The Other End of Sunset

Saturday, October 16, 2010

The menu from the restaurant at the end of the universe

Hi to all…

Since ZestCash launched, there's been a lot of discussion about our product, and the space as a whole. We thought it would be helpful to drill down on a few areas of our business, especially pricing and costs.

Come writers and critics

Who prophesize with your pen

--Bob Dylan

On our site, we lay out several options for short-term credit. Readers will note a few key points on that page. Most importantly, credit (of any sort) is more expensive than using savings to buy something.

Even so, people still need credit. A borrower who does not have access to traditional credit could go to a payday loan store or to a pawn shop. According to the FDIC survey of the un- and underbanked in the US, 30 million Americans have taken out a payday loan or a pawn loan in the past year. Clearly there is a need for this kind of credit.

Given that, I believe that people deserve to have credit that is reasonably priced, transparently offered, and fair. I don't believe anyone disagrees on this point.

However, thoughtful people can -- and should -- disagree on exactly how to provide that credit.

There is evidence that payday loans yield a marked increase in personal bankruptcies. There is also evidence that *lack* of access to payday loans leads to higher bankruptcy rates and higher costs for alternative credit-related products like bounced checks.

Both articles point to the need for credit, and the fact that people who get payday loans are right on the edge of financial ruin. Payday loans could push them over the edge -- or not having them when needed could push them over the edge.

The data is unclear. So, let me start with the hardest, most important question: What is a fair interest rate? This is hard because the question has so many facets, and so much importance to social policy.

You'll be singing in the rain

Said don't stop to the punk rock


First of all, let's be clear: APR is a good measure to use to compare credit options. It's been the standard for 30 years, and has been used to drive public policy discussions across many credit domains.

On our site, though, we suggest that total loan cost can also be a useful measure for short term credit. Let me explain why we say so.

For a given loan, with the same interest costs, APR varies with the length of the loan. Generally, all other things being equal, a shorter loan with the same out of pocket cost for a borrower, has a higher APR. If you were to stretch exactly that same loan out over a longer period of time, it would have a lower APR.

However, these two loans would have exactly the same out-of-pocket costs to the borrower, despite different APRs. The borrower will have paid the same dollar amount of interest for both loans.

Mullainathan and Shafir (2009) point out, in fact, that APR may not capture the way that payday loan borrowers actually make credit decisions.

This doesn't make APR a bad measure. It means that, under certain circumstances, looking at the cost -- the out of pocket costs -- is important to consider as well.

This is why we suggest looking at total loan cost on our site. We aren't trying to hide APR -- in fact, we list it on each page of the application -- we are just trying to help our customers understand their actual out-of-pocket costs.

There have been several attempts to set reasonable prices for credit. Many advocacy groups and governmental organizations have suggested that 36% APR is the appropriate interest rate for small dollar, subprime credit. This rate has been embodied in various state and federal regulations over the past few years.

The FDIC did a two-year study, the Small Dollar Pilot Program, to examine bank and credit union alternatives to payday loans and other high cost loans. They asked 28 banks to give loans to consumers at 36% APR or lower. The loans ranged from under $1,000 to $2,500. Overall, more than 30,000 loans were made, with loan durations of 12 - 18 months, and total loan principal of $40m.

The pilot showed reasonably low default rates, which is promising, and showed that traditional financial institutions can, with appropriate incentives, offer less expensive credit. This is very promising for the credit industry.

However, it's important to recognize the limitations of the study as well. The overall pilot -- the total loan principal -- was relatively small. This makes it harder to predict how the products would scale into the broader market.

Also, the banks didn't make profit on the loans: "However, given the small size of [loans], the interest and fees generated are not always sufficient to achieve robust short-term profitability." [FDIC final report, page 5].

Banks currently offer higher cost short-term credit products, especially overdraft protection. There is evidence that banks and other financial institutions don't offer lower cost short-term credit products because they compete with overdraft-related products.

Given that the FDIC pilot loans weren't profitable and compete with banks' other revenue streams, it's not surprising that the pilot participants aren't really marketing the products any longer.

This doesn't mean that 36% is the wrong rate. It means that, with current underwriting, it is difficult to make a profitable product at 36% APR. Better underwriting yields reduced default rates, which, in turn, should yield lower interest. This suggests that we should advance the state of the art in underwriting.

There is hope that underwriting can lower the costs of borrowing. BillFloat shows us that hope. BillFloat offers short-term loans for a low interest rate -- they are normally under 36% -- to pay a monthly utility bill. They are able to charge this little both because they are exceptionally smart and because loans to pay off a month of an ongoing utility bill have very low default rates. You want to keep your utilities on and you're accustomed to paying the bill, so defaults will be rare.

Although this isn't our market -- we offer more general cash loans, which is a segment of the market that has dramatically higher default rates -- this makes us optimistic, knowing that there is at least one company that is doing it.

The kids are all wrong

that's all I ever really learned


This is why we are working so hard on underwriting. If we can underwrite loans more effectively, we can offer credit at lower than current rates. Underwriting for a general loan -- without a specific purpose and with less historical data -- is harder; these loans have a higher default rate, and hence require higher prices. But if we can underwrite better, and lower the default rate, we can provide credit at lower costs and build a good business.

This is important: I am trying to build a business. I am not trying to build a nonprofit. Nonprofits can have great impact on the world, and many social changes have begun with nonprofits. However, we believe that long-lasting change in the financial services world requires a sustainable business model, one that generates profit.

Building a profitable business means pricing goods and services above their cost of production. In this space, the cost of production is the sum of how much it costs to acquire customers, the cost of the money lent out, and the rate at which people fail to pay off their loans. This last factor -- default rate -- is key. As default rates increase, pricing must increase as well to cover those costs.

This is what yields such high prices on subprime loans. We price our loans to cover defaults, based on our underwriting. We are already markedly less expensive than payday loans, and our aim is to be even less expensive over time.

Market pricing is very important; pricing competition is good. In fact, the Kansas City Federal Reserve found that competition between payday loan providers yielded lower prices. Adding our alternative products into the mix should increase downward pressure on payday loan prices, yielding substantial benefit to borrowers.

There has been a bit of confusion in some of the comparisons between our products and payday loans. This makes sense since there are a lot of moving parts in these products.

Before going into the comparison, I want to be clear that we understand our loans are expensive. There are cheaper options, and we explicitly recommend to our customers that they should use less expensive options if they can. To fail to make this recommendation would be neither transparent nor fair.

I was just passing through

must have been seven months or more

--Creedence Clearwater Revival

If a borrower doesn't have other options and needs a short-term loan, there are only a few options.

If a person wants to take out a payday loan, and will pay it back within two weeks -- without rolling the loan over -- then that person should not take out a loan from us. This is why we don't offer loans for less than two months -- our loans will not be less expensive for shorter loans than that. Again, we call this out clearly on the site.

Our loans are normally less expensive than other options, like pawn shop loans or payday loans. How can this be true? It's true because people don't normally pay their payday loans back after only one cycle, they normally require several cycles to pay them back.

If you don't have the money to pay your loan back after the first cycle, the payday loan provider will lend the money -- the same money -- to you again, but charge you fees again.

According to the Center for Responsible Lending, people roll over their loans 9 times. Other researchers have suggested that most people roll over their loans 6 times on average. Like it or not, payday loan borrowers normally roll over their loans.

Each time the loan is rolled over, new fees apply, but the principal remains unchanged. So, if you borrow $400 and pay $80 in fees for the first loan, two weeks later, you will pay another $80 in fees, but still owe $400 in principal. And so on until you pay off the entire principal.

If you roll this loan over once, you will pay $160 in fees ($80 for the loan, and another $80 for the rollover) and then pay an additional $400 (the principal) at the end of the second period. Thus, in one month, you will have paid $160 in fees and $400 in principal.

If you roll the loan over 4 times, you will have the loan for 8 weeks (4 loans at two weeks each), and will pay $320 ($80 * 4) in fees. At the end of the 8 weeks, you will also pay the $400 in principal back, for a total of $720.

Ok, to use round numbers, let's assume you roll your loan over 7 times. That will get you a total loan duration of 4 months (two weeks for the first loan, and 7 * 2 weeks for the rollovers, for a total of 16 weeks). You will owe $400 in principal -- at the end. You'll pay $80 for the first loan, and for each of the 7 rollovers, for a total of $640 in fees. All in, you will pay $1,040, since you pay both fees and principal back.

And a ZestCash loan? If you borrow $400 for 4 months, you will pay $80 every two weeks for the life of the loan. Just like a payday loan, right?

No, wrong.

Because at the end of the 4 months, in a ZestCash loan, you have paid off BOTH interest and principal. So, you will pay ZestCash a TOTAL of $640 (8 * $80), which includes the principal. Because ZestCash loans are installment loans, you pay principal and interest off at the same time.

So, in this example, our loan is $400 less expensive ($1,040 - $640) than a payday loan of the same duration.

The photograph on the dashboard

taken years ago


So, that's our story. People need credit, and sometimes their only option is a relatively expensive short-term loan. Although a 36% APR sounds great, it has proven difficult to create general purpose subprime loan products at that interest rate. There has been relatively little market pricing pressure on more expensive loans, so prices of the higher cost loans are not dropping.

I got involved in this space because I think this is a really important problem to be solved. I believe that the current market is not putting sufficient price pressure on subprime loan products, and that adding a markedly lower cost product that is sustainable will push prices down across the entire space. This cost decrease could put literally billions of dollars back into the pockets of subprime borrowers, who don't have a lot of extra cash to play with.

This is a complicated and controversial business to be in. However, if nobody tries to find a solution, nothing will ever change.

We are trying to find a solution.

We think entering the market at a significantly lower price point, and directing our resources toward developing better underwriting models, is the best way we can do that.

We're thrilled people are talking about the problem -- more ideas always yield better outcomes.


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