Finance Roll

Lenders and brokers who loan money to people with lower incomes and spotty credit will all claim that they provide a valuable service to a community that is under-served by traditional lenders. But do they really? Or are they instead exploiting the plight of our most vulnerable citizens by promoting an endless cycle of debt and making a killing off the interest and other fees they charge?

While it is a good idea to give people who might not normally have the access to financing a leg up, surely that leg up should not also come with a heavy weight attached to it in the form of draconian and exotic terms that make it close to impossible for the borrower to successfully meet his obligations.

Payday Lending

Payday lenders love to claim that they are providing an essential service to those who might otherwise be unable to borrow money in a time of need. The concept is relatively simple: the payday lender loans the borrower, frequently a member of the working poor or living on a fixed income such as disability or social security benefits, a small amount, usually between $300 and $500. To secure the loan, the borrower writes the payday lender a personal check for the amount of the loan and the fee. On the borrower's next payday, the lender cashes the check and gets paid back.

That doesn't sound so bad, right? It sure is nice that its available if you have some unexpected expense like your car breaking down or if you're unable to cover that higher than normal power bill. This is the payday lending industry's argument. If they weren't there, well, poor and moderate income Americans would have nowhere to turn for the cash they need, and if used responsibly, the fees are marginal.

As is the case with most financing targeted at lower income families and those with marginal credit, the terms of these loans are such that they become very difficult to pay off and the debt trap closes. To begin with, the interest rate on them, when expressed on an annual basis, is often in excess of 400%, making payday loans among the most expensive type of financing available. In addition, because the term of the loan is very short, one to two weeks, and because the entire loan must be repaid all at once, most payday loan borrowers often must get a new loan, for an additional fee, to cover the first one. This cycle continues repeating until the borrower has paid fees more than double the amount of the original loan without having touched the principle.

In fact, over 90% of payday loan revenue comes from recycled loans. Payday lenders know that the people who get these loans will be unable to pay them back when due and will have no choice to but to roll them over into a new loan.

The payday lending industry can do all of the things it does because is it is largely unregulated and is fighting tooth and nail to remain so. Alan Jones, the owner and CEO of one of the larger payday lending companies, has even gone so far as to claim that payday lenders live in poverty and therefore shouldn't be regulated. This is a guy with a net worth of over half a billion dollars and a regulation size football field, complete with stands and lights, in his backyard.

Overdraft And NSF Fees

As the cost of living has continued to skyrocket and in the absence of growing incomes, people have come to rely on overdraft coverage as a source of credit. The problem with this is that like payday lending, it is a wealth stripping exercise and next to payday lending, among the most expensive forms of credit you can get.

For example, if you have $5.00 left in your bank account and you use your ATM card to buy something that costs $6.00. Your bank will allow the transaction to go through and charge you $35.00 for the $1.00 of your overdraft. So now you're in the red by $36.00, for $1.00 of credit advanced to you "as a courtesy."

Of note, recent changes to the laws governing overdraft charges will require that banks get your permission, in the form of an opt-in, for overdraft protection and fees. This only applies to ATM charges, not to checks, and does not cover non-sufficient funds charges.

70% of bank income is now from overdraft and non-sufficient funds fees. In 2008 banks charged their customers $34.3 billion dollars in fees, most of this from people who have overdrawn their account more than once. In fact, 20% of US bank accounts generate 80% of overdraft fee income.

Another egregious practice used by the banks to maximize their overdraft and non-sufficient funds fee income is the re-ordering of check-clearing from the highest dollar amount to the lowest. This means that if three checks are presented to your bank for payment and you have sufficient funds for all but one of them, the bank will clear the largest dollar amount check first, ensuring that the other two smaller checks will overdraw your account, thereby allowing them to collect two overdraft or NSF fees instead of just one. Unfortunately, this practice remains legal.

Prepaid Debit/Credit Cards

Prepaid debit or credit cards are marketed to the unbanked as a way to access their money more conveniently and safely as well as do things like shop online. Prepaid cards are easy to get as the only thing required is cash with which to load the card.

However, the convenience and added safety come at a steep price; often much higher than the fees necessary to maintain a bank account would be. Depending upon the card, monthly maintenance fees are required, which can range as high as $10 a month. In addition to maintenance fees, the cardholder is charged every time he or she uses it. There are charges for point-of-sale ATM transactions, charges for credit transactions, charges to withdraw money, charges to check the balance,charges for loading the card, and even inactivity fees.

For the people to whom these cards are marketed, every dime counts and using these cards often causes a slow bleed of cash that can be devastating.More disturbingly, more states are requiring that benefit checks such as unemployment and public assistance be paid through prepaid debt cards instead of via check. Social Security will be offering this as well, although at this writing, it is not a requirement.

Subprime Mortgage Loans

In the last number of years, about the last twelve or so, a new breed of lender and a new kind of loan was created. This type of lender and loan were was supposed to unlock the housing market to groups previously locked out: those with lower incomes and spotty credit histories. The so-called subprime loan was born. The fact that the terms of these loans were often so bad, and so expensive as to render them doomed to failure from the beginning was washed away with assertions by the brokers who sold them and the lenders who made them that the borrower could always refinance into something better in the future, "after their credit improves."

Evidence now suggests that the industry point of view was at best misguided and at worst downright predatory. In recent testimony before the the FCIC, Julie Gordon of the Center for Responsible Lending, a non-partisan, non-profit group, revealed some shocking truths regarding subprime lending:

First, these loans were engineered, primarily and in all aspects, to make the most money for mortgage brokers, lenders, servicers, and investors. With yield spread premiums to reward brokers for making subprime loans and with Wall Street itchy for more loans to bundle off into Mortgage Backed Securities, it was all about making money now, and since these actors didn't hold the mortgages they made themselves, the risk was passed on to the next guy.

Second, far from helping lower income families and those with lower credit scores obtain access to financing that they didn't have before, it placed them at a strong disadvantage to be able to pay these loans back from the very start. Empirical evidence gathered in a 2008 study found that borrowers with similar risk profiles, in other words, with similar credit scores and incomes, whether they were low, middle, or high income borrowers, were more than five times as likely to default on a subprime loan as compared with a prime loan with reasonable rates and repayment terms.

Furthermore, 61% of borrowers who were put into these risky loans could have qualified for prime loans with conventional repayment terms. However, it was more profitable to place people into these exotic loans with terms that even financial experts would themselves have a hard time understanding, let alone the borrower.

Lastly, far from expanding homeownership, 90% of the mortgage loans made in the period of 1998 to 2006 went to families who already owned a home: 60% were refinances and the other 30% went to families moving from one residence to another.

Far from helping people who would otherwise not have access to financing enter our financial system and prosper, bad credit lending all too often leads to borrower default and failure. This failure is not the result of their inability or unwillingness to pay as agreed, but is instead a function of the financing terms themselves.

The bottom line in financing should be that if you can't give someone a loan with a fair interest rate and terms, then perhaps you shouldn't be making the loan at all.