Installment loans seem like a kinder, gentler version of their “predatory” cousin, the payday loan. However, they can be even more harmful to consumers.
The use of installment loans, where a consumer borrows a lump sum and repays the principal and interest in a series of regular payments, has increased dramatically since 2013 when regulators began restricting payday loans. In fact, payday lenders seem to have designed installment loans primarily to evade this heightened scrutiny.
A closer look at the differences between the two types of loans reveals why we think installment loan growth is worrying – and warrants the same regulatory attention as payday loans.
At first glance, it seems that installment loans might be less harmful than payday loans. They tend to be larger, payable over longer periods of time, and usually have lower annualized interest rates – all potentially good things.
While payday loans are typically around $ 350, installment loans are typically between $ 500 and $ 2,000. The potential to borrow more can benefit consumers who have greater short-term needs. Because installment loans are repaid in bi-weekly or monthly installments over a six to nine month period, lenders say lenders are better able to cope with the financial burden that put them on their business in the first place.
In contrast, payday loans typically require a lump sum payment of interest and principal on the borrower’s next payment date, often just days away. Lenders offer cash in exchange for a postdated check from the borrower’s checking account for the borrowed amount and “fees” – what they often refer to as “interest” to circumvent usury rules.
Finally, and perhaps most importantly, installment loans are often cheaper than payday loans, with annualized interest rates of around 120% in some states, compared to the typical payday loan range of 400% to 500%.
Harmful to consumers
Unfortunately, some of the structural features that appear beneficial can actually be harmful to consumers – making them even worse than payday loans. For example, the longer payback period keeps borrowers in debt longer and requires continued repayment discipline, potentially increasing the stress and the possibility of error. And the fact that the loan amounts are larger can cut back in either direction.
It is true that often the small size of payday loans is insufficient to meet a borrower’s immediate needs. Approximately 80% of payday borrowers do not fully repay their loan when due, but rather “roll over” their loan to the subsequent paycheck. Extending a loan allows borrowers to simply repay the interest and then extend the loan in exchange for another payment cycle to make the repayment at the cost of one more interest payment.
In a recent study, we examined the effect that larger installment loans have on borrowers. We used a dataset with thousands of installment loan records in which some borrowers got bigger loan because of higher income. Although similar in terms of factors such as credit risk and income level, borrowers with slightly higher incomes were offered a loan of $ 900 while others were only offered $ 600.
We found that borrowers with these larger loans were more likely to later take out other installment loans, shop window and online payday loans, and auto title loans. Our results suggest that the higher initial installment loan may not have served its primary purpose of helping borrowers manage their finances and may even have resulted in an increased financial burden.
Abuse and abuse
As some of our previous research has shown, even payday loans, with their sky-high annualized interest rates and balloon payments, can be beneficial to consumers in some cases. Installment loans are no different. When used carefully, they can help low-income consumers with no other credit access to consume smoothly. And if they are repaid on time, the loans can certainly be of net benefit.
But their nature means that abuse and abuse afflict them as well. And all of the negative effects apply to a wider group of consumers as they are considered more “mainstream” than payday loans. Lenders target consumers with higher credit scores and higher incomes than those of the “rand” borrowers who tend to take advantage of payday loans.
Installment loans are making up an ever larger part of the alternative lending industry. Should regulators continue cracking down on payday loans, installment lending will likely account for the bulk of lending in the small dollar, high-interest loan market. Given the current lack of regulation for these types of credit, we hope they will be subject to intensified scrutiny.