When 400 is bigger than 400,000
The unit economics of impact from lending
Financial institutions can have different goals in lending, from return on assets to community impact. But every institution strives to offer products that make people’s lives better - it’s the best long term recipe for sustained success.
But how do you measure making someone’s life better? For lending products, there are countless secondary analyses to try, but the simplest (and most uniform) for the borrower is:
How much money did I save using this product versus the alternatives I could have used?
In the current landscape, there’s a product that beats all others in this metric of maximizing borrower savings: small dollar loans. And here’s how big the difference in borrower savings is - $400 allocated to small dollar loans saves borrowers more money than $400,000 of other loans per year. And if that sounds irrational, then it’s time to look at the math. To start, compare a borrower’s savings from a $40,000 auto loan, and a $400 small dollar loan, versus the available alternatives.
For a $40,0001 60-month auto loan, the market interest rate is 7.50%2 . For a lender offering a 1% lower interest rate than the competition, the borrower’s year 1 payments will be:
$9,618 in yr 1 payments for the market auto loan (7.50% rate)
$9,382 in yr 1 payments for the cheaper auto loan (6.50% rate)
Yr 1 Borrower Savings of $226
For a lender offering a $400 two-month loan at a 36% interest rate versus the alternative of a payday loan, the borrower payments will be:
$745 in payments for the market payday loan (>400% estimated APR)
$418 in payments for the cheaper small dollar loan (36% rate)
Borrower Savings of $327
How is that math possible? It’s because of the structure of a payday loan. First, traditional payday loans largely charge fees instead of interest. On average, the fee for a payday loan is $15 per $100 borrowed3 [$15 fee to borrow less than $100, $30 fee to borrow $100-$199, etc]. So, for a $400 loan, the fee charged is $75 . Second, payday loans are due in two weeks. If the borrower doesn’t have the money, they can borrow $475 (covering the original fee and principal due) for an additional $75 fee, owing $550 two weeks later. This is called “rolling” the loan, and roughly 80% of payday loan borrowers end up doing it4.
After an initial borrow and three rolls, the borrower ends up paying $745 to borrow $400 for two months. The poor quality of alternatives in the small dollar loan space drives a massive benefit for borrowers when institutions give them small dollar loans.
Clearly, small dollar loans can drive better financial benefits than auto loans. But what about mortgages? For a $400,000 30-year fixed rate mortgage loan5, the market interest rate is 6.625%6. For a lender offering a 0.25% lower interest rate than the competition, the borrower's year 1 payments will be:
$30,687 in yr 1 payments for the market mortgage loan (6.625% rate)
$29,899 in yr 1 payments for the cheaper mortgage loan (6.375% rate)
Year 1 Borrower Savings of $788
While that looks better at first blush, let’s add an important fact. The small dollar loan gets paid back in two months. That capital can be re-deployed, and payday loan borrowers often need to re-borrow more than once a year7. So when that $400 gets re-deployed two more times during the year, the cumulative savings are 24% larger than one year of mortgage payment savings:
Borrower Savings of $327 on a 2 Month Small Dollar Loan
$327 + ($327 * 2 additional loans made) = Year 1 Borrower(s) Savings of $981
In the small dollar loan space, there is a massive opportunity to make people’s lives better in a capital efficient way. When lenders can deliver bigger savings with $400 of loan capital than they can with $400,000, that’s more than a product worth exploring - that’s a product worth offering.
The Efficient Frontiers will let you know what we’re doing at Salus, what we’re thinking about, and where we’re going next. We want to hear from you, so reach out to us at info@salusfintech.com or check out salusfintech.com to take a deeper dive into what we’re building. As always, thanks for coming on this journey with us.
“Average Auto Loan Amounts.” https://www.lendingtree.com/auto/debt-statistics/#Averageautoloanamounts
“Finance Rate on Consumer Installment Loans at Commercial Banks, New Autos 60 Month Loan”https://fred.stlouisfed.org/series/RIFLPBCIANM60NM
CFSA Payday Loan Statistics. https://www.cfsaa.com/facts
CFPB Data Point: Payday Lending. https://files.consumerfinance.gov/f/201403_cfpb_report_payday-lending.pdf
https://www.foxbusiness.com/economy/average-mortgage-loan-size-holds-near-record-despite-4-rates
https://www.mortgagenewsdaily.com/mortgage-rates/30-year-fixed
https://www.pewtrusts.org/~/media/legacy/uploadedfiles/pcs_assets/2012/pewpaydaylendingreportpdf.pdf