A couple weeks ago, I launched my one-man campaign to eradicate APR when it comes to short-term lending and proposed we replace it with TRUST. APR is bad because actually it doesn’t help the consumer, it provokes anger which informs regulations which causes the unintended consequences of even less availability and less competitiveness and therefore either no credit to people who need it or worse terms than the status quo.
While I received exactly zero public comments, that post was shared more than any I have ever written and generated positive private responses from advocates, bankers, and lenders. Today, I want to focus on the proposed alternative to APR: TRUST.
Term flexibility – suit the loan to fit various users’ needs
Repaid fully – design the loan to be payable without rollover
Understandable – make the terms and fees clear and transparent
Selective – good loans should be priced according to risk
Transitional – offer a graduation path for good performance
Again, these are not entirely my ideas. I have merely assembled the fewest possible guidelines that align consumer value and commercial value as much as possible. The idea is to provide a basis that could serve as an alternative to guiding companies and policy than merely focusing on APR. I would guess that even outgoing FDIC chairman, Sheila Bair, would recognize the limitations of her efforts to cap APR at 36%. Clearly well intended and certainly aspirational, banks who participated in the pilot program found the cap was unsustainable and unscalable. While at the same time some advocates and other institutions chastise these 36% lenders as being predatory. Here goes:
Term flexibility – the underbanked are a large and diverse market and one size does not fit all. Term flexibility allows users to select of more than one choice in repayment periods. Longer terms, of course, increase risk to the lenders, so it is understandable if it is associated with a corresponding price difference, as long as this is clearly and understandably communicated. Some, even minimal customization on repayment period should help accommodate a wide array of people and also give customers the opportunity to actively see, understand and choose what best suits their needs, presumably decreasing defaults.
Repaid fully – a good and responsible short-term loan should work well – for lender and borrower – as it was offered, without rolling 0ver. Quite a high percentage of payday loans are “rolled over,” meaning the borrower isn’t able to repay the loan fully and has to pay a fee to take out another loan on the first. Many such loans roll over many times, sometimes as often as 7 or 8 times, with genuinely tough economic consequence for the borrower. Being able to repay a loan fully places a burden on the lender to make reasonable efforts to verify that the borrower has the means to repay (the ability to pay). It also means good loans are structured to accept multiple payments, not just one lump sum. Finally, and importantly, fully repayable loans should offer a cooling off period between full repayment and any subsequent loan. This is tough to implement, because inter-entity borrowing is commonplace: Lender A forces me to “cool off” so I get another loan from Lender B in order to pay off Lender A. Here both industry-wide best-practices and payday credit bureaus (such as Teletrack, DataX, CL Verify) could serve an important role. I would much rather see a higher priced fully amortizing loan than a “lower” cost one which rolls over 5 times, ultimately more expensively and creating a downward economic and behavioral spiral for customer.
Understandable – few people squabble over transparency, yet few are great at it. The standard needs to be high in an industry known for reams of “mice type” legalese associated with anything from a credit card to a mortgage. Terms for all aspects of a short-term loan need to be crystal clear and easy to understand up front. The latter is important, since some regulators require certain disclosures which actually are less easy to understand by consumers. For example, APR – while allowing for easy comparison – has little bearing on price for anyone without a multi-function calculator. Then, of course, there is the question of “effective” APR, which is meant to include all the fixed fees into the APR. Huh? Make it understandable.
Selective – Many forms of short-term loans have just one risk-tier: high. This means you either get the loan or you don’t. For a product and population which includes significant defaults all the “good risks” are subsidizing the “bad risks.” It is not unusual for just four honest people to need to subsidize one jerk. Simplistically, they are paying 25% more if the loss rates are 20%. Good short-term loans should be selective, or risk based. The more accurately the lender can assess risk, the better for all concerned. Extra credit goes to those who create multiple risk categories, each with prices which reflect the level of risk, so that the (typically lower income) “good” borrowers don’t have to subsidize the entire population of “bad” guys, but only a smaller subset in their own risk category.
Transitional – I’m very curious who thinks they offer loans which comply with all the above: if you do, send me a note. This last item is important, if less often discussed. Given the nature of short-term lending, and the relative economic fragility of those who use them, I believe a hallmark of a “good” or “responsible” loan includes its capacity to graduate customers to a “better” life. This transition can take several forms, some listed here, from good to great: In a closed-loop transition a lender would offer its customers superior terms upon successful and on-time repayment for a subsequent loan. An open-loop transition would offer the customer, presumably by reporting to the credit bureaus, the opportunity to access better priced, and/or more “mainstream” financial products upon proving themselves responsible. Another form of transition is in the use of proceeds: a loan used for generating income clearly helps a customer get into a stronger economic position. Think small-business or micro-loans. You see where I’m going.
This discussion is a work in progress. I encourage your feedback and suggestions, privately or by commenting here. The larger objective is to create or inspire real, clear aspirational guidelines for responsible short-term loans of all shapes and flavors, to abandon APR as such a guideline and ultimately to offer the unbanked and underbanked access to long-term value financial products by a healthy and profitable industry who wins when their customers win. Whose in? Let’s build some TRUST, already!