

Fortunately, I remembered I had established an overdraft line of credit at my credit union for up to $3,000. I used this line of credit to cover the credit card payment. When it was all over, I paid less than $2 for a nearly $1,000 loan for just over a week.

While I was lucky to have access to this available, affordable option, not everyone does. In the latest issue of Consumer & Community Context, my colleagues and I explore whether and how small-dollar credit can help consumers stay financially afloat. These loan options are typically offered in amounts less than $1,000. 

A lack of options to meet shorter-term credit needs

Who might use small-dollar credit products and why? According to one source, the potential need is widespread.

The Federal Reserve Board’s 2022 Survey of Household Economics and Decisionmaking (SHED) found that more than one-third of adults in the US would not be able to cover a $400 emergency with cash, savings, or a credit card paid off at its next statement. The SHED report also notes that 11% of adults incurred at least one overdraft fee, while 5% of adults used a payday, pawn, auto title, or tax-refund-anticipation loan in 2022.

What’s more, lower-income adults, Black and Hispanic adults, and adults with disabilities are more likely than other adults to use these expensive products.

Until recently, consumers with no credit history or poor credit scores couldn’t access affordable short-term credit products, such as the overdraft line of credit I received.

This lack of affordable products makes it difficult for people seeking short-term small-dollar credit and unable to repay a loan in full, leading to a cycle of debt as they continue to repay the previous loan or make up for subsequent cash shortages.

For example, Consumer Financial Protection Bureau (CFPB) research from 2014 found that four out of five payday loan borrowers rolled over or renewed their borrowing within two weeks. In 2021, the CFPB noted that one in 10 borrowers paid 10 or more overdraft fees per year, similar to SHED’s 2022 finding. These trends suggest that while such loans may fulfill a short-term need, they may not be sustainable in the long run.

Expanding small-dollar credit options

Fortunately, more options are now available to consumers who need small-dollar credit. In addition to reducing their overdraft fees, some banks have started offering new short-term credit products—usually three- or four-month installment loans—for their customers who are seeking credit.

As of January 2023, six large banks now offer new small-dollar loans or lines of credit. Furthermore, more than 150 banks and credit unions are members of financial technology (“fintech”) networks offering small-dollar installment loans online. Generally, these products have a lower cost and more manageable repayment terms.

There are several reasons for banks’ growing interest in this market. For one, the federal banking regulators (in the May 2020 Interagency Lending Principles for Offering Responsible Small-Dollar Loans) have clarified what types of products banks may offer that can better serve customers who need short-term, small-dollar credit.

Advances in technology now allow banks to use new data and methods to evaluate consumers’ creditworthiness more efficiently and cheaply, increasing innovation and competition among small-dollar credit providers. Banks, credit unions, credit bureaus, fintech companies, and other lenders are developing ways to use cash flow data (the inflows and outflows of money in customers’ accounts) to evaluate potential borrowers’ creditworthiness, rather than relying on traditional credit scores to do so.

To illustrate how such an approach can help more people obtain credit, consider the case of two potential borrowers with similarly low credit scores and different checking account inflows and outflows. These differences in account activity make the two very different risks in the eyes of different lenders. For example, a lender using cashflow data to underwrite small-dollar loans may be more generous to a borrower with regular direct deposits, autopay, and no recent overdrafts. These are measures that are unrelated to traditional credit scores, but which can help banks assess risk.

This expansion in ways to consider applicants allows banks to offer credit to the millions of consumers without enough credit history to produce a credit score. In addition, by eliminating the need to evaluate credit applications manually, this new technology gives banks the ability to process these loans online. This reduces costs to lenders and helps make loans more affordable.

It remains to be seen how impactful these changes will be in extending credit to consumers more widely. So far, large banks and fintech firms appear to be reaching more borrowers who might otherwise not have qualified for credit and offering credit at lower cost. Early indications from lenders are that default rates appear low. That said, anecdotal information suggests that only about half of bank customers may qualify for these newer small-dollar loans.

Also, unless there is more sharing of data about consumers across banks and other financial companies—which raises privacy and other concerns—we don’t yet know how many banks will eventually offer similar products to consumers who are not current customers. So far, though, the trend toward expanding access to affordable small-dollar loans has been promising. I’m looking forward to a market where more consumers have the chance to borrow at the favorable terms that I was afforded.

To learn more about small-dollar loans, read the latest issue of Consumer & Community Context.

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