New Foundry Ventures: November 2009

With select state legislatures moving to ban Payday Loans via interest rate caps and the Federal Government looking to put its hat in the ring with a 36% federal interest rate cap, it begs the question “is government regulation enough to help consumers avoid predatory lending?” Surely setting caps at 36% will prevent the unscrupulous payday loan model that creates long term debt traps at 400% APR interest. Compare that to the APR for a 30-year fixed Home Loan which is only 5.225%. Payday Loans are unsecured – they have extremely high costs of borrowing and short term limits—thus they are dangerous product for chronic borrowers. With only 14 days to repay, payday loans create massive pressure for loan rollovers which incur more fees and increase the debt burden. This is supported by a study of practices in Indiana before new laws went into effect, that saw an average rollover rate of 10 times. This usurious practice is unsustainable for the borrowers. So banning payday lending via an interest rate cap is a good thing because these products will no longer exist, right?

Not so fast. There is a reason people are taking out payday loans. It is because they are either consciously rejecting mainstream banking products or more likely, unable to gain access to mainstream credit products that charge reasonable interest rates. So if the borrowers were so desperate to use a payday lender in the first place, how will they fair? Many will bounce checks or incur overdraft protection fees as their main source of credit. This practice can be just as exploitative as payday loans4. Credit cards can perpetuate a cycle of debt, as available credit on cards often exceeds one’s realistic ability pay down principal balances. Just as often, credit cards are typically inaccessible to many in this population population. More than 100 million Americans are considered “unbanked”, “underbanked”, or credit underserved5. So what options are left for this population if governments essentially ban short term small dollar loans? Pawnshops or black market loan sharking? The answer is that tough choices will have to be made by consumers until mainstream banks and credit unions can develop credit tools and risk models that address the needs of the underbanked.

Fortunately, there are a handful of organizations working on payday lending alternatives including community development credit unions and social venture funds. This is a perfect opportunity for social enterprise and innovative solutions. Social Enterprise can step in to prove the market, as early stage venture philanthropy will be needed to cover the initial costs of research and development and subsidize the development of risk models and new technologies to reach these consumers. To serve the underbanked, there is an immediate need to have a socially minded business model that is more focused on educating and serving the consumer for the long haul; rather than continuing a practice of short term economic exploitation. Furthermore, innovation is essential to create new financial products that are economically sustainable and viable. In the long run, for any loan product to reach scale and have a significant social and economic impact it will have to be financially profitable in order to reinvest revenues back into more loans and more social benefit. Innovation in terms of technology, risk-modeling, private-public-nonprofit partnerships, and education have the potential to reduce costs and develop a loan portfolio with risk profiles that can compete with mainstreamed personal loan products. Together social enterprise and innovation can address Payday lending properly.

It would be much easier if the problem of predatory lending could be solved via a legislative fiat. Unfortunately, this problem is a complex one that governmental regulation alone cannot fix, and worse yet, traditional business structures have neglected to substantially address. Which is why Rubicon National Social Innovations is stepping up to the challenge: to serve the poor by filling the gaps between the abilities of government, traditional charity, and for-profit businesses (see Table Below). Whether one is concerned about predatory lending’s impact upon the working poor or worried about government regulation into the market, it can be agreed that social enterprise solutions can address this issue. To learn more about the work of Emerge, our product in this area visit http://rubiconnational.org/our-projects/emerge-loan-program/