Written by Jeff Keltner, SVP Business Development
Financial institutions generally don’t originate and underwrite small-dollar and short-duration loans. Small-dollar loans are more challenging and riskier than traditional credit types like auto and mortgage loans. This is why the payday lending industry exists — it provides consumers with high-interest loans based on income. While they are convenient, payday loans aren’t without their issues for borrowers.
Thanks to modern technologies, banks and credit unions may now be able to step in. Offering small dollar loans could provide lenders with a unique opportunity to better serve their customers in their times of need.
The automation of manual operations can help institutions reduce the financial risks and operational costs and serve the customers when they need it the most.
The challenge of originating and underwriting small-dollar loans
In consumer lending, lenders consider loans of around $1,000 (or less) as very small since they’re much smaller than traditional auto loans, home equity lines of credit, and real estate-backed loans.
Because of their size, small dollar loans can be challenging to originate, underwrite and process at a profitable level. The small size and short duration of loans make it more difficult for lenders to recoup the costs of originating them in the first place.
On top of these issues, consumers in need of small-dollar loans tend to be riskier than those looking for more traditional forms of credit. Small amounts are given with little to no collateral and are expected to be repaid in a year or less, often even months and weeks. When the cash flow is so tight that consumers need a quick loan, they run at a risk of not being able to repay the loan on time.
Issues of payday lending for borrowers
Without the ability to obtain smaller loans from a bank or credit union, a borrower in need of short-term liquidity to cover an emergency or other expenses have limited options:
- Over-drafting their bank account
- Applying for a new credit card (if they qualify)
- Turning to payday lenders
Payday loans tend to be the go-to for small dollar, short-duration loans. Although convenient, these loans often come with extremely high price tags. They also often lead to repeated loans that exacerbate the costs of borrowing. In other words, payday loans might offer a solution, but it’s not exactly an ideal one.
The opportunity of small dollar loans
Many Americans today might be well-served by $10,000, $20,000, or even $30,000 loans, however, they might not necessarily need that much when they’re looking for short-term liquidity.
With all of the modern technology available today, financial institutions may be able to underwrite the risk of those small dollar loans and lower the costs of doing so. The automation of manual operations can help institutions reduce the financial risks and operational costs and serve the customers when they need it the most.
Serve borrowers better with small dollar loans
Small dollar loans provide a tremendous opportunity for financial institutions to serve their customers and build long and trusting relationships with them. While these loans won’t be the most profitable consumer lending services, they enable lenders to offer customers much-needed support in a time of crisis.
For consumers, the ability to rely on small dollar loans in emergencies means they won’t have to resort to overdrawing on their checking accounts or obtaining expensive payday loans. In essence, by allowing for smaller loan amounts, a bank or credit union can make a substantial difference in the lives of their customers.