Are people better off taking payday alternative loans?

Background

Around 12 million Americans take out payday loans each year. Payday loans are generally small amount, short-term loans. The loan amount is determined by one’s paycheck and is intended to be repaid within two weeks. Although lending companies claim that payday loans offer a valuable solution to cash-flow emergencies, their actual usage is cyclical and expensive. The average borrower takes 8 loans a year, and while the average loan is $375, the borrower pays an additional $520 in fees and interest.

To help address the need for emergency funding, some federal credit unions offer short-term, small-dollar loans called Payday Alternative Loans (PALs). These loans have lower interest rates compared to true payday loans and give borrowers more time to repay the loan. In addition to PALs, some credit unions have created savings loans, a small-dollar loan product that includes a forced savings component—an additional loan amount is held in a savings account and upon successful repayment of the full amount, the loan recipient gains access to their new savings.

However, these loan products are relatively new and only 8% of credit unions reported issuing PALs in Q4 2017. There is little research on the impact of these loans for consumer financial well-being. In partnership with Redstone Federal Credit Union, we examined the effect of short-term, small-dollar loan products (both payday alternative and forced savings loans) on the financial well-being of members. We analyzed two years of archival savings and loan data and compared the savings balances of members who did and did not take out these loans.

Key Insights

To account for the correlational nature of these data, we employed a series of propensity score matching models and compared savings account balances at Month 24. The sample was matched based on member age, credit union tenure, and Month 1 savings balance.

**The differential effects of payday alternative vs. forced savings loans **

Using propensity score matching to compare members who take one of the two loan types against similar members who do not take out a small-dollar loan, the data suggest that, for members with similar loan likelihoods, taking a PAL is associated with significant decrease in one’s savings balance of 46%, while taking a Stretch & Save (Redstone’s forced savings loan product) is associated with an increase in one’s savings balance of 80%. Those who do not take a loan end the sample period with an average savings balance of $95.50, while those who take out a PAL end with $51.57, and those who take a Stretch end with $171.90.

**A positive bump from forced savings loans **

While the propensity score models suggest that a Stretch loan is associated with a higher savings balance over time, the granularity of the data allowed us to examine savings balances just before and after a member successfully repaid a Stretch loan. It could be that members repay their loan and gain access to the 20% savings only to immediately withdraw or spend it.

We ran a multilevel regression to examine the change in savings balances two months before and two months after Stretch repayment. Although balances do tend to be slightly lower than one’s average as the loan term ends, repaying one’s Stretch loan is associated with a jump in end-of-month savings balance of 169%, moving from $43.35 to $116.72, even when controlling for one’s general tendency to save. This suggests that members are keeping some portion of their newly accessible funds in savings.

In this dataset, we are unable to measure any potential crowding out effect of these payday alternative loans on actual payday loans, but it is possible that members are taking these loans instead of more predatory external loans and thus still benefiting from their offering, even if this is not reflected in savings balances. Additional archival analysis or novel prospective data collection could address this question more definitively and should be examined in future work.

Results

We found that basic PALs had no effect on financial well-being but that an alternative small-dollar loan product with a forced savings component did seem to increase final savings account balances.

• Consistent with national data, these loans tend to be cyclical; 58% of members who take a small-dollar loan take out a second; 33% take out 3 or more.

• Loan recipients have lower savings balances and lower credit scores than their non-loan taking peers. PAL loan recipients are more likely to have lower or no credit score and have lower savings balances at baseline compared to savings loan recipients at baseline.

• Accounting for these differences between loan recipients using a propensity score matching analysis, we find that PAL recipients have final savings balances that are 49% lower ($51.57) than matched members who do not take a small-dollar loan ($95.50).

• Using a propensity score model, members who take a savings loan have final savings balances that are 80% greater ($171.90) than their matched counterparts.

Although the correlational nature of this data and the preexisting differences between PAL and Stretch loan recipients mean that we cannot rule out alternative explanations for these differences in savings outcomes, these results suggest that short-term, small-dollar loans with a forced savings component work as intended, increasing subsequent savings balances for members. This increase in savings is most noticeable in the months immediately after repayment but is still detectable even after several months to a year may have passed. Credit unions should continue to design and offer small-dollar loan products with a forced savings component for qualified members.