We are thrilled to announce that, effective October 18, 2018, the interest rate on our payday alternative loan of $300 – $500 has been lowered from 35% to 10% APR! In this post, we provide background on the issue of payday lending, why we used to charge 35%, and we chose to lower the rate.
What’s the Deal with Payday Lenders?
Most Americans would agree that payday loans are one of the great scourges of the financial system. These short-term, small-dollar loans carry interest rates that average an astronomical 300% and are targeted at vulnerable populations such as the elderly, veterans, immigrants, and the low-income. Every year, millions of families are trapped in a cycle of debt that can lead to bankruptcy, wiped out savings, damaged credit, hunger, and homelessness. Yet despite broad public support for reining in this industry, payday lenders continue thrive, in part because their powerful lobby succeeds in resisting sensible regulatory reforms, including in Rhode Island and Florida, where we’ve seen this power firsthand. And even in states with strong consumer protections, payday lenders find ways to get around them by relocating to a more industry-friendly state, becoming an online-only lender, or even incorporating in Native American tribes to claim sovereign immunity. At the federal level, the Trump Administration is eager to eliminate or weaken regulations wherever possible, including in the consumer loan arena. Finally, banks and credit unions rarely offer small personal loans, and even those that do tend not to provide them at scale.
Aware of these issues, with funding from the United Way of Rhode Island, the Catholic Diocese of Providence, and others, in 2013 we launched our own payday loan alternative product: the Emergency Loan. In designing the product, we sought to answer three questions: What is an equitable rate for our clients? What is a sustainable rate for us to charge? And, what do payday reformers / consumer advocates recommend as a maximum interest rate?
How did we choose 35%?
Stakeholders such as the United Way, AARP, the Center for Responsible Lending, the Urban League, and UnidosUS advocate for an interest rate cap of 36% on small-dollar loans; this is also the maximum allowable rate for active duty military. With these facts in mind, 36% was a logical starting point for us. But even at 36%, we saw that the economics would be challenging: on a $300, we earn just $60 in interest over the course of a year. While the rate is equitable for the borrower—with monthly payments of $30, she saves $700 as compared to a payday loan—a lender will struggle to cover the costs of making and servicing the loan. Charging a lower rate would have made it that much harder to make the product work for us.
Based on these factors—the recommended rate; the affordability of the product for clients; and the fact that a lower rate would’ve impacted our sustainability—we settled on 35% APR. The product also had, and still has, consumer-friendly terms: no prepayment penalty or other fees; no collateral or minimum credit requirement; affordable, fixed monthly payments; and we report to the three major credit bureaus, thus helping our borrowers build their credit. As a result of these features and our excellent customer service, the product has been a huge success: since its launch, we’ve financed 920 Emergency Loans for $436,000 in Rhode Island, Delaware and Florida.
Why the Lower Rate?
Given all this, why did we restructure the Emergency Loan? There are two reasons for the change:
(1) While 35% is far more affordable than what is available to those we serve, both in terms of monthly payments and total borrower, many stakeholders—donors, investors, community partners—were understandably uncomfortable with the rate. Interestingly, this was rarely a concern for clients, who saw the pricing as a tremendous savings compared to the 300% APR they would otherwise pay. But there’s no doubt that 35% is a big number, and can ill-afford to be unresponsive to the legitimate concerns of our stakeholders.
So why did we persist in charging the higher rate for so long? Simply put: sustainability. Given our goal to cover 100% of operating expenses through interest income by 2023, we had to price our products in a way that was affordable for the client but also financially viable for us. Even then, the resultant $60 of interest was not enough to cover the costs of defaults, borrowing, and making and servicing the loan. Our thinking was that if we were going to lose money on each loan, we should minimize the loss to the extent possible.
(2) But then we did a we did a detailed financial analysis and found that, even when we have a $68 million loan portfolio (which combines Emergency Loans with our entire suite of products—Auto, Immigration, Energy-efficiency, and so on), the difference between 35% and 10% is only $100,000 in lost interest income. Weighed against the benefits of charging 10%—stakeholders, more comfortable with the rate, are likelier to refer clients and make donations and investments—the cost is immaterial. Most importantly, this new rate, competitive not only with payday lenders but even credit cards, also ensures that the most vulnerable of our clients—those who find themselves in an emergency—are able, at little cost, to access the capital they need.
While we will lose revenue at our new 10% APR, in other words, due to the tremendous social impact of the product, Emergency Loans are and must continue to be central to our mission; as a nonprofit, the mission comes before financial concerns. But we haven’t forgotten the sustainability question. Instead, we have developed a business model that allows us to offer such affordable loans without jeopardizing our goals of sustainability. The approach is simple: we balance larger, safer and higher-margin loans with smaller, riskier and higher impact loans. Put another way, our larger loans subsidize our smaller loans, and the combined portfolio works from an impact as well as a financial perspective.
We are thrilled to now have a product that is so affordable—just $22 of interest per year on a $300 loan—and so capable of helping vulnerable families make it through an emergency and get back on a path to their financial and life goals. We imagine that our socially-minded investors, donors, community partners and other stakeholders will join us and those we serve in celebrating this exciting new development!