Where do Americans turn when they need some extra cash? Most use their credit cards or apply for loans from banks or credit unions. Others seek financing from retailers or manufacturers. For those who struggle with less than stellar credit, borrowing from payday or auto title lenders is often a go-to source. Installment loans, another segment of the nonbank consumer credit market, has not been as well studied. Even so, $10 billion Americans are using installment loans annually.
In fact, Americans are spending more than $10 billion on fees and interest to borrow amounts that range anywhere from $100 to more than $10,000. These loans are offered at around 14,000 stores in 44 states. Pew’s latest research notes that installment loans can be a safer, more affordable option to other high-cost credit products. However, state laws put installment loan borrowers at risk.
Why? State laws governing these loans are not strong enough to prevent lending practices that obscure the true cost of borrowing – putting customers at financial risk. The biggest problem is that customers are not protected from front-loaded origination or acquisition fees, stated annual percent rates that do not reflect the true total costs of the loan and the selling of credit insurance (and other low-value products with upfront premiums).
Pew’s research also discovered that when states set rate limits for consumer financing – under which consumer finance companies cannot make loans profitably – some lenders sell credit insurance. This allows them to earn revenue that they are not permitted to generate through fees or interest. In fact, in just one fiscal year, five of the nation’s largest installment lenders reported revenue of more than $450 million from ancillary products.
So, how can consumer financing be improved? Experts suggest that lenders and policymakers should embrace certain safeguards that consider the interests of borrowers and lenders. For example:
- Spreading costs evenly over the life of the loan. Origination or acquisition fees should be nominal and pro rata refundable to safeguard the lenders incentive to refinance loans and to protect borrowers.
- Changing the way credit insurance functions. Having credit insurance function like other standard insurance policies, with typical loss ratios and monthly premiums, should be a requirement.
- Separating the sale of ancillary products from issuance of credit. Credit insurance and other unrelated products should only be offered after a loan transaction is completed.
These straightforward improvements to state laws would ensure installment loans are a safer, more affordable alternative. In the fast-paced world of consumer financing, nonbank credit solutions must keep pushing for better ways to serve customers, whose options are already few and far between.
Author Bio: Electronic payments expert Blair Thomas is the co-founder of high risk payment processing company eMerchantBroker. He’s just as passionate about his business as he is with traveling and spending time with his dog Cooper.