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 disproportionately 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 found in some AFS products include charging prepayment penalties, packing 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 the pensioner’s 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 (see also Private Employer-Provided Retirement Plans).
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. This can result in long-term harms such as increased 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.
A 2021 report from the Consumer Financial Protection Bureau 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. In June 2019, of the consumers who had taken out a loan in the previous six months, 63 percent still owed money on a payday loan; 83 percent still owed money on an auto title loan; and 73 percent still owed money on pawn loans. A 2014 bureau study found that among borrowers who are paid on a monthly basis, one out of five remained in debt for the entire year of the study. Payday borrowers who fall into this category include many older Americans or disability recipients receiving Supplemental Security Income and Social Security Disability.
Debt-trap lending also includes car-title loans and high-cost installment loans. 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 the 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 enacted laws to 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. Support for the law was based on a Department of Defense finding that payday loans were hurting military preparedness. In 2015, the Department closed loopholes under this law to better protect military borrowers.
In 2017, the CFPB issued a final rule governing many types of high-cost loans, but the rule was delayed. In 2020, the CFPB reversed course, finalizing a rule that removed the proposed ability-to-repay requirements for these loans. The final rule only established payment protection, that is, limits on the ability of lenders to repeatedly attempt to gain access to a borrower’s bank account without a new authorization.
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: A number of third parties now offer early access to a worker’s wages before their regular payday. For example, some offer immediate pay for the hours already worked during a pay period. 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. This leads to payment of effective interest rates similar to payday loans. Products may also contribute to chronic financial instability if borrowers become too reliant on them to meet expenses.
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. These platforms appeal to investors by advertising attractive returns in a low-interest-rate environment. Peer-to-peer platforms attract borrowers interested in obtaining loans they may not be able to obtain otherwise. They may seek these loans for purposes as varied as consolidating debt, paying off medical bills, and covering small-business expenses by advertising an alternative to traditional loans from banks or other depository institutions with low fixed rates.
Peer-to-peer lending platforms are loosely regulated. They are not generally required to evaluate a borrower’s ability to repay a loan. Some lending platforms equate the ability to deduct payments directly from a borrower’s bank accounts with the ability of a borrower to repay a loan. However, this practice does not necessarily indicate a borrower’s ability to repay a loan, as borrowers may be required to take on additional loans to cover any shortfalls generated by such withdrawals.
A meaningful evaluation of the ability to repay a loan requires platform companies to consider the ability of borrowers to repay a loan while meeting other expenses, without refinancing or reborrowing. Peer-to-peer lending platforms use so-called black box or secret sauce algorithms to underwrite loans and obtain leads. These can circumvent traditional underwriting best practices. Because peer-to-peer platforms rely on data brokers for referrals, borrowers may be directed to loans that generate the highest referral yield for a data broker rather than the most favorable terms for repayment of a loan.
Despite the apparent novelty of peer-to-peer lending platforms, they are essentially a rebranding of debt securitization. Rather than marketing debt instruments primarily to institutional investors, these platforms create an online marketplace in which any individual, not just professional investors, may buy debt instruments. It is unlikely that the majority of individual investors have the financial sophistication required to understand the risk inherent in peer-to-peer lending agreements.
The peer-to-peer lending platforms’ use of debt securitization means that they transfer risk to borrowers and lenders. In other words, such platforms do not have “skin in the game” if a loan does not perform. Additionally, because the lending platforms contract with borrowers, investors cannot directly oversee or monitor the underlying loans that make up their investment. That means investors are essentially relying on the lending platform’s word for what constitutes different categories of risk.
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 $6.43 billion in hidden fees in international transfers in 2019. Survey data shows that consumers, including many older adults, are not aware of the hidden fee structure.
In 2020, the CFPB issued a rule to create more transparency in the remittances market. Providers making under 500 transfers per year are exempt. Under the rule, money transfer providers are required to disclose the exchange rate, the amount of certain fees, and the amount that the recipient will receive. They also must 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. Doing so will allow consumers to compare costs across providers before choosing a remittance company.
ALTERNATIVE FINANCIAL SERVICES: Policy
ALTERNATIVE FINANCIAL SERVICES: Policy
Consumer protections in alternative financial services (AFS) products
Regulators should eliminate unfair, deceptive, or abusive practices in the AFS industry.
All banks and their subsidiaries or partners should be prohibited from making high-cost payday, installment, or other loans that may trap borrowers in a costly cycle of debt.
Prior to extending a loan, bank and nonbank lenders should be required to evaluate whether an applicant can reasonably be expected to repay the loan without reborrowing or refinancing and while covering reasonably expected essential expenses.
Banks and their subsidiaries and lending partners should have to comply with the laws of the state where the consumer receives the loan’s proceeds.
States’ ability to cap interest rates and enforce interest rate caps on online loans should be upheld.
Pay advance products
Programs that offer early wage access or pay advance benefits should be regulated as loans subject to state and federal law (see also Other Savings Approaches). This does not apply to programs in which workers never pay a fee to participate.
Policymakers should limit refinancing of consumer loans. They should eliminate rollovers, including taking a new loan out shortly after paying off a prior loan.
Lenders should be required to disclose that the criminal justice system cannot be used for collections. Lenders should provide consumers with a private right of action. States should require lenders to disclose the cost of refinancing compared with the cost of obtaining a separate loan. States should also limit the number of times and the frequency with which loans can be refinanced.
Platform lenders should protect consumers. They should:
- evaluate whether borrowers have the ability to repay their loans,
- create transparency in underwriting so that investors understand how much risk they are taking on, and
- be required to comply with the laws in their home state. This is the case even when they have a partner in another state.
Peer-to-peer lenders should retain a portion of the risk in the loans they securitize. Asset-backed security sponsors are required to retain a minimum amount of risk in the loans they make. Similar credit risk retention standards should apply to peer-to-peer lending platforms.
International money transfers
The cost of sending international transfers should be transparent to the consumer. The full cost of sending the transfer should be disclosed, including any increase added to the exchange rate.
Oversight and enforcement
Regulators should provide robust oversight to ensure compliance with federal, state, and local consumer protection laws. These include small-dollar interest rate caps, usury laws, and disclosure laws.