Alternative Financial Services

Alternative financial services (AFS) are provided outside the traditional banking system. AFS providers include check cashers, payday lenders, pawnbrokers, car-title lenders, high-cost installment lenders, rent-to-own stores, nonbanks offering international money transfers (commonly called remittances), and tax preparation companies that make loans on the basis of anticipated tax refunds. AFS providers are predominately located in neighborhoods with a large proportion of Black and Hispanic/Latino residents. As such, they disproportionately strip wealth from these communities. AFS providers are also a major source of transactional and credit services for consumers with low and moderate incomes and people with heavy debt burdens or less favorable credit histories.

The use of the AFS transactional and loan products is increasing among U.S. households, including older adults, according to the Federal Deposit Insurance Corporation (FDIC). Millions of households headed by someone age 50 or older use some form of AFS each year. Most frequently, they used transactional AFS products for money orders, check cashing, and international remittances. This includes 3.1 million unbanked households headed by people age 50 and older (4.4 percent) who do not have a checking or savings account at all.

Generally, the industry lies outside the system of federally regulated traditional financial institutions. Interest and fees charged are often many times higher than those charged by traditional lenders. Other unfair, deceptive, or abusive practices can include charging prepayment penalties, adding expensive credit insurance onto loans, and allowing multiple rollovers.

Some companies have begun offering pension advances. A pensioner receives a lump-sum loan in exchange for future pension payments. The payments also include fees related to the loan. A related product, the pension investment, bundles advance pension payments in exchange for an up-front lump-sum investment. Federal law does not explicitly regulate either pension advances or pension investments. General protections against unfair, deceptive, or abusive acts and practices may apply to these financial products.

Debt-trap lending: Millions of Americans take out payday loans each year, spending billions of dollars on loan fees alone. The typical payday loan has an annual percentage rate (APR) of about 400 percent. Payday loans usually require borrowers to pay off the loan on the date of their next paycheck. These high-cost loan products churn consumers through a cycle of debt, collecting high fees for extended periods. The Consumer Financial Protection Bureau has found that consumers using payday loans, auto title loans, and pawn loans frequently roll over these loans or take out a new loan soon after repaying the previous loan. This can result in long-term harms such as difficulty paying bills, delayed medical spending, involuntary bank account closure, and increased likelihood of filing for bankruptcy. As a result, payday loans are one example of debt-trap lending.

In car-title lending, struggling borrowers pledge their car’s title as collateral. Lenders typically charge around 300 percent APR for these loans. Many borrowers are unwilling to default on these loans because the loss of their car means they cannot commute to and from work. They prioritize repaying their high-cost car-title loan, run out of money, and take out another loan. This cycle of lending creates a similar debt trap to payday lending. The Consumer Financial Protection Bureau (CFPB) found that approximately one in five car-title loan borrowers loses their car to repossession. Other high-cost payday and installment loans are made by expensive online lenders. One in four online payday loan borrowers ultimately ends up with closed bank accounts.

Some states have enacted laws to begin to address debt-trap lending. Less than half have laws that set the maximum interest rate for debt-trap loans at around 36 percent APR. Other states have enacted more measured reforms that seek to limit the cycle of debt.

The Defense Authorization Act of 2007 includes a provision capping the interest rate on payday loans to military personnel at 36 percent. As a result, active military personnel and their families generally cannot receive payday or car-title loans.

As policymakers have sought to restrict high-cost loans such as payday and auto title loans, lending practices have evolved in an attempt to evade these restrictions. This includes making high-cost installment loans with costs similar to payday loans but with payments over a longer duration of time. This also includes the use of “rent-a-bank” or “rent-a-charter” practices in which a bank, not subject to state prohibitions, makes a loan and then sells or transfers it to a nonbank entity. Some state banking regulators and attorneys general have attempted to crack down on these lending practices that violate state law. Meanwhile, in 2020 the FDIC and the Office of the Comptroller of the Currency finalized rulemaking that would potentially codify some of these practices and preempt state laws, citing the desire for a consistent national marketplace.

Early wage access: Third-party lenders and some employers now offer workers early access to wages before their regular payday. In some cases, this may help address financial shortfalls and emergencies. It can also help workers avoid riskier or more expensive alternatives, including overdraft and payday loans. However, some of these products impose fees, interest, or other charges on workers that mimic high-cost payday loans with triple-digit annual percentage rates. They may also contribute to chronic financial instability if borrowers become too reliant on them to meet expenses. The Consumer Financial Protection Bureau (CFPB) has found that employer-sponsored loans are becoming more common. The number of such loans nearly doubled between 2021 and 2022. Few employers cover the costs of the advances. Some offer no-cost advances but charge fees for expedited transfers, which the majority of consumers request.

So-called direct-to-consumer wage advances, which are not sponsored by employers, frequently request a “tip” for the service. This is an unregulated fee that the consumer ostensibly provides voluntarily. However, tips are often included by default. Moreover, the lending platforms create intense pressure to pay a tip, leaving many consumers with the impression that tipping is not optional. The CFPB found that tips are paid nearly three-quarters (73 percent) of the time. The pervasive collection of tips makes these loans considerably more expensive and contributes to the lack of transparency around the products.

Buy now, pay later (BNPL): This is a type of installment loan that typically allows a consumer to buy something immediately and pay for the item over time in regular installments.

BNPL lenders are not required to evaluate consumers’ ability to repay the loan, and borrowers can take out multiple loans at the same time. Failure to repay a BNPL loan may be reported to credit agencies, leading to lower credit scores and to debt collection proceedings (see also Credit Reports and Scores and Debt Collection Practices).

BNPL loans increased by almost tenfold from 2019 to 2021, according to the CFPB. Ten percent of consumers age 65 and older had used BNPL loans in the prior year. These borrowers were more likely to be indebted, carry a balance on their credit cards, experience delinquencies in traditional credit products, and use alternative financial services.

Platform lenders: Peer-to-peer and other lending platforms connect individual borrowers with lenders and investors. Borrowers seek out alternatives to traditional loans while maintaining low interest rates. Healthy returns attract investors. Peer-to-peer lending platforms are loosely regulated. They are not generally required to evaluate a borrower’s ability to repay a loan and afford their other essential expenses. Individual investors may not understand the inherent risk of these loans.

International money transfers: Consumers in the United States send billions of dollars to recipients in foreign countries each year, according to the CFPB. Electronic money transfers to foreign countries, sometimes called remittances, are often made by people sending small amounts of money to friends and relatives in other countries. Most transfers are made by nonbanks.

A key consumer challenge is that hidden fees create confusion over the true cost of sending money internationally. Some companies advertise $0 fees and hide the cost in an inflated exchange rate (typically 4-5 percent above the market exchange rate). American consumers paid an estimated $5.8 billion in hidden fees in international transfers in 2023. Survey data shows that consumers, including many older adults, are unaware of the hidden fee structure.

In 2020, the CFPB issued a rule to create more transparency in the remittances market. Under the rule, money transfer providers who make at least 500 transfers per year must:

• disclose the exchange rate, the amount of certain fees, and the amount that the recipient will receive;
• provide consumers with cancellation and refund rights; and
• establish procedures for resolving errors.

Unfortunately, hidden fees remain a problem. Consumers need more detailed information than is currently provided, including the cost associated with any increase in the exchange rate. Having this information would allow consumers to compare costs across providers before choosing a remittance company.