Sustainable Small-Dollar Lending: A Pandemic and Regulatory Silver Lining
January 20, 2025 by Nicky Downs
The Rise of Payday Lending
To make almost any major life decision in the United States—such as leasing an apartment, purchasing a car, applying for a job, or securing a loan—you need a credit score.[1] More importantly, you need a good (or at least passable) credit score, as a bad score can be the death knell to your job application or purchasing needs. Credit checks remain a firmly rooted practice despite their role in perpetuating racial inequities and biases,[2] and the lack of clear evidence that credit history predicts job performance.[3]
Banks and other mainstream financial institutions historically offered few, if any, services to customers with bad credit or no credit at all.[4] In low-income communities, this led to the rise of an alternative financial system, marked by the rapid expansion of the payday lending industry, which preys on the vulnerable position and urgent need of borrowers who predominantly seek loans to cover basic expenses.[5] Payday lending took off following the financial deregulation of the 1980s, which removed long-standing restrictions on interest rates.[6] The loosening of these rate restrictions permitted lenders to charge fees of $15 per $100 borrowed, which equates to an APR (annual percentage rate) of 400 percent.[7] A typical payday loan is due in fourteen days, a timeframe that is too short for most borrowers to repay the loan.[8] This inevitably results in high rollover rates—that is, the terms of the lending all but compel borrowers to extend their loans for additional fees.[9] Payday lenders make huge profits by stacking these fees on a single loan and trap borrowers in an inescapable cycle of debt. The average payday borrower remains in debt for five months on a single loan and pays, on average, $520 in fees to borrow $375.[10] Although a handful of states have passed legislation capping interest rates—thereby effectively prohibiting payday lending—it remains a robust industry in thirty-six states.[11]
Until recently, conventional banks and financial institutions abstained from offering small-dollar loans that would serve low-income communities by providing a sustainable alternative to payday loans at a fraction of the cost. Studies demonstrated that banks could offer these services at greatly reduced rates compared to a typical payday lender: For example, a standard three-month $400 loan from a payday lender costs $350 in fees, while it would only cost $48 from a bank.[12] Despite this seemingly obvious solution, for many years, banks were instead content to sit on the sidelines and bankroll the payday lenders, getting a piece of their usury-derived profits along the way. In 2010, Wells Fargo & Co., US Bancorp, JPMorgan Chase, and other banks provided $2.5 billion in credit to payday lenders.[13] Wells Fargo alone extended credit to six of the eight largest payday lenders in America.[14] Suffice it to say, “the fringe banking sector would not exist without lines of credit extended by the conventional one.”[15]
A Regulatory Shift
Despite the exploitation and abuse created by this “fringe” financial system, regulatory developments spurred by the COVID-19 pandemic offer reasons for optimism about small-dollar lending moving forward. In response to the pandemic-induced economic downturn in early 2020, a coalition of government agencies, including the Federal Deposit Insurance Corporation (FDIC) and the Board of Governors of the Federal Reserve, issued guidance to financial institutions encouraging the practice of responsible small-dollar lending to consumers and small businesses.[16] This regulatory guidance was intended to spur banks into action, in turn helping stem consumers’ financial short-falls and cash-flow imbalances caused by the pandemic.[17] The Consumer Financial Protection Bureau also approved the small-dollar lending guidance, creating a strong regulatory consensus. This consensus marked a significant shift in policy as previous guidance expressed concern with small-dollar lending, dissuading banks from furnishing these services.[18]
Since the 2020 guidance was issued, a number of the largest commercial banks launched small-dollar lending services, offering loans for a fraction of the cost of payday lenders.[19] These loans, unlike their payday counterparts, (a) have a repayment schedule that is spread out over multiple months, reducing the burden on the borrower’s cash flow and (b) require much lower initial fees.[20] Compared to a standard $500 payday loan, borrowers can save up to $580 in fees over the course of the loan’s term.[21] Put differently, borrowers only pay one-fifteenth of the cost of a typical payday loan.[22] Unsurprisingly, this sustainable repayment structure and much lower pricing have yielded positive outcomes, both in terms of consumer demand and repayment behavior.
A recent report from ideas42, a nonprofit consulting firm, highlights the successful trajectory of these small-dollar loan services. For one, these services have been met with strong demand from individual consumers: Credit unions set records for small-dollar loan volumes in 2022, eclipsing the previous highs by over 30%.[23] Bank of America’s service offers further evidence of consumer appetite. Since launching its new Balance Assist small-dollar loan service in December 2020, Bank of America has disbursed over 1.1 million small-dollar loans, totaling over $500 million.[24] Second, and perhaps most critically, banks have reported favorable repayment behavior from borrowers. One provider cited repayment rates above 95% and others reported losses far below their pre-launch predictions.[25]Providers also noted that the small-dollar lending services have provided a powerful incentive for retaining new and existing customers and that the service has created goodwill among consumers, who want to retain access to these services in the future which encourages healthy repayment habits.[26] Strong repayment behavior is a particularly positive development given that risk of default is a primary concern voiced in opposition to these services.[27]
On the customer side, borrowers report being pleased with the utility these loans provide in their daily lives.[28]Borrowers reported that the digital applications for loans are straightforward and more importantly that repayment is manageable due to the much lower costs and the more generous repayment schedule.[29] Given that these small-dollar loan services were largely non-existent in the conventional banking sector only a decade ago, their success is encouraging.
Challenges Ahead
While the early prognosis for expanded access to more equitable lending services is positive, millions of Americans remain excluded from the system altogether. After all, even applying for a payday loan requires a certain threshold of financial security: a borrower must have both a checking account and a reportable income.[30] However, approximately 7.1 million American households were unbanked as of 2019, meaning no one in the household has access to a checking or savings account.[31] As a result, many millions of Americans do not even have access to payday lending options, let alone conventional bank alternatives.
Those who are unbanked and need a loan are left with few options—and no good ones. They are often forced to sell their possessions to the local pawnbroker or do business with a local loan shark.[32] So, finding ways to extend sustainable small-dollar lending to this segment of the population is a crucial next step. Banks have the market power to leverage the demand for these services to reach a broader swath of the population. The more banks who see the upside to offering these services, the larger, and more stable the customer pool becomes. As the success of these services grows and enters the economic mainstream, more banks will be incentivized to enter the market and should expand the services to reach more people. Access to small-dollar loans, from both an economic and moral perspective, can, and should, be universal.
[1] Matthew Desmond, Poverty, By America 56 (2023).
[2] Vinny Parthasarathy, Credit Checks in Employment, OnLabor (Nov. 7, 2023), https://onlabor.org/credit-checks-in-employment/.
[3] Sarah Ludwig, Credit scores in America perpetuate racial injustice. Here’s how, Guardian (Oct. 13, 2015),https://www.theguardian.com/commentisfree/2015/oct/13/your-credit-score-is-racist-heres-why.
[4] Desmond, supra note 1, at 57.
[5] Michael A. Segman, Savings for the poor 63 (1999).
[7] Desmond, supra note 1, at 57.
[8] Payday Loan Facts and the CFPB’s Impact, The Pew Charitable Tr. (May 2016), https://www.pewtrusts.org/-/media/assets/2016/06/payday_loan_facts_and_the_cfpbs_impact.pdf.
[9] Payday Loan Facts and the CFPB’s Impact, The Pew Charitable Tr. (May 2016), https://www.pewtrusts.org/-/media/assets/2016/06/payday_loan_facts_and_the_cfpbs_impact.pdf.
[12] Nick Bourke, Momentum is Building for Small-Dollar Loans, The Pew Charitable Tr. (Sept. 12, 2018),https://www.pewtrusts.org/en/about/news-room/opinion/2018/09/12/momentum-is-building-for-small-dollar-loans.
[13] Nathaniel Popper, Big Banks Play Key Role in Financing Payday Lenders, L.A. Times (Sept. 15, 2010, 12:00 AM), https://www.latimes.com/archives/la-xpm-2010-sep-15-la-fi-payday-banks-20100915-story.html.
[15] Desmond, supra note 1, at 59.
[16] Press release, Bd. of Governors of the Fed. Rsrv. Sys., Interagency Lending Principles for Offering Responsible Small-Dollar Loans (May 2020), https://www.fdic.gov/news/press-releases/2020/pr20061a.pdf.
[17] Daniel Gorin et al., Empirical assessment of SR/CA small-dollar lending letter impact, Fed. Rsrv. (July 28, 2023), https://www.federalreserve.gov/econres/notes/feds-notes/empirical-assessment-of-sr-ca-small-dollar-lending-letter-impact-20230728.html.
[19] Lois Aryee et al., The Promise of Small-Dollar Loans for Banks and Consumers, ideas42 2 (Mar. 2024), https://www.ideas42.org/wp-content/uploads/2024/03/I42-1477_SmallDollarLoans_Memo_final.pdf
[27] Id. at 2 (explaining that banks were hesitant to launch these small-dollar services because of “potentially high repayment risks,” the costs of the technological development required, and a lack of regulatory clarity on this type of lending).
[30] Payday Loan Facts and the CFPB’s Impact, supra note 8.
[31] How America Banks: Household Use of Banking and Financial Services, 2019 FDIC Survey, Fed. Deposit Ins. Co., (Oct. 2020), https://www.fdic.gov/analysis/household-survey/2019/2019report.pdf.