State laws put installment loan borrowers at risk
When Americans borrow money, most use credit cards, loans from banks or credit unions, or financing from retailers or manufacturers. Those with low credit scores sometimes borrow from payday lenders or auto titles, which have come under significant research and regulatory scrutiny in recent years.
Another segment of the non-bank consumer credit market — installment loans — has not been as well studied. About 10 million Americans use installment loans each year, spending over $10 billion in fees and interest to borrow amounts ranging from $100 to over $10,000. Lenders offer these loans in approximately 14,000 stores in 44 states. The largest has a wider geographic presence than any bank and has at least one branch within a 25 mile radius of 87% of the US population.
The latest research from Pew indicates that installment loans may be safer and more affordable alternatives to other high-cost credit products like payday loans or auto title loans. But state laws governing these loans are not strict enough to prevent lending practices that obscure the true cost of borrowing and expose customers to financial risk. Customers are not protected against pre-loaded origination or acquisition fees, annual percentage rates that do not reflect the full costs of loans and ancillary products, and the sale of credit insurance and other low value with initial premiums.
Refinancing an installment loan may make sense for some consumers, but high upfront fees and upfront finance charges disproportionately hurt those who do.
Non-refundable origination fees make the first few months of the loan the most expensive for the consumer and the most profitable for the lender. Many state laws allow and even encourage these practices rather than requiring that monthly fees be spread evenly over the life of the loan. The anticipated fees are a strong incentive for lenders to refinance loans to generate more from those lucrative first months. Every year, about 2 in 3 loans are refinanced consecutively, prolonging debt and dramatically increasing the cost of borrowing, especially when origination or other upfront fees like credit insurance premiums are reapplied .
When loan contracts include credit insurance or other ancillary products, lump sum premiums or other charges are financed, which increases both the total amount borrowed and the amount of interest paid by the borrower. The cost of these products is not factored into the stated APR, resulting in loan agreements where the rate stated in the contract is often significantly lower than the “all-in” APR – the annual percentage rate that a borrower pays after all costs have been calculated.
This practice allows installment lenders to contractually comply with state interest rate caps while providing loans with all-inclusive APRs that often exceed these regulations. It also conceals all-inclusive APRs from borrowers, making it extremely difficult for consumers to evaluate credit products and compare costs.
Differences between stated and all-inclusive APRs are endemic in states that cap interest rates but allow the sale of credit insurance in conjunction with lending and premium financing. Added credit insurance and other ancillary products increase the cost of borrowing in states that allow them by more than a third, on average.
Pew’s research indicates that when states set rate limits under which consumer finance companies can’t make loans profitably, lenders sell credit insurance to earn revenue they don’t have. not allowed to generate through interest or fees. In one fiscal year, five of the nation’s largest installment lenders reported combined revenues of more than $450 million from ancillary products.
To improve outcomes for consumers who use installment loans and reform payday loans and other high-cost loans, lenders and policymakers should adopt reasonable safeguards that align the interests of borrowers and lenders, including:
- Spread the costs evenly over the term of the loan. Origination or acquisition fees should be nominal, proportional to the amount financed, and repayable on a pro rata basis to minimize lenders’ incentives to refinance loans and avoid harming borrowers.
- Require credit insurance to work like other standard insurance policieswith typical loss ratios and monthly premiums rather than pre-billed and funded premiums.
- Mandate that the sale of ancillary products be separated from the issuance of credit. Credit insurance and non-loan products should only be offered after the loan transaction has been completed and the borrower has either received the product or been notified that the loan has been approved.
- Establish or continue to establish transparent maximum allowable costs that are fair to borrowers and viable for lenders. If policymakers want modest installment loans to be available and safe for consumers, they should allow interest rates high enough to allow efficient lenders to operate profitably and ban ancillary products rather than setting lower rates and then allow lenders to sell ancillary products to increase their bottom lines. Existing research is mixed on the overall impact of small credit on consumer welfare, so policymakers can—as those in some states have already done—effectively prohibit small credit by setting limits on low rates and prohibiting fees and ancillary products.
These improvements to state laws would allow installment loans to evolve into safer and more affordable alternatives to other non-bank credit and better serve customers who have few good options today.
Alex Horowitz is Head of Research for The Pew Charitable Trusts Consumer Credit Project.