Payday lending is big business. Nonbank financial services companies, such as stand-alone payday stores, financial service centers and online payday lenders, generate nearly $50 billion in payday loans annually, according to Financial Service Centers of America, or FiSCA, a trade association that represents more than half of the nation's financial service centers. The banking industry would like a piece of that pie.
Payday lending has had a less-than-stellar reputation. The industry routinely gets pounded by consumer groups that criticize the loans as an extraordinarily expensive form of credit. It would not be unusual for a customer to pay a $50 finance charge on a two-week, $300 loan, according to a paper published by the Federal Reserve Bank of Kansas City. That amounts to an annual percentage rate of 435 percent. Too often, the customer can't repay the loan on time and rolls it over, incurring even steeper charges.
FDIC's pilot programThe Federal Deposit Insurance Corp., or FDIC, is in the midst of a two-year pilot program to see if banks can provide an alternative -- not only to payday loans but to fee-based overdraft protection, a bank product that's also scorched by consumer activists. The idea is to reduce the cost of the loans, make them cost-effective for the bank and encourage borrowers to become regular customers of the bank. Ironically, payday loan customers generally need a checking account to complete their transactions at a payday lender. If banks can provide those customers with the loans they need, they may, eventually, be able to sell them other products.
The FDIC's Small-Dollar Loan Pilot Program began with 31 banks in February 2008. The institutions are primarily community banks, often near military bases or in low- to middle-income neighborhoods. To be sure, there are many banks across the country that make small-dollar loans and are not part of the pilot program. But by and large, banks have shied away from small loans as it can be difficult to make them profitable.
The pilot program sets parameters for the terms of the loans. The FDIC's latest statistics show that more than 11,700 loans have been originated with a principal balance of $13.5 million.
"The amounts are generally larger than $500; terms are longer (than at a payday lender), nobody in our pilot is doing two-week loans; and interest rates are much less," says Rae-Ann Miller, a special advisor with the FDIC.
Building a relationship"In general, what (the banks) are looking for is a relationship. Most payday lenders aren't looking to sell other products to these consumers. They're looking to make fees on these immediately, and that's the primary goal. The primary goal here is a relationship-building aspect," says Miller.
The FDIC's guidelines for the pilot program include the following:
- Loan amounts up to $1,000.
- Payment periods extending beyond a single paycheck cycle.
- Annual percentage rates below 36 percent.
- Low or no origination fees.
- No prepayment penalties.
- Encourage principal reduction.
- Automatic savings component.
- Access to financial education.
Streamlining the underwriting process enables banks to save money and get the loan into the customer's hands quickly. At Mitchell Bank in Milwaukee, customer service representatives are authorized to pull the borrower's credit report, verify income and make the loan. You might think that could lead to a high percentage of bad loans, but bank Chairman James Maloney says that hasn't been the case.
"We've had only one loan that was charged off, and that was a mistake in the underwriting. Other than that, all of the loans that we've made have paid as agreed. We look at the credit score to determine the interest rate we're going to charge -- starting at 15 percent for decent credit, going to 22 percent for very poor credit, a credit score below 570. We verify the receipt of at least $1,000 of monthly income from some source. It could be Social Security, unemployment compensation -- it doesn't have to be employment," says Maloney.