The Downside of Loans: Online Installment Loans

The calculation of the loans is relatively simple. An institution, be it a bank or another type of lender, has access to funds at cheap rates. It lends these funds and usually adds an interest margin.

The margin covers the cost of funds used to lend, the operational costs of the loan and the risks associated with it. In other words, net income = interest income – interest expense – net non-interest expense.

It’s that simple.

Now think of a basic bell curve, and you can see how FICO scores play a role in deciding who gets credit and who doesn’t. For the lowest 20%, you have the highest credit risk. It represents those with poor credit, low income, or difficult work histories; for the top 20%, you have the reverse.

The remaining 60% is quasi-prime or prime.

If you are designing the pricing for a basic Bank of America Cash Rewards card, Chase Freedom card, or Discover It card, you will focus on the 60% group. This is the American consumer credit market, with around 80 million households.

There are many potential customers among the many credit card issuers in the United States. The top 20% are more likely to benefit from card products such as the Bank of America Premium Rewards Card, Chase Sapphire, or a premium Discover It card.

But, for the bottom 20%, we have outsized credit risk. In this group are undocumented or low-income people with limited repayment capacity, those who have failed to manage past credit responsibilities, and those who may have extended their credit.

But they still need credit to run their household budget.

Secured cards are a viable option for this segment, but like prepaid cards, you need money to fund the account, which locks in 58% of US households with less than $1,000 in savings.

With that in mind, consider an unexpected financial event like a broken down car, medical emergency, or other household crisis. If you’re a Joe or Jane consumer, there may be an immediate need for a temporary financial bridge, which brings us to today’s credit story from the Los Angeles Times.

The LA Times talks about the emergence of online installment lenders to service this niche. The fact is, American consumers have over $150 billion in installment loans, ranging from low-cost financing at Walmart at Affirm to 5-figure debt consolidation loans from Marcus of Goldman Sachs.

But the interest group today are consumers somewhere in between, with poor credit and short-term cash needs.

  • It’s called online installment lending, a form of debt with much longer maturities but often the same kind of crippling triple-digit interest rates.
  • If the payday loan’s target audience is the nation’s poor, then the installment loan is for all working-class Americans who have seen their wages stagnate and unpaid bills pile up in the years following the Great Recession.
  • In just five years, online installment loans have grown from a relatively niche offering to a booming industry.
  • Unpreferred borrowers now collectively owe about $50 billion on installment products, according to credit reporting firm TransUnion.
  • In doing so, they are helping to transform the way much of the country accesses debt. And they did so without drawing the kind of public and regulatory backlash that has dogged payday lending.
  • “Installment loans are a cash cow for creditors, but a devastating cost to borrowers,” said Margot Saunders, senior attorney at the National Consumer Law Center, a nonprofit advocacy group.

Eeew: The payday loan.

  • Yet the change had a major consequence for borrowers.
  • By changing the way customers repaid their debts, subprime lenders were able to partially circumvent growing regulatory efforts to keep families from falling into the debt trap built on exorbitant fees and endless renewals.
  • While payday loans are usually repaid in one installment and over a few weeks, installment loan terms can range from four to 60 months, apparently allowing borrowers to take on larger personal debts.

Online installment loans are a step above payday loans.

For subprime lender Enova International Inc., outstanding installment loans averaged $2,123 in the second quarter, compared with $420 for short-term products, according to a recent regulatory filing.

  • Larger loans have allowed many installment lenders to charge triple-digit interest rates. In many states, Enova’s NetCredit platform offers annual percentage rates between 34% and 155%.
  • Between Enova and rival online lender Elevate Credit Inc., first-half installment loan write-offs averaged about 12% of total outstandings, well above the credit card industry’s 3.6%. credit.
  • “With high-cost credit, you’re only serving people who won’t be eligible for other types of credit, so you’re already in a tough spot,” said Jefferies LLC analyst John Hecht. “Companies have to put a price on that.”

The bell curve works in credit, allowing you to contain costs; risk is an expense that lenders must charge directly to those who present it. Costs will be higher for riskier loans. The facts are simple, and while Shakespeare’s advice through Polonius in Hamlet may seem harsh, it says a lot.

“Neither a borrower nor a lender be; / For the loan often loses both itself and a friend.

Preview by Brian RileyDirector, Credit Advisory Services at Groupe Conseil Mercator

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