Suppose you are in the lending business. Which of the following two applications would you favor?
Applicant 1 needs the cash to cover a one-time, unexpected expense. His credit history is good, and he earns more than enough money to repay the debt in full and on time. So whatever you have in mind to charge in the form of interest rate and fees, and the manner in which the loan is to be structured will have to be competitive with what the applicant can easily obtain in the open marketplace.
Applicant 2 is barely able to make ends meet each month. As such, there's a risk that the loan may not be repaid on time, or in full. His employment situation, however, is stable, and his credit report, while not pristine, is not hateful. Add to the mix a fair amount of desperation, and it appears as if you have the latitude to charge a high rate of interest, a healthy amount of fees and, perhaps, to require a direct-debit repayment plan that coincides with the timing of the prospective borrower's future payroll deposits, just to be sure there's enough cash in his checking account.
That second scenario likely encapsulates the credit underwriting, pricing and structuring considerations that underlie many short-term lenders' marketing strategies for payday, account-advance and bill-pay loans: Collateral that can be tightly controlled (payroll deposits in this instance), and a borrower who is charged as high a price as he or she can tolerate without defaulting on the loan.
In other words, let's subvert the traditional risk versus reward trade-off by earning outsize profits while taking only moderate amounts of risk.
Of course, the added benefit of this approach is the dependency it engenders. Consumers who are compelled to take out payday, bill-pay and account-advance loans, and small businesses that sign up for merchant-advance loans — which does for small businesses what payday loans do for (or to) consumers, but this time with their accounts receivable — end up diminishing their already inadequate cash flow (hence the need for the loan in the first place). That sets the stage for them to re-borrow the same funds time and again.
It's no wonder this segment of the alternative-finance marketplace continues to attract so much attention — and capital — from private-equity and venture-capital firms.
More Lenders, More Scrutiny
The risk all these startups run, however, will stem from those who push the envelope, which will in turn inspire policymakers to take actions that will end up hindering the industry segment's collective ability to continue raising reasonably-priced debt and generously-valued equity investments.
Consider the impact of a federally mandated usury limit that would preempt more lender-friendly statutes that vary from state to state. What if regulators required prospective borrowers to prove at the outset their ability to repay the debt over time, rather than merely permitting them to pledge self-liquidating collateral (automatic payroll deposits and forthcoming customer payments, in this instance) to guarantee their loan's repayment?
Indeed, what if these firms' investors and institutional lenders were held equally accountable for any potential wrongful actions (i.e., predatory practices) of the firms they are bankrolling, or if the next economic downturn disproves the secret algorithms that are responsible for all these credit decisions?
The point is, if legislation changes the game — and I'm betting it will — you can expect that a good chunk of the capital that has been gushing into online lending ventures will slow to a trickle. No worries for the investors who will likely cash out ahead of time. They'll just move on to the next deal. Not so, however, for the hapless shareholders (to whom the investors sold their stakes), the rank and file of the companies that will be forced to retrench or worse, and the consumers and small businesses that have come to rely upon this method of financing.
Perhaps someday this "take as much as you can for as long as you can get it" mentality will give way to a more equitable way of doing business.
This story is an Op/Ed contribution to Credit.com and does not necessarily represent the views of the company or its partners.
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