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If your rent was due and you were a few hundred dollars short, and you could quickly get approved for a $700 loan with a low fee, would you be interested?
A growing number of consumers are answering yes to this question, and banks and credit unions are increasingly meeting their needs with small-dollar loans, which are generally defined as loans up to $500 to $1,000.
Credit unions issued a record $227 million in small-dollar loans in 2022 through National Credit Union Administration (NCUA)’s Payday Alternative Loan (PAL) program, up 30% on 2019, according to a recent analysis by the Pew Charitable Trusts, a non-governmental research and public policy organization. The program started in 2010, and expanded in 2019.
“Small-dollar loans are considered a cheaper and safer alternative to products like payday loans. ”
Small-dollar loans are considered a cheaper and safer alternative to products like payday loans. Their wider availability at banks and credit unions is especially good news for lower-income people and consumers whose financial needs haven’t been traditionally met by big banks, consumer advocates and industry experts say.
“This is really a watershed for financial inclusion,” said Alex Horowitz, principal officer of the consumer finance project at Pew Charitable Trusts. “For customers who have been living paycheck to paycheck and haven’t had access to affordable credit before, this is a game changer and can be a major improvement in their household budget.”
So what are small-dollar loans and what should consumers know about them? Here is everything you need to know:
What are small-dollar loans and where can you find them?
Small-dollar lending is gaining steam especially among big banks and federal credit unions.
Among big commercial banks, six out of the eight largest banks in the U.S. now offer small-dollar loans, according to Pew. The big banks’ small loans range up to $500, $750 or $1,000, depending on the institution.
Small-dollar loans have a quick application process, and can usually be available to the applicant within minutes or even seconds.
While traditional bank loans usually use a loan applicant’s credit score to determine whether the applicant qualifies, a credit score isn’t necessary for small-dollar loans. To determine eligibility for these loans, banks and credit unions look at the applicant’s checking account history, such as whether the applicant has been making regular deposits, whether their checking account is at least 12 months old, and whether they have a positive balance.
“A credit score is typically used to determine whether an applicant qualifies, but that isn’t necessary for small-dollar loans. ”
Under federal rules that went into effect in 2019, fees for NCUA’s PALs are capped at $20 and the maximum annual percentage rate is 28%, while non-bank payday loans can charge rates of up to 200% and 300%. That means borrowing $500 for three months with a small-dollar loan would cost no more than $44, Pew noted, “compared with an average of $450 to borrow that same amount via payday loans.”
Many state-chartered credit unions also offer similar products, which have an APR rate no higher than 18%, per federal law.
Most bank programs give consumers at least three months to pay back the loans, while the NCUA’s loans can be borrowed for one to six months.
Different from payday loans and other non-bank loans that target the general public,
Bank and credit-union-issued small-dollar loans are only available to members of those banks or credit unions. Consumers are able to see the offers through their online or mobile banking page if/when they pre-qualify for it.
How do small-dollar loans affect an applicant’s credit score?
Although the application for small-dollar loans does not require a credit score, it’s still an open question whether paying the loan late or taking the loan itself would affect the borrower’s credit rating, Horowitz said.
The programs do not have a consistent approach on credit reporting, he said; for instance, some of the programs currently report to credit bureaus while some others do not.
“It’s an open question if reporting these loans to credit bureaus helps customers or not, the jury’s still out,” Horowitz said. Given many programs started only last year, little research is available to measure it, he added.
Who might find small-dollar loans most helpful?
Small-dollar loans are most helpful for “underbanked” consumers. Those are people who have a checking account with a bank, but also have to use alternative financial services such as payday loans, check-cashing services, pawn-shop loans, tax-refund advances, and other services that could have high interest rates or high fees.
While most U.S. adults (81%) are “fully banked,” meaning that they have a bank account and don’t use alternative financial products, some 13% of Americans are considered underbanked, according to the Federal Reserve’s 2021 report on household economic well-being.
“These adults are considered ‘underbanked’ because the banking services they accessed appear to have been insufficient to meet their financial service needs,” the Fed report states.
“Before small-dollar loans became widely available, consumers with tight budgets often turned to payday loans from non-bank lenders. ”
Before small-dollar loans became more widely available, consumers with tight budgets often turned to payday loans from non-bank lenders. Using payday loans has the potential to put the borrower into a cycle of expensive debt that can be difficult to pay off.
Payday loans charge fees that can range from $10 to $30 for every $100 that’s borrowed, according to the Consumer Financial Protection Bureau. As the fees and interest pile up, borrowers can end up paying more for the loan than the amount they borrowed.
At the moment, the average payday loan borrower earns around $30,000 a year, which is $15 an hour, according to the Pew Charitable Trusts data. Underbanked consumers tend to work in low-paid jobs and are more likely to be Black or Hispanic, the Fed report found.
For vulnerable consumers, small-dollar loans could be a safer, more affordable alternative to payday loans, Horowitz said. “These loans can save millions of borrowers billions of dollars,” he added. “Because they’re priced 10 to 15 times lower than average payday loans.”
What’s behind the rise in small-dollar loans?
Two factors have driven the rapid growth in small-dollar loans: clearer regulations for lenders, and automation technology.
In May 2020, federal agencies issued guidelines to encourage financial institutions to offer “responsible” small-dollar loans. The guidance was initially part of an effort to provide better support for consumers and small businesses at the beginning of the pandemic.
A wave of credit unions and banks rolled out small-dollar loan products after the guidance came out. Three of the six national banks that offer small-dollar loans announced the products in the last quarter of 2022, and more banks and credit unions are expected to begin offering them in 2023 and 2024, Horowitz said.
“Consumers were sometimes pushed away from traditional banking products because of the uncertainty in the loan-approval process.”
The rise in automation and online banking enabled quick application processes and quick issuance for small-dollar loans, which was a “game changer” in helping underbanked consumers, Horowitz said.
In the past, consumers were sometimes pushed away from traditional banking products because of the uncertainty in the loan-approval process, and the time spent waiting for loan approval.
“Payday and high-cost lenders in the past have been quicker at providing funds than banks and credit unions, giving the high-cost lenders an advantage with customers in financial distress seeking funds for urgent expenses,” the Pew analysis said.
Small-dollar loans could help build trust between underbanked customers and traditional banks. Of those people who borrowed from alternative financial services, 80% said they would be willing to borrow from a bank or credit union if they heard “yes” from the institutions about their loan application, a previous Pew survey found.
“But they’ve heard no, they’ve heard no for a long time,” Horowitz said. “These are customers who are used to not qualifying and they’ve been charged overdraft fees in the past. But that’s changing.”
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