Low-Income & Minority Families Rely Increasingly On High-Cost Financial Services.

America’s most financially vulnerable households are turning more and more to high-cost alternative financial services providers — commonly called “fringe” lenders — to meet their basic financial services needs, according to a report released by the Fannie Mae Foundation.

In Financial Services in Distressed Communities: Framing the Issue, Finding Solutions, the Foundation reports a variety of complex reasons why many lower-income and minority households use “fringe” financial providers, including check-cashers, payday lenders, title lenders, pawnshops, and rent- to-own stores. Typical among these reasons are (i) such households’ lack of physical proximity to mainstream financial institutions, (ii) their lack of understanding of or trust in such institutions, and (iii) their relative lack of basic consumer finance education, including even general familiarity with traditional banking and savings services. Reinforcing their reluctance to do business with mainstream financial firms, many lower-income consumers are attracted to alternative financial providers because they offer many of the customized services and conveniences that these consumers want.

The convergence of these forces is evidenced by explosive growth among “fringe” lenders in recent years, according to the Foundation report. Check cashers, payday lenders, pawnshops, rent-to-own stores, and related institutions now engage annually in at least 280 million transactions, generating $78 billion in gross revenue and $5.5 billion in fees. Alternative financial services fees are typically much higher than those charged by mainstream firms.

As many as 12 million U.S. households, fully one-fourth of all lower- income families, have no relationship with a bank, savings institution, credit union, or other mainstream financial service provider. One-third of these households are African American and 29 percent are Hispanic.

“While there are many reasons why lower-income, largely minority households don’t do business with mainstream financial institutions, it’s clear that these households’ reliance on alternative services leaves them seriously disadvantaged,” said Stacey H. Davis, president and CEO of the Fannie Mae Foundation. “This report helps identify strategies both to improve the scope and quality of financial services available in distressed communities and to help individuals avoid excessive interest rates and fees that preclude them from saving and building wealth.”

The report identifies three reasons for the recent growth of high-cost lending. First, increased consolidation among alternative financial services outlets into large, publicly held firms has resulted in storefronts popping up across the nation. Second, the mainstream financial sector too is increasingly offering higher-cost products to so-called “high-risk” populations. Finally, the fringe sector is becoming more sophisticated in developing and marketing products and services that meet the special needs of low-income, low-wealth households, including more convenient business hours and the ability to conduct a variety of household financial activities in one place.

James H. Carr, Fannie Mae Foundation senior vice president of Innovation, Research and Technology and principal author of the report, said, “Over-paying for financial services drains a household’s wealth and limits its ability to save. Lack of savings seriously disadvantages low-income and minority households and communities, including by frustrating people’s efforts to become homeowners and by limiting market-driven community investment activity.”

Findings reported in Financial Services In Distressed Communities, co- authored by Jenny Schuetz, demonstrate the growth and impact of alternative financial services. For example:

* The number of check-cashing outlets has doubled in the past five years, while the number of credit unions, banks, and thrifts has steadily decreased. Fees in these outlets can run as high as 20 percent for cashing a check, and only 19 states regulate such services. About 11,000 check-cashing outlets annually process more than 180 million checks,
worth roughly $60 billion.

* 12,000 to 14,000 pawnshops operate nation-wide, outnumbering credit unions and banks. Even though state laws cap interest rates at levels as high as 25 percent, loopholes often allow “lease back” agreements to add fees, sometimes effectively doubling interest rates.

* Payday lending grew nationally from 300 stores seven years ago to more than 8,000 in 1999. Payday lenders generally offer small consumer loans of $100 to $300 and routinely charge 15 percent per each two-week period, with annualized interest rates of 400 percent.

The Fannie Mae Foundation report recognizes that check cashers, pawnshops, rent-to-own outlets, and similar storefronts have filled an important gap in the financial services needs of lower-income households by developing products and services to meet their specific demands. But, the report warns, those services often come at staggering costs that can undermine the financial well being of the consumers they serve.

Importantly, the report points out, because pawnshops, payday lenders, and similar establishments typically do not offer savings products or services, households that rely exclusively on such establishments to meet their financial services needs have neither the incentive nor the opportunity to save.

Carr and Schuetz also highlight the substantial costs to households unnecessarily burdened by excessive levels of subprime lending. The report recognizes subprime loans as a critical source of credit for households that have demonstrated difficulty in managing credit. But, the authors emphasize, the recent explosive growth of subprime lending raises questions about the extent to which households may be targeted for high-cost mortgages as a result of their race or ethnicity, rather than their creditworthiness. Subprime loans are three times more prevalent in lower-income neighborhoods than in high-income areas, and five times more likely in black communities than in white neighborhoods.

In 1998, high-cost subprime loans accounted for more than half of the home loans in black neighborhoods but less than 10 percent of the home loans in white areas. A recent U.S. Department of Housing and Urban Development study shows that, between 1993 and 1998, the dollar volume of subprime loans grew more than sevenfold, from $20 billion to $150 billion; and the number of subprime refinances grew almost 1,000 percent, from 80,000 loans to 790,000 loans. This growth compares to less than a 40 percent increase in prime lending for home purchases and a 2.5 percent increase in prime refinances during the same period.

The report recommends three solutions to improve financial services in distressed communities:

Collect Additional Data and Enforce Laws

* Because check cashers, pawnshops, title lenders, and payday lenders are regulated at the state level with widely varying regulatory oversight, a single national reporting requirement would greatly enhance regulators’ and others’ ability to examine these establishments’ practices and to encourage more aggressive enforcement of equal credit opportunity and consumer protection laws. Data elements might include fee schedules, collateral requirements, number of customers served, and revenue and earnings statements. For subprime loans, information about credit life insurance, balloon payments, prepayment penalties, and related major loan characteristics, as well as interest rates, points, processing fees, and closing costs would be critical. More complete information on these items would allow regulators and policy makers to immediately understand the potential vast differences in credit terms extended to borrowers on the basis of race, ethnicity, age, gender, or other personal attributes unrelated to creditworthiness.

Enhance Products to Serve Lower-Income Households

* Three types of efforts would help promote a wider range of financial products and services for poor and minority families: 1) connect households receiving government benefits to low-cost access through electronic transfer accounts and related initiatives; 2) enhance the use of technology, such as sophisticated ATMs and the Internet; and 3) target innovative products and partnerships designed to meet the unique needs of lower-income families. For example, partnerships between mainstream financial services firms and “fringe” lenders could leverage the strengths of each. Mainstream financial firms could learn much from these lenders’ demonstrated expertise in marketing, packaging, and bundling services, such as check- cashing, money orders, money wiring, utility and cable bill payment, and related services.

At the same time, larger financial institutions can offer economies of scale that could help reduce the costs of financial services for lower-income households. Innovative programs have recently been introduced or are being test-marketed by institutions such as community development credit unions; these should be encouraged and expanded (see report for
examples).

Improve Financial Education and Outreach

* Even with improved law enforcement, consumers should be better educated about the types of institutions, products, and services available. Many lower-income households have limited financial savvy and do not know the most basic aspects of household budgeting. Quality consumer education programs can be instrumental in helping households to more effectively manage their finances.