Wells Fargo launched a widely available small-dollar loan for its customers on November 16, becoming the fourth major bank to offer an affordable alternative to costly payday loans. With the move, financial institutions that operate nearly 13,000 branches — about 18% of all bank branches in the US — are now offering automated and near-instant small loans to their customers.
This change opens up access to borrowing for many checking account customers with low credit ratings who might not otherwise qualify for a bank loan. Banks have found that these customers are more likely to repay the loans because of their past relationship with the bank and because the loans are repaid in affordable installments over several months.
The maximum amount of these loans is set at $500 or $1,000 depending on the bank, allowing consumers to borrow as much as they would on a payday loan, but at a much lower cost and with strong safeguards. Payday loans typically have interest rates in excess of 300% and often have prohibitive lump sum payments that can eat up a large chunk of the borrower’s regular paycheck. In most cases, repeated use leaves borrowers carrying costly debt for many months.
Although banks use different criteria to determine eligibility for small loans, the four largest that they offer – Bank of America, Huntington, US Bank and Wells Fargo – base their qualifications primarily on the customer’s account history with them; for example, whether the prospective borrower has been a customer for a certain number of months, uses the checking account or debit card regularly, or has a direct deposit for paychecks. Every 12 million Americans who take advantage of payday loans annually have a checking account and an income, as those are the two requirements for getting a payday loan.
The big banks that offer small loans charge at least 15 times lower rates than average payday lenders. Loans are repayable over a period of three to four months, which is in line with consumer perceptions of the time it takes to repay small loans. Compared to typical payday loans, where borrowers remain in debt for an average of five months a year, bank loans can save consumers hundreds of dollars. For example, the average cost to borrow $400 for three months from a payday lender is $360; Now these banks charge $24 or less for this loan. Similarly, the average cost of borrowing $500 for four months from a payday lender is more than $500 in fees alone, while the cost of borrowing through any of these banking programs is $35 at most.
Previous research has found that using payday loans can put customers at increased risk of losing their checking accounts, suggesting that bank microcredit borrowers can reap benefits beyond saving hundreds of dollars in fees. And since the average payday loan borrower makes about $30,000 a year — less than $1,200 per biweekly paycheck — the overall savings would be significant.
When Pew surveyed payday loan borrowers, 8 out of 10 said they would switch to borrowing from their bank if they started offering small loans and they were likely to be approved. Their primary criteria for selecting the loan location was how quickly the money would be available, how certain it would be of approval, and how easy it would be to apply for. Banks all have simple, fast online or mobile applications and transfer loan proceeds to customers’ accounts within minutes. This is much quicker and easier than a payday lender’s process. This speed and ease indicate strong customer acceptance of small bank loans.
Checking account customers who have turned to payday and other high-priced lenders because their banks didn’t offer small loans now have an option far cheaper than any previously widely available. These new small loans are now an option in part because the Federal Deposit Insurance Corporation (FDIC), the Federal Reserve Board of Governors, the Office of the Comptroller of the Currency, and the National Credit Union Administration, who have welcomed the automation, are thoughtful, well Guidelines that were designed advocated this type of lending and gave banks the regulatory certainty they needed to develop these products.
So far, only Bank of America, Huntington, US Bank and Wells Fargo have stepped up to offer secure small installment loans or lines of credit to customers who need it most and who would not normally be eligible for bank loans. Several other institutes have announced that they are developing new small loan products. To reach millions of borrowers and help them save billions of dollars annually compared to what they would owe payday lenders, more banks need to prioritize financial inclusion. To do that, they should join these four and offer similar loans to their customers who need help the most.
Alex Horowitz is an officer and Linlin Liang is a senior associate at The Pew Charitable Trusts’ consumer finance project.