What is a traditional small-dollar installment loan?
Traditional small-dollar installment loans are loans that are repaid in equal monthly installments of principal and interest, with no balloon payments. In this sense, they are just like a standard mortgage or car loan that you get from a credit union or bank.
How does a person get a traditional installment loan?
Borrowers apply for a traditional installment loan at their local consumer finance office, just as they would for an auto loan at a credit union or bank.
A borrower is required to submit a credit application to the lender. The lender then underwrites the loan according to its credit standards. The lender reviews the applicant’s credit history and requires verification of income, residency, and ability to repay the loan.
If, after reviewing the borrower’s information and current budget obligations, the lender determines that the borrower can safely afford the repayment terms, the lender approves the loan.
If the borrower’s current obligations are excessive, or if the borrower has insufficient income, the lender will decline the application, because it does not serve the consumer, and there is no financial incentive to the lender to make a loan that a borrower cannot pay back.
How do these loans work?
The amount borrowed is paid off over the term of the loan with fixed, equal monthly payments that are structured to ensure that the loan fits the borrower’s monthly budget.
Why is it referred to as a “traditional” installment loan?
Traditional small-dollar installment loans have been a regulated credit option for consumers for over 100 years. They were created by a coalition of consumer advocacy groups and state legislative representatives and commissions in order to provide a safe option for small-dollar credit.
These loans were established to offer a regulated, safe, and affordable option to consumers for small-dollar loans, so that consumers would not have to resort to unregulated and illegal lenders known as “loan sharks.”
As long as installment loans were the only form of small-dollar credit available to consumers, there was no problem in society with “over-lending” or with consumers falling into a “cycle of debt.” This is because traditional installment lenders test the borrower’s ability to repay and because the installment structure gives the borrower a clear “roadmap out of debt.”
Traditionally, finance companies made installment loans to individual consumers in communities around the country, while commercial banks made loans to companies (including finance companies).
A final reason why these companies are referred to as “traditional” is that recently some new lending firms have appeared on the scene claiming to be installment lenders, while offering loans, some through the Internet, that do not represent traditional installment loans at all. Some of these new companies require that borrowers give them direct access to their bank accounts;, they may also be unregulated offshore lenders. Traditional installment lenders do not require direct access to a borrower’s bank account. All traditional installment loans are made from brick-and-mortar offices in communities and feature fully amortizing terms; in addition, payments are reported to credit bureaus, so borrowers can build good credit.
How were the rates established for traditional installment loans?
The coalition knew that for legitimate businesses to offer small-dollar loans to consumers, a sufficient rate of interest would be required to generate enough income to provide for a reasonable rate of return and to cover the businesses’ costs.
At that time, around 1915, it was expected that the interest rate would be 3% per month, or 36% per year. Very few businesses today could operate charging 1915 prices. Recently, the FDIC tried to offer small-dollar consumer installment loans through banks and discovered that a 36% rate was indeed insufficient to earn the banks enough money to process and handle the loan. To be viable, those loans would have to be subsidized by the government with taxpayer dollars.
Are traditional installment loans regulated?
Yes. While each state has its own unique rules, regulations, and licensing requirements, all traditional installment loans fall under the same federal regulations, including the Truth in Lending Act, which requires detailed disclosures of costs.
Aren’t traditional installment loans “high cost” credit?
No. Because the Federal Truth in Lending Act requires an “annual” percentage rate, APR numbers can appear to be high, while the dollar cost in interest for the consumer is actually low. This fact was noted by Jennifer Tescher, Director of the Center for Financial Services Innovation, one of the country’s leading advocacy organizations for the unbanked and under-banked, in her letter to the FDIC concerning the need for protecting and providing small-dollar loans:
“Double-digit interest rates in excess of 36 percent APR can provoke community outrage, yet over the course of a month, what may seem like an overly high interest rate may generate a relatively small cost to the consumer.”
This statement is illustrated by considering the difference between a $500 loan with an 18% APR versus a $500 loan with a 69% APR. When paid over a seven-month period under a traditional installment monthly payment plan, the 18% loan carries a monthly payment of $76, compared to a monthly payment of $89 for the 69% loan. The difference is actually only 40 cents a day.
The majority of the monthly payment on a traditional consumer installment loan is the repayment of principal. If someone cannot afford an $89 dollar-a-month payment, they most likely cannot afford a $76 dollar-a-month payment. And the ability of the lender to offer the loan often depends on that 40 cents a day.
Aren’t traditional small-dollar installment loans like payday loans?
No. Traditional small-dollar installment loans are entirely different loan products, more like credit union or bank loans. In addition, they are offered for longer terms and require equal monthly payments of principal and interest, which fully pay off the loan at its maturity.
Payday loans are short-term loans that are due in either two weeks or one month—a person’s payday cycle. Payday loans come with no payment plans, except for the requirement to pay the entire balance, known as a balloon payment, at maturity. This can be difficult for a borrower to manage.
Payday loans do not include a budget review to determine if the borrower has the ability to repay the loan at the two-week or one-month maturity.
Traditional installment loans generally require a loan application, budget review, and a credit check, and are underwritten by the lender to ensure that the monthly payment is affordable in the borrower’s budget. This helps ensure that the consumer can pay off the loan in a responsible and timely manner.
Aren’t there “cheaper” alternatives to these traditional installment loans?
No. Because of the “high touch” relationship required in traditional installment loans, there are simply no other options that provide the same service and disciplined and responsible loan repayment terms. Only nonprofit and government subsidies would allow for lower interest rates on this type of loan, and often the difference in cost to the consumer is negligible, while the burden to taxpayers is extreme.
Why can’t banks provide small-dollar loans?
Banks have rarely provided small-dollar consumer loans because of the significant overhead costs associated with underwriting and servicing installment loans and the relatively small amount of interest dollars that can be earned to cover operating expenses.
Recently, the FDIC attempted to encourage banks to explore the possibility of providing small-dollar installment loans through the Small-Dollar Loan Pilot Program, which required a 36% APR cap.
The results from the two-year study, which ended in June of 2010, demonstrated that it was not economically feasible for banks to provide and service small-dollar installment loans without the support of taxpayer subsidies to cover losses. Even with taxpayer money being used to help cover defaulted loans, operational costs could not be met by the relatively small amount of interest dollars earned. The pilot was not a financial success, while traditional installment lenders have offered these small-dollar loans effectively and successfully for a century.
Aren’t credit cards a better option for consumers?
While many credit cards certainly have an important role to pay, and some carry interest rates significantly lower than most small-dollar installment loans, the minimum-payment terms and the ability to instantly access additional credit can trap consumers who are less disciplined in their financial management. Paying minimum monthly payments greatly increases the cost to consumers. Consumer installment loans are more financially responsible and affordable.
Recent changes in the law require credit card companies to state how long it will take to pay off a balance with minimum payments and the total amount of interest that the consumer will pay. Since credit card terms lack the discipline of the fully amortized repayment schedule required with traditional installment loans, a loan amount that would take one year to pay off using an installment loan could take 10 years or more on a credit card, at a much greater cost to the consumer.
Shouldn’t people have savings to use instead of borrowing?
Borrowing and saving are both useful and financially beneficial. Borrowing allows people to pay for large expenses that would deplete or wipe out their savings if used for that purpose. For example, most Americans could not purchase a car or furniture, pay for college, or even make car repairs if they had to pay for it out of savings.
Responsible borrowing allows people to meet their needs and goals, as well as emergencies, in a measured way without seriously disrupting their ability to manage their household finances.
Aren’t these loans sometimes given to people who can least afford them?
No. Traditional small-dollar installment loans are made only to people who can afford to repay them. The lender carefully examines the consumer’s ability to repay the loan without undue strain on their monthly budget. Traditional installment lenders require borrowers to submit a detailed credit application. The lender then underwrites the loan according to its set credit standards. The lender reviews the applicant’s credit history and requires verification of income and residency.
If the borrower’s current obligations are excessive, or if the borrower has insufficient income, the lender will decline the application, because there is no benefit to the consumer and no financial incentive for the loan company to make a loan that a borrower cannot pay back.