crackdown was vital, but credit unions must expand after coronavirus to fill void

The cost of accessing small personal loans can be extremely high for those who need them the most. Take the UK, where a £ 200 loan Personal Credit Provident more than 13 weeks costs £ 86 in interest. That’s an equivalent APR of a whopping 1,557.7%.

These offers are available even after the payday loan cap that the UK introduced five years ago. In the months following the reforms, the Financial Conduct Authority (FCA) reported that the number of loans and the overall amount borrowed are down 35%. From there, the decline continued: there was 5.4 million high cost loans totaling £ 1.3 billion in 2018 with a total repayable amount of £ 2.1 billion; five years earlier, there had been 10.3 million loans worth £ 2.5 billion.

Yet it is clear that high cost credit has not completely disappeared and looks set to rise again. Provident, the largest home loan provider in the UK and Ireland, anticipates increased demand when unemployment rises as the UK leave scheme ends. The lender is said to have set aside £ 240million for an increase in defaults.

So what have we learned since the rules changed, and will those who need credit be able to access it in the wake of the pandemic?

To cap or not to cap?

High interest rates are usually justified by the argument that borrowers are more likely to default, having often been turned down elsewhere. Higher rates compensate the lender for a higher risk.

Either way, payday loan companies have gained a reputation for predatory lending, especially after the last financial crisis. UK restrictions set a cap on interest and charges at 0.8% of the principal unpaid per day, and a maximum total cost of 100% of the amount borrowed.

It reflected a global trend. In Germany, for example, the maximum authorized APR is double the market rate. as calculated by their financial regulator, [BaFin]. In France, it is 1.33 times the market rate.

The primary intention was to make credit more affordable for vulnerable consumers. This follows clear proof that most high cost credit customers are in a low income category with poor credit history and poor financial resilience, which means they may find it difficult to cope well with financial setbacks.

They often borrow based on convenience and repayment capacity rather than the cost of the loan. This can lead to financial stress, repeat borrowing and defaults. After all, credit is debt.

High cost credit is tied to low income consumers.
Thin glass

Nonetheless, the debate continues among political experts around the world as to whether caps are the best answer. Supporters point out that the restrictions have lowered the cost of credit for low-income borrowers, fought over-indebtedness and helped prevent people from to be exploited.

Some consumers may no longer have access to credit because vendors change their business models or exit the market, but many of these people would likely not pass tight affordability checks and may already be over-indebted.

Opponents point to the possible unintended consequences. In addition to less access to credit, they worry about the potential for more illegal pawn shops and loan companies to introduce fees that circumvent the restrictions.

Influenced by these arguments, Ireland is among a minority of European countries that favor stronger regulation and supervision rather than caps. For example, high cost warnings in loan advertising became a requirement effective September 1. Although the government is examining its general approach, the fear that restrictions might reduce the supply of credit always seems to have the upper hand.

What the evidence says

A OECD Report 2019 found that interest rate caps reduced exploitation and over-indebtedness, made short-term loans cheaper, and reduced defaults. However, the OECD cautioned against excluding riskier consumers from formal credit, as they could borrow from lenders in countries with more flexible rules. This happened in the Netherlands, for example.

In the same way, FCA exam 2017 found that UK restrictions had led to cheaper loans and fewer debt problems. And he saw little evidence that consumers were turning to illegal pawn shops. Our own research in 2017, he approved the cheaper loans, but warned that they must be accompanied by measures to provide more affordable alternatives and to help consumers make good credit decisions.

Credit unions are one of the few alternatives, as the FCA recognised. They aim to build consumers’ financial resilience by lending at affordable rates, encouraging regular savings, and providing education and financial information. This helps to improve the credit records of the borrowers.

There are around 440 credit unions in the UK, with 2 million members and growing. Loans to members topped £ 1.5bn in 2018, surpassing that of high-cost loans.

Currently UK credit unions are allowed to charge up to 42.6% APR, a far cry from the rates allowed for high cost providers. Yet penetration is low relative to the total population, at only around 3.5%. We need to expand the reach of credit unions and enable a greater online presence to support much faster lending decisions.

Fair4All Finance, an organization founded by the government from dormant accounts has started to help credit unions build their capacity, but funding is limited and mostly only available in England. An expansion would be valuable.

Woman choosing between different credit cards.
Many people live on endless refinancing.

Scaling up affordable alternatives has certainly never been more urgent. Providing reports that its customer base fell in 2020 after tightening its lending practices, but that could be due to declining consumer spending, as well as increased savings and government support in response to the COVID-19 pandemic. The picture could be very different a year from now.

Stimulating credit unions would also challenge new breed of digital lenders, who are armed with people’s personal data to entice them to borrow more. This new form of loan will be more prevalent in all socio-economic groups, rather than just a poor person’s problem, and will likely be more difficult to regulate as it will cross international borders. Government support for the pandemic has been essential, but they need to think about the increased demand for loans that is on the way.

About Judith J. George

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