Can Credit Unions Replace 'Predatory' Lending?

Felix Salmon has a really interesting piece about a professor who took out a loan from a personal finance company--at a roughly 40% APR--after her credit union turned her away.

Is it a good idea for the professor to be taking out loans at 40% interest rates? Really, she didn't have much of a choice. She needed the money, she got precious little help from her credit union, and the loan company was friendly and extended her the cash on terms she could afford.

What's more, the professor's relationship with World Finance has indeed improved her credit. Since taking out that first loan, she's obtained two different credit cards, and also bought a brand-new BMW with 2.9% financing. All with essentially no help at all from her primary financial institution, which is Missouri Credit Union. The debt the professor is taking on may or may not be wise, given her unique individual circumstances. And the credit union could in theory be a valuable resource in terms of helping her work out whether, for instance, she can really afford that car. But the relationship there is broken, and I see no chance that it will be fixed.

James does admit that he let the professor down: "I think we did fail her," he says, "and I don't think we did what we should have done." The credit union dropped the ball with respect to her loan application, which was left in limbo when she was in a time of need. But at the same time, he also admitted to me that the credit union would not have given her the unsecured loan she was looking for.

The professor's credit score is now good enough that she qualifies for a mortgage; it wasn't before. That's the kind of help a credit union should be able to give, and it's disappointing that Missouri Credit Union doesn't seem to be able to bring itself to do that. If the professor (a) wanted credit and (b) wanted to improve her credit score, then the loan company was, sadly, the place she needed to go.

Salmon, who is an enormous booster of credit unions, thinks that this points to directions for reform:

So two things are needed here, I think. The first is effective regulation, with teeth; I hope that Richard Cordray, newly installed at the head of the CFPB, will start providing that soon. There's no time to waste.

But regulation isn't enough: we also need alternatives -- non-predatory financial products which allow people with bad credit to repair that credit and get back on their feet. Many credit unions provide such products, but as we've seen, many credit unions don't. And credit unions are in any case often difficult institutions to navigate: it's never entirely obvious who's allowed to join any given one. Can someone set up a Kiva for America? Help is needed, here. And it's very hard to find.
I too, am a fan of the credit union. We got our mortgage through Navy Federal, and even though we could probably refinance to something cheaper, we're sticking with them because I like the customer service and the fact that they will bend over backwards to fix issues with your loan.  (Back when I had a car loan, it took me a year to straighten out issues with my car titling, and as long as I made the payments, they kept giving me more time).

But I don't think that they are somehow going to substitute for the lenders at the bottom of the risk market: loan companies and payday lenders.  Felix, who is on the board of a credit union, may have some insight into this that I don't, of course.  But right now, I don't see it.

Credit unions are not charities.  They have responsibilities to the members who deposit money with them: they cannot make loans that are reasonably likely to lose money (at least in aggregate).  And while the interest rates on products like payday loans are indeed eye-popping, the companies themselves are not especially profitable.  This suggests that the reason the loans are so expensive is that they cost a lot to make.

Why is this?  For starters, because the risk of default is very high.  It's hard to get good numbers, and estimates vary widely, but I'm pretty sure that they're well north of 10%.  That's a pretty high default rate for any type of loan, but particularly one where the term is measured in weeks.

That's not the only reason to think that these loans are expensive.  Since they are often for very small amounts, they have high transaction costs relative to the loan amount--it takes just as much time to process forms for a $200 loan as it does for a $10,000 loan.

There's also the structure of the loan, which involves a lot of intensive interaction with the borrower.  Remember, the short term (and the fact that they're tied to payday) helps hold down the default costs on payday loans.  It's also really expensive to achieve; it means maintaining a storefront with people in it at all hours.

Credit unions might make those loans somewhat cheaper by layering that overhead on top of existing operations, and because they don't need to make a profit.  On the other hand, credit unions lack expertise and skill in this sort of loan.  In general, credit union loans are not wildly cheaper than similar loans from other institutions.

But I suspect that what Felix has in mind is substituting a different--and much cheaper--type of loan for the payday loans.  And I'm skeptical that this can happen.  All of the research that I've seen on these super-expensive loan products indicates that most of the people who are taking them are not doing so because they don't understand how high the interest rate is, but rather, because they have exhausted all of their other borrowing options.  (And frequently, the alternative is even more expensive: a bounced check fee, a utility disconnect that will require a hefty fee for reconnection, a lost day of work because of car trouble).

So I take it that the reason that the credit unions aren't putting them into cheaper loans is that they can't.  The cost of an unsecured loan to someone with terrible credit is high because those loans go bad very frequently, resulting not only in the loss of funds, but in considerable overhead expended on collection.  Particularly in the case of credit unions, who--as my auto loan illustrates--work very, very hard to keep their members' loans from going bad.

And I'd guess that credit unions, for all sorts of reasons, don't really want to get into the super-expensive-super-risky loan business.  That's why they focus on figuring out how to help you not need the money.  Obviously, that is going to be a bad outcome in some particular cases, because no system is ever perfect.  But on balance, I can understand why credit unions aren't eager to get into the payday loan game.

Update:  Apparently, some are.  But the products often aren't substantially cheaper than regular payday loans--though Felix highlights this program at a State Employees credit union, which does look much cheaper.

Felix asks me if there's any reason that last program can't scale.  I think there are three possibilities:

1.  They're losing money on it, and a lot of credit unions can't be in the business of charity to people who need payday loans

2.  Their lending population is somehow different from those who need regular payday loans (state paychecks are pretty steady, and the program requires direct deposit)

3.  It's a game changer that will revolutionize payday loans.

I'm pretty skeptical that #3 is the answer--these loans are cheaper than most credit cards, and that's a very competitive space.  On the other hand, all game changing innovations suffer from not having been done before: that's no proof that they can't be.  I'll only note that the general experience of nonprofits in this space seems to be that they have to charge high APRs (or fees that amount to the same thing) in order to make up for the costs.