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Truth in Lending for Small Dollar Credit
Transparency in the cost to borrow short-term credit
For years, the fintech space has identified access to short-term credit as an important problem worth solving for the unbanked and under-banked. And digital products have expanded access to emergency cash for people that live paycheck to paycheck. But in today’s marketplace, with products like earned wage advances, cash advances, and everything in between, the complexity of what these products actually cost isn’t easy to see.
So - how much do they really cost?
To answer this, you have to start at the simplest form of cost - interest on a loan, with no fees or additional costs. While lending regulations vary, several prominent rules limit the maximum APR to 36%; having said that, what types of fees/costs are included in that calculation can vary (more on that below). So, what could a lender charge for a one month, $200 loan at a 36% APR? About $6.
The reality is for most people, this loan size and tenor probably doesn’t exist at their primary financial institution outside of overdraft protection. And if it does, it could be tough to get approved for it without a prime credit score. And this is where the alternatives can flourish - providing access to this capital for borrowers that need it. Two of the most common forms of alternatives:
Earned Wage Access - workers that can receive a portion of earned wages ahead of their scheduled pay date, with the advance deducted from the next paycheck. These are typically offered through fintechs partnering with employers.
Cash Advances - the “borrower” receives a dollar amount, and that amount is repaid through a deduction from their next paycheck. These are typically offered by fintechs offering different levels of banking services.
In both cases, the alternative does not charge any interest on the dollars advanced. That sounds great - but that is not where the cost to use the product actually occurs. Here’s what the cost to use those products actually looks like:
How did these products end up costing more than a 36% APR? There are a few typical sources:
Expedited Fee. The typical advance product may take 2-3 business days to land in the borrower’s account. But practically speaking, most people who use this type of product need the cash immediately. 98%1 of users of one cash advance product chose to pay the fee.
Other Fee. Many advance products are tied to an in-house debit card to access funds. For borrowers that don’t transfer their direct deposit to that card, that can mean paying for adding cash, different forms of transfers, and other charges.
Tip. While this is usually noted as having no impact on access to funds, tips are solicited in many cash advance processes - in one case, 79%2 of users choose to pay a tip, which was on average $4.
Subscription Fee. Many cash advance services are offered as part of a package of services offered. While the subscription fee isn’t specifically tied to the advance, it needs to be paid in order to have access to funds.
One thing that was not mentioned in this analysis: these alternative products typically require repayment by the next payday. Which means the money is repaid in two weeks or less. Borrowers would have to repay and then re-borrow in order to have the funds for a month. In that case, the cost to borrow $200 for one month through these products doubles:
Now, while these products are clearly more costly than they appear at first blush, it’s important to note that they are cheaper than borrowing a payday loan or paying your checking account’s overdraft fee(s). In that way, they are an improvement over the status quo of the last 15 years. But the best consumer experiences don’t lure people in and then hit them with surprise costs. That’s especially true when we know that the financial product is going to someone in a precarious position.
Full transparency in cost isn’t something small dollar credit providers should strive for - it should be the minimum.