Written by Ronald D. Orol
Published: Marketwatch.com on Nov. 10, 2009

Editor's Note: While we continue our work to support Emerge WorkPlace Solutions, a payday loan alternative delivered through employers (www.newfoundryventures.org), I remain fascinated by other attempts to serve this vastly underserved market. There is such a huge opportunity vacuum between ripping people off and doing honest business. It amazes me that more don't see it. Bravo to Amarillo and others in this program. [more]

Loan program helps 'unbanked' climb economic ladder
FDIC program aims to help low-income consumers avoid payday loans
By Ronald D. Orol

WASHINGTON (MarketWatch) -- Lilia Escajeda, a vice president at Amarillo National Bank in Amarillo, Texas, says she doesn't understand why other banks don't offer small loans to low- and moderate-income borrowers.

"We have a high propensity of people in low-income ranges that we offer small-dollar loans to," Escajeda said. "If they meet the criteria that we have set, they can get a loan."

Amarillo Bank is one of 31 commercial institutions in 26 states, including Texas, Louisiana and Illinois, participating in a Federal Deposit Insurance Corp. program to offer short-term, small-dollar loans of under $2,500 to low-income Americans, many of whom have low or no credit scores. Amarillo has offered small-dollar loans for decades, but roughly half of the banks in the program first started offering them as part of the FDIC program.

So far, the banks collectively have offered $28 million in loans under $2,500.

The FDIC's goal is to help the estimated 80 million to 100 million so called under-banked Americans avoid payday loans or overdraft programs that provide quick cash but carry high fees or triple-digit interest rates. The agency will release a final report on the two-year program in February 2010. Read the one-year results on the FDIC site.

"Our goal is to show low-income Americans that there is a much less expensive alternative to these options in the form of small-dollar loans from banks that can help build their credit scores," said FDIC Vice Chairman Martin Gruenberg. "The goal is also to show banks that small-dollar borrowers represent an attractive new customer base, while retaining other borrowers."

Escajeda said that institutions like Amarillo Bank offer small-dollar loans of under $2,500 or less for an average of nine months, at a 14% to 18% annual percentage rate -- a rate significantly lower than what individuals pay when over-drafting their accounts or taking out payday loans. And when low-income consumers take on a small-dollar loan and pay it back, they improve their credit scores; that doesn't happen when using payday lenders or overdraft protection.

With overdraft protection, consumers can overdraw their accounts and banks will cover the transaction with fees as large as $35 for each overdraft, irregardless of the size of the draw.

However, FDIC's Gruenberg said that a large percentage of bank profits from overdrafts -- about $35 billion in annual fees for the whole industry -- come not from individuals who make a mistake but from low-income consumers who overdraw their accounts on purpose, as a type of short-term loan because they can't cover their basic living expenses.

"Overdrafts are a line of credit people are using," Gruenberg said. "It can be the most expensive line of credit you can use."

According to Moeb Services, an economic research firm, consumers pay a fee of $26.68 on average every time they overdraw their accounts. That leads to thousands of dollars of charges for some consumers.

Payday loans have steep costs

Another problematic alternative for low-income people: the 23,000 payday lender outlets around the country that make up the $70 billion payday-loan market. Low-income individuals without bank accounts turn to payday lenders, who provide cash for a large fee. According to one statistic, 70% of payday loans come from repeat users.

In California, a consumer can write a check to a payday lender for $300 to receive a two-week loan, generally until they receive their next paycheck. That breaks down into a $45 fee for the lender and a $255 loan, which the borrower repays when he gets his work payment. That translates into a 460% annual percentage rate fee.

"The payday loan needs to be paid in full after two weeks," said Patrick Kirscht, risk-management vice president at Progresso Financiero, a small-loan lender in Mountain View, Calif. "What typically happens is the consumer pays off the payday loan by taking out another payday loan. The industry calls this rolling over the loan."

That's a significantly higher fee than what small-dollar lenders charge for their loans. James Gutierrez, Progresso's chief executive, offers small loans with significantly lower interest rates. Gutierrez charges an origination fee and interest fee that combine to about a 36% annual interest rate.

Since its formation, Progresso Financiero has made 30,000 loans averaging $900 each. The company, with 17 locations and 120 employees, offers loans ranging from $250 to $2,500 for an average 9-month term.

Credit score is key

Gutierrez said the fees and interest paid to payday lenders and banks for overdraft protection contribute to a larger problem for low-income individuals -- those types of loans do not help build credit scores.

"Not having a credit rating is like not having a face," Gutierrez said. "Without one you don't exist, you can't get a cell phone, can't get some jobs and can't buy a home or build that economic ladder to prosperity."

He adds that a failure to build a credit score limits low-income individuals' ability to advance economically.

"It's disproportionately affecting minority communities. They are the ones falling further behind because they don't have a credit score and they lack credit," Gutierrez said.

Low default rate

Even with little information about a borrower's credit information, the lenders participating in the FDIC's program have experienced low default rates on small-dollar loans. In the second quarter of 2009, 5.2% of small-dollar loans provided by banks participating in the program defaulted, according to the FDIC. Roughly 9% of loans in the second quarter were in delinquency, or 30 days late, indicating that some borrowers had a difficult time paying the loan but most eventually paid it off.

Agency officials said they hope the success of the program will drive more banks to set up offices in low- and moderate-income districts, where foot-traffic will drive more customers. The FDIC said that many participating banks are working with non-profit institutions and community organizations to help identify potential borrowers who might benefit from small loans.

The FDIC program has been successful for Amarillo Bank. The bank offered 1,818 loans of under $1,000 -- with a total volume of $1.4 million -- to low- and moderate-income individuals from January 2008 through Sept. 30, Escajeda said. Over the same period, Amarillo made $6.8 million in loans ranging in size from $1,000 to $2,500 to 3,779 individuals.

The small loans have the same default rates as other categories of loans, and that small-dollar borrowers often become long-term customers, Escajeda said.

"We have found many success stories out of our small-dollar loans," Escajeda said. "They refer people to us, bring their relatives in, become long-term customers and buy other products...it's a mushroom effect."

Ronald D. Orol is a MarketWatch reporter, based in Washington.