State Laws Put Installment Loan Borrowers at Risk
When Americans borrow money, most use credit cards, loans from banks or credit unions, or financing from retailers or manufacturers. Those with low credit scores sometimes borrow from payday or auto title lenders, which have been the subject of significant research and regulatory scrutiny in recent years. However, another segment of the nonbank consumer credit marketâinstallment loansâis less well-known but has significant national reach. Approximately 14,000 individually licensed stores in 44 states offer these loans, and the largest lender has a wider geographic presence than any bank and has at least one branch within 25 miles of 87 percent of the U.S. population. Each year, approximately 10 million borrowers take out loans ranging from $100 to more than $10,000 from these lenders, often called consumer finance companies, and pay more than $10 billion in finance charges.
Installment lenders provide access to credit for borrowers with subprime credit scores, most of whom have low to moderate incomes and some traditional banking or credit experience, but might not qualify for conventional loans or credit cards. Like payday lenders, consumer finance companies operate under state laws that typically regulate loan sizes, interest rates, finance charges, loan terms, and any additional fees. But installment lenders do not require access to borrowersâ checking accounts as a condition of credit or repayment of the full amount after two weeks, and their prices are not as high. Instead, although statutory rates and other rules vary by state, these loans are generally repayable in four to 60 substantially equal monthly installments that average approximately $120 and are issued at retail branches.
Systematic research on this market is scant, despite its size and reach. To help fill this gap and shed light on market practices, The Pew Charitable Trusts analyzed 296 loan contracts from 14 of the largest installment lenders, examined state regulatory data and publicly available disclosures and filings from lenders, and reviewed the existing research. In addition, Pew conducted four focus groups with borrowers to better understand their experiences in the installment loan marketplace.
Pewâs analysis found that although these lendersâ prices are lower than those charged by payday lenders and the monthly payments are usually affordable, major weaknesses in state laws lead to practices that obscure the true cost of borrowing and put customers at financial risk. Among the key findings:
- Monthly payments are usually affordable, with approximately 85 percent of loans having installments that consume 5 percent or less of borrowersâ monthly income. Previous research shows that monthly payments of this size that are amortizedâthat is, the amount owed is reducedâfit into typical borrowersâ budgets and create a pathway out of debt.
- Prices are far lower than those for payday and auto title loans. For example, borrowing $500 for several months from a consumer finance company typically is three to four times less expensive than using credit from payday, auto title, or similar lenders.
- Installment lending can enable both lenders and borrowers to benefit. If borrowers repay as scheduled, they can get out of debt within a manageable period and at a reasonable cost, and lenders can earn a profit. This differs dramatically from the payday and auto title loan markets, in which lender profitability hinges on unaffordable payments that drive frequent reborrowing. However, to realize this potential, states would need to address substantial weaknesses in laws that lead to problems in installment loan markets.
- State laws allow two harmful practices in the installment lending market: the sale of ancillary products, particularly credit insurance but also some club memberships (see Key Terms below), and the charging of origination or acquisition fees. Some costs, such as nonrefundable origination fees, are paid every time consumers refinance loans, raising the cost of credit for customers who repay early or refinance.
- The âall-inâ APRâthe annual percentage rate a borrower actually pays after all costs are calculatedâis often higher than the stated APR that appears in the loan contract (see Key Terms below). The average all-in APR is 90 percent for loans of less than $1,500 and 40 percent for loans at or above that amount, but the average stated APRs for such loans are 70 percent and 29 percent, respectively. This difference is driven by the sale of credit insurance and the financing of premiums; the lower, stated APR is the one required under the Truth in Lending Act (TILA) and excludes the cost of those ancillary products. The discrepancy makes it hard for consumers to evaluate the true cost of borrowing, compare prices, and stimulate price competition.
- Credit insurance increases the cost of borrowing by more than a third while providing minimal consumer benefit. Customers finance credit insurance premiums because the full amount is charged upfront rather than monthly, as with most other insurance. Purchasing insurance and financing the premiums adds significant costs to the loans, but customers pay far more than they benefit from the coverage, as indicated by credit insurersâ extremely low loss ratiosâthe share of premium dollars paid out as benefits. These ratios are considerably lower than those in other insurance markets and in some cases are less than the minimum required by state regulators.
- Frequent refinancing is widespread. Only about 1 in 5 loans are issued to new borrowers, compared with about 4 in 5 that are made to existing and former customers. Each year, about 2 in 3 loans are consecutively refinanced, which prolongs indebtedness and substantially increases the cost of borrowing, especially when origination or other upfront fees are reapplied.
Based on these findings, Pew recommends that lenders, legislators, and regulators improve outcomes for consumers who use installment loans by:
- Spreading costs evenly over the life of the loan. Origination or acquisition fees should be nominal, proportional to the amount financed, and pro rata refundable to minimize lendersâ incentives to refinance loansâand to avoid harm to borrowers.
- Requiring credit insurance to function like other standard insurance policies, with typical loss ratios and monthly premiums rather than premiums that are charged upfront and financed.
- Mandating that the sale of ancillary products be separate from the issuance of credit. Credit insurance and products unrelated to the loan should be offered only after a loan transaction is completed and the borrower has either received the proceeds or been notified that the loan has been approved.
- Setting or continuing to set transparent maximum allowable costs that are fair for borrowers and viable for lenders. If policymakers want small installment loans to be available and safe for consumers, they should allow finance charges that are high enough to enable efficient lenders to operate profitably and prohibit ancillary products rather than setting lower rates and then permitting lenders to sell ancillary products to boost their bottom lines. Existing research is mixed on the overall impact of small credit on consumer well-being, so policymakers mayâas those in some states already haveâeffectively ban small credit by setting low rate limits and forbidding fees and ancillary products.
This report describes the installment lending market, estimating its size and providing an overview of typical loans, particularly elements that work well, especially compared with other subprime credit products.
The analysis then turns to examining the two main problems with state laws that result in consumer harm: allowing upfront fees and the sale of low-value credit insurance. It concludes with recommendations to resolve these issues while maintaining access to affordable credit.
All-in APR: The full annualized loan cost, including charges for ancillary products such as credit insurance and club memberships expressed as a percentage of the loan proceeds. This measure is also known as a military APR because it is the rate used in the Military Lending Act.1
Amount financed: The sum of loan proceeds plus the cost of ancillary products. Interest is calculated on the amount financed.
Ancillary products: Insurance policies or noninsurance products such as club memberships sold in conjunction with installment loans.
Club membership: A product installment lenders sell to borrowers, usually in the form of enrollment in an auto club that provides services, such as roadside assistance or reimbursement for such assistance. The cost of membership is charged in full upfront and financed with the loan proceeds, with customers paying interest to borrow the amount of the dues.
Consumer finance company: A nonbank provider of installment loans, also called an installment lender. These companies operate through networks of brick-and-mortar branch locations.
Cost: The total amount in dollars that a consumer pays for a given loan, including fees, interest, and the cost of ancillary products.
Credit insurance: Insurance sold in conjunction with a loan, which ensures that the lender will receive payments in the event the borrower becomes unable to make them. Installment lenders act as brokers, either including credit insurance in loan contracts or offering it to borrowers. The premiums are charged in full at the outset of the loan and financed with the loan proceeds. Customers pay interest to borrow the amount due for premiums, and the cost of credit insurance counts toward the all-in APR but not the stated APR.
Credit insurance loss ratio: The share of premium dollars paid out as benefits that is used as a standard measure of value in the insurance industry. The higher the ratio, the greater the share of premium dollars paid out as benefits and the better the value for consumers.
Finance charges: The sum of interest and fees that must be disclosed in the contract under the Truth in Lending Act (TILA).
Interest rate: The proportion of the loan charged, calculated on an annualized basis, excluding any origination or transaction fees or the cost of any ancillary products.
Large/small loan: For the purposes of this analysis, an installment loan with proceeds of $1,500 or more is considered large and one with proceeds of less than $1,500 is small.
Loan proceeds: The amount of cash disbursed to a borrower at the time the loan is issued.
Origination (or acquisition) fee: A nonrefundable charge that is either a flat dollar amount or a share of the loan proceeds, is assessed at the time the loan is issued, and is added to the amount the borrower owes.
Stated APR: The annualized finance charges expressed as a percentage of the amount financed. This rate has to be disclosed in the contract under the TILA. The stated APR includes certain fees, such as origination, that the interest rate does not; both exclude costs for ancillary products.
Truth in Lending Act: A 1968 law requiring uniform disclosure of certain terms of credit, including an APR that reflects interest and certain fees, so consumers can compare loan costs.
How installment lending works
Consumer finance companies offer installment loans in 44 states to borrowers who usually have low credit scores.2 Although allowable finance charges vary significantly across these states,3 prices for these loans are generally higher than banks or credit unions charge customers with higher credit scores. Installment loans range from about $100 to more than $10,000, are repayable in four to 60 monthly installments, and can either be securedâmeaning the borrower provides collateral, such as an automobile title or personal propertyâor unsecured.4 The market is split into lenders who primarily issue small loans, under $1,500, and those that mostly offer large loans.5
Approximately 14,000 consumer finance stores operate nationally, about half of which are owned by the 20 largest national lenders.6 The nationâs largest consumer finance company operates more than 1,800 branches in 44 states.7 These national lenders offer small loans in 18 states,8 while large loans are available across all 44 states that allow installment lending. In general, Southern states tend to allow higher prices and have more stores per capita. (See Figure 1 and Appendix A.) An estimated 10 million people spend more than $10 billion annually for these loans.9 These figures do not include installment loans issued by payday or auto title lenders, which are multipayment loans issued at much higher prices than the traditional installment loans described in this report.10
Terms and conditions
To obtain an installment loan, a borrower applies at a local branch or fills out an application on a company website, and then brings proof of identity and residence and recent paystubs to the store to complete the transaction.11 Although the loans are often described as unsecured, most lenders require an auto title and/ or nonessential household goods, such as consumer appliances, electronics, firearms, or jewelry, as collateral, especially for larger loans.12
The approval process usually takes 15-60 minutes, during which an employee assesses the applicantâs creditworthiness and underwrites the loan by pulling a credit report and analyzing monthly payments on major credit obligations and some self-reported recurring expenses.13 Loan proceeds are typically disbursed by check or are deposited into the borrowerâs checking account, but occasionally proceeds of very small loans are distributed in cash.14
The stated APR, finance charges, amount financed, total repayment amount, loan duration, and monthly payments are disclosed by the lender in the loan contract in accordance with state and federal laws, including the TILA.15 The loans are fully amortizing, meaning each payment reduces principal until the balance reaches zero, and the loans have substantially equal monthly payments that are set during the underwriting process.
Based on the loan contracts analyzed, monthly payments range from about $50 to $400, averaging around $100 and $200 for small and large loans, respectively. The largest trade association representing installment lenders, the American Financial Services Association (AFSA), reports that its membersâ payments average $120.16 These findings are consistent with installment loan data previously reviewed by Pew, consisting of several hundred thousand installment loans ranging from $100 to $3,000 obtained from a credit bureau; an analysis of that data set revealed that 85 percent had monthly payments of 5 percent or less of a borrowerâs gross monthly income, the threshold for affordability established in previous research.17
Installment loans from nonbank providers typically have âprecomputed,â as opposed to âsimple,â interest. Precomputed interest means that the payment schedule, including the amount of interest due, is calculated at the time the loan is issued, so even if a borrower makes early payments, the total interest charged does not change.18 By contrast, when a consumer takes out a simple-interest loan, such as a student loan or borrowing on a credit card, the interest is calculated on the outstanding principal on the day each payment is due.
In general, the cost of an installment loan comprises the interest, fees, payments for credit insurance premiums and other ancillary products, and interest charged for financed premiums. However, under the TILA, stated APRs do not include all of these costs.19 The more accurate representation is the all-in APR, which captures all costs associated with the loan, including those for credit insurance and other ancillary products, and is the rate a borrower actually pays based on how much cash they received and how much they owe.20
Among the loan contracts Pew analyzed, the highest all-in APR was 367 percent on a $129 loan and the lowest was 16 percent on $10,000. The average was 90 percent for small loans and 40 percent for large ones. Although APRs decreased as loans got larger, the dollar cost as a share of the loan proceeds increased. Average costs were 45 percent of loan proceeds for small loans and 65 percent for large loans. (See Table 1 and Appendix Table A.2.)
These findings are largely consistent with data published by the states, which regulate loan sizes, interest rates, fees, the sale of credit insurance, and other terms, though the rulesâand therefore loan structures and costsâ differ significantly by state.21 Permissible stated APRs for small installment loans are usually far lower than for payday loans but higher than for credit cards. South Carolina publishes detailed data on finance charges and loan size; the most frequent stated APR in that state is 107 percent on loans of $600 to $1,000, and 88 percent for $1,000.01 to $2,500.22 A South Carolina rate chart from a large consumer finance company indicates an all-in APR of 101 percent for a $738 loan with a 12-month term.23 Other state regulatory data reveal the following costs and all-in APRs for a $740 loan that lasts 11 months: $294 and 72 percent in Alabama and Tennessee, $316 and 77 percent in Oklahoma, and $336 and 82 percent in Texas.24
Similarly, a survey of AFSA members found that 49.7 percent of loans had stated APRs between 49 and 99 percent, and 10.9 percent had stated APRs of more than 100 percent.25 Californiaâs regulatory data show that more than half of loans under $2,500 have stated APRs of 35 to 70 percent.26 In Arizona, stated APRs on $2,500 loans with three-year terms that are secured by auto titles range from 26 to 36 percent.27 Industry reports show average stated APRs of 30 percent for $4,000 to $5,000 loans, and 25 percent for $6,000 loans.28
In general, smaller loans have higher APRs. (See Figure 2.) One reason for this, as explained above, is that APRs are annualized, so they tend to be higher for loans with shorter terms. Another reason is that lendersâ operating costs, which are charged to borrowers, are largely constant across all loans, so they are higher on a per-dollarloaned basis for small loans than for large ones. For example, a lender must pay its employees and pay rent for the branch regardless of how much is lent for any individual loan, and those fixed costs represent a much smaller share of the revenue from a $2,500 loan than from a $500 loan. Another reason is that installment loans often carry upfront acquisition or origination charges, which increase APRs far more for small loans than for larger loans. For example, a three-month loan with a fixed $50 origination fee and 36 percent interest will yield a 132 percent APR for a $300 loan and a 56 percent APR for a $1,500 loan.
The relationship between APR and dollar cost, however, tends to be inverse: As loans get larger, their terms lengthen, so APRs, which are calculated on an annual basis, fall while dollar costs rise with the higher number of payments required. (See Figure 3.)
Stated loan durationsâthe number of months a loan is scheduled to last at the time the borrower signs the contractâgenerally vary from four to 60 months. The average stated loan duration for the analyzed sample is about one month for every $70 borrowed for small loans and $120 for large loans. However, the stated durations tend to differ substantially from the number of months that borrowers spend in debt because most loans are refinanced. (See the âUpfront fees, front-loaded interest charges harm consumers who refinance or repay earlyâ section below.) For instance, it would take twice as long for a borrower to repay a $1,000 loan with a 12-month stated term if a loan is refinanced three times after its fourth month.
Although installment loans are generally considered unsecured because they are not purchase-money loans, such as those used to buy a home, vehicle, or other goods, most large national lenders do secure some loans with nonessential household goods, such as computers, appliances, and lawnmowers, and/or auto titles.29 For instance, one company that offers small loans secured 20 percent of its portfolio by volume with vehicles, and another that issues larger loans secured 43 percent with collateral.30 Similarly, 83 percent of loans issued in North Carolina in 2015 were secured by vehicles or personal property.31 In the contracts reviewed for this analysis, most loans also were secured with household goods or vehicle titles.
These collateral items offer little in resale value, and lenders usually do not attempt to seize household goods in the event of default. Instead, the goods serve primarily to reduce the risk of default by giving lenders leverage to sell certain insurance products, particularly nonfiling or property, and to threaten repossession to compel repayment. (See âCredit Insurance Explainedâ below.)
Comparisons with payday and auto title loans
Loans from consumer finance companies are less dangerous for borrowers than payday and auto title loans in three important ways. First, they have much smaller payments, which are affordable for typical consumers. Second, their interest rates are lower. And third, they are based more on the borrowersâ ability to repay than on the model used in the payday and auto title market: a lenderâs ability to collect, in which the lender obtains access to the borrowerâs checking account or vehicle title.
Consumer finance companies, by comparison, normally assess each applicantâs income and certain expenses and do not require access to a borrowerâs checking account. Because installment lenders assess borrowersâ ability to repay, issue loans with terms longer than 45 days, and schedule loans to be repaid in equal installments rather than balloon payments, they are not covered by the Consumer Financial Protection Bureau regulation of payday and auto title loans that was finalized in October 2017.32 Although some larger lenders have begun to offer automatic electronic payments, many prefer that borrowers pay their monthly installments at the store as part of a âhigh-touch servicing modelâ that enables the companies to encourage frequent refinancing.33 (See the âLender-driven refinancing is widespreadâ section below.)
In one respect, however, the business models of payday and auto title lenders and consumer finance companies are similar. Both generally offer only a small number of products, and their revenue streams are not diversified: They rely heavily on existing borrowers to frequently refinance loans or reborrow to generate revenue.34 This means that operating expenses are spread over a relatively small number of borrowers per store, which contributes to the loansâ high costs.35 (See Figure 4.) Consumer finance companies are somewhat more efficient than payday lenders in this regard, serving more than 700 unique borrowers at an average location annually, compared with about 500 and 300 at payday and auto title stores, respectively.36
In addition, although all of these lenders primarily serve consumers with subprime credit scores, typical installment borrowers tend to have credit scores in the high 500s and low to mid-600s, compared with the low 500s for payday loan customers.37 Consumer finance companies also reject a larger share of applicants than do payday lenders; and unlike most payday and auto title lenders, they report customersâ repayment behavior to traditional credit bureaus.38
Harmful features of installment loans
Stated APRs tend to underestimate what borrowers will pay
When loan contracts include credit insurance or other ancillary products, the lump-sum premiums or other charges are financed by default, which increases both the total amount borrowed and the amount of interest the borrower pays.39 The cost of these products does not count toward the stated APR, resulting in loan agreements where the rate stated in the contract is often significantly lower than the all-in APR.40 (See Figure 5.) This practice enables installment lenders to contractually comply with state interest rate caps while issuing loans with all-in APRs that often exceed those regulations. It also conceals the all-in APRs from borrowers, which makes it extremely difficult for consumers to evaluate credit products and compare costs.
One of the borrowers in the focus groups, who was aware of the difference between stated and all-in APRs, explained, âThereâs a big difference between the [stated] percentage rate and what youâre really being charged.â As an example, a stated APR for a nine-month, $511 loan issued in Kentucky was 43 percent, but the all-in APR was 138 percent. (See Figure 6.) Because the lender sold credit insurance with the loan and financed the $203 lump-sum premium, the amount financed increased from $511 to $714, which resulted in higher interest and other charges.41 When all the fees and insurance premiums were included, the all-in APR was 138 percent, three times more than the stated APR.
Credit Insurance Explained
Credit insurance sold as part of the loan transaction pays out all or a portion of the outstanding balance in the event the borrower experiences a life event, such as an injury or job loss, that makes it difficult to pay off the loan. State statutes usually regulate the type of insurance products that can be sold with installment loans, as well as maximum premium charges and sometimes minimum loss ratios. Almost every state allows the sale of some type of credit insurance, but some specify a minimum loan amount that can bear insurance or set other regulations.42 Installment lenders are typically allowed to sell the following types of credit insurance:43
- Life: repays a loanâs outstanding balance to the lender if the borrower dies. The payout decreases the longer the loan is outstanding because the policy covers only the remaining loan balance.
- Accident and health or disability: Makes the monthly payments to the lender if the borrower becomes disabled during the loan term, continuing until the borrower recovers from the health issue or the loan term ends, unless other policy restrictions apply or limit coverage.
- Involuntary unemployment: Makes required monthly payments to the lender if the borrower loses his or her job during the loan term until the customer finds new employment.
- Property: Covers the value of property pledged to secure a loan if a lender is unable to repossess the property for any reason.
- Nonfiling: Protects lenders against losses up to the value of the collateral in the event a borrower defaults and the lender did not undertake the time and expense to file the paperwork to register a security interest in the property.
Installment lenders also are often allowed to sell accidental death and dismemberment insurance that makes loan payments if a qualifying event occurs. Lenders can also sell auto club memberships and automobile security plans.44
State regulations on insurance and other ancillary products significantly affect borrower costs
Differences between stated and all-in APRs are endemic in states where interest rates are capped but sales of lump-sum credit insurance in conjunction with the loan and financing of premiums are permitted. Pew analyzed contracts from nine such states and found that for loans under $1,500, the all-in APR was 55 percent higher, on average, than the stated rate. However, some states have alternative tiered fee structures, generally for loans under $1,500, that permit higher finance charges but prohibit the sale of insurance and other ancillary products with the loans. In these states, lenders generally charge the maximum allowed, but contracts reflect the actual cost to borrowers. (See Figure 7.)
In dollar terms, added credit insurance and other ancillary products increased the cost of borrowing in states that allow them by more than a third on average. (See Table 2.) These findings are consistent with previous research, which estimated that credit insurance increased the cost of borrowing by over 35 percent on average.45
This analysis also found that in states with higher interest rate caps but bans on ancillary products, loans tend to cost borrowers less than in states that have caps of 36 percent or less but allow the sale of insurance and other products.46 (See Figure 8.) These findings indicate that when states set rate limits under which consumer finance companies cannot make loans profitably, lenders sell credit insurance to earn revenue that they are not permitted to generate through interest or fees. Setting artificially low interest rate limits while allowing the sale of credit insurance raises costs for consumers while obscuring the scale of those increases.
Where credit insurance is allowed, state laws often provide strong incentives for lenders to sell it
Not all states permit consumer finance companies to sell credit insurance with their loans, but where they do, lenders have four main reasons to do so:
- To earn more in interest on the increased amount financed.
- To receive commissions from insurance companies. (When the insurer and lender are owned by the same parent company, the revenue goes to the lender.)
- In states with low interest rate caps, to generate sufficient revenue to support operations.
- To reduce debt collection costs and losses.
The scale of the increase in revenue and reduction in costs can be substantial. As much as a fifth of lendersâ earnings come from selling ancillary products,47 including a substantial share from the commissions that insurers pay to installment lenders for brokering the policies in conjunction with loans. Insurance companies spend almost half of their revenue paying these commissions.48 In one fiscal year, five of the largest national installment lenders reported combined revenue of more than $450 million from ancillary products.49
Insurance premiums provide an important source of revenue for lenders. Premiums are calculated on the total payments on the loan, including not only the proceeds but also the share of each payment covering other premiums, fees, and interest.50 As previously noted, premiums are charged when a loan is issued, then added to the principal and financed, triggering more interest and in some cases larger origination fees and longer loan durations, which increase borrowersâ costs and boost lendersâ revenue.51
For example, a contract from North Carolina for $2,173 in loan proceeds had monthly payments of $150. Without the addition of insurance, those payments would have paid off the loan in 18.5 months. However, because of the premiums the loan lasted 30 months and the cost quadrupled, from $592 to $2,327, exceeding the loan proceeds.
(See Figure 9.)
The cost of credit insurance masks the true cost of borrowing for consumers and enables installment lenders to earn a profit even when state rate caps would otherwise render them unprofitable. As previously discussed, because lump-sum premiums are included in the overall loan size, lenders are able to offer loans with stated APRs that conform to state rate laws but have all-in APRs that are much higher.
Reduced debt collection costs and losses
Selling insurance can also reduce lendersâ collection costs and minimize losses because credit insurance protects them against a borrowerâs inability to pay back a loan due to events, such as death, disability, or a job loss. These policies benefit borrowers by covering loan payments during a time of hardship, but their value to lenders is greater because they guarantee repayment, eliminating the need for expensive debt collection activities.
This misalignment of interests in which borrowers pay for policies that primarily benefit lenders is particularly acute with property and nonfiling insurance. Lenders often secure loans with low-value collateral, such as used appliances and electronics, that they do not intend to repossess. The lenders then sell property and/or nonfiling insurance on those items to the borrowers, which guaranteesâat the customersâ expenseâthat the lender gets paid should the borrower default because of a covered event and the lender not collect the collateral.52
This reduces lender costs because the consumer finance company does not have to verify the value of the collateral or perfect its security interestâthat is, file paperwork establishing the lenderâs legal right to seize the items in the event of nonpayment.
Credit insurance is frequently included in loan contracts by default
Credit insurance and other ancillary products are voluntary,53 but borrowers in focus groups reported that these products were automatically added to their loan contracts with an opportunity to opt out, rather than offered before the papers were drawn up. These qualitative findings are consistent with previous research showing that insurance is frequently a standard component of loan contracts.54
Pewâs analysis found that in states where the sale of credit insurance is allowed, almost 80 percent of contracts had at least one type of insurance. (See Table 3.) About 70 percent of loans in each of North and South Carolina had credit life insurance.55 Moreover, lenders often sell more than one type of insurance to the same borrower: On average, the contracts Pew analyzed included 2.67 insurance and other ancillary products.56
Insurance Automatically Added, Borrowers Say: âIt Was Just Thereâ
Low loss ratios indicate low value to borrowers
Credit insurance products have extremely low average loss ratiosâthe share of insurance premium dollars that are paid out as benefitsâcompared with other forms of insurance.57 Such figures indicate that insurance policies are overpriced and have less value to consumers because companies pay out few benefits relative to the premiums they receive. Insurance with a high loss ratio is considered more beneficial and fairly priced. The National Association of Insurance Commissioners (NAIC), which comprises chief state insurance regulators and sets best-practices for insurance companies, recommends a minimum credit insurance loss ratio of 60 percent.58 But the national averages for credit life and disability insurance are 45 and 42 percent, respectively.59
(See Figure 10.)
Some insurers have unusually low loss ratios even by credit insurance industry standards. (See Table 4.) For example in 2015, Life of the South Corp., a provider for one of the installment lenders, reported loss ratios of only 53 and 16 percent for credit life and disability insurance, respectively.60 With regard to disability insurance, a proportion of these low loss ratios can be explained by the fact that some claims can be denied later if the borrower is found to have a pre-existing condition or other policy restrictions apply.61
Some state regulators set minimum required loss ratios for credit life and disability insurance, but even in these states loss ratios are often lower than the required minimum.62 For example, the minimum ratios in Texas are already lowâ43 and 44 percent, respectively, for credit life and disability insuranceâbut policies in that state still have average five-year loss ratios of 35 and 28 percent, respectively. (See Table 5.) These data suggest that states are frequently lax in enforcing their requirements, and they reinforce the earlier finding that credit insurance products are overpriced and artificially increase the cost of the loan to the benefit of insurance companies and lenders, and the detriment of borrowers.
Upfront fees, front-loaded interest charges harm consumers who refinance or repay early
Refinancing an installment loan may make sense for a consumer in some instances, but some market practices such as charging large upfront fees and front-loading finance charges disproportionately harm those who do so. Nonrefundable origination fees make the first months of the loan the most expensive for the consumer and the most profitable for the lender if the loan is repaid earlier. Many state laws allow and even encourage these practices rather than requiring that monthly fees be spread evenly over the life of the loan and better align lendersâ and borrowersâ interests. Front-loaded fees give lenders a strong incentive to refinance loans to generate more of these lucrative early months.
Among the refinanced loans examined in this study, a third had cash disbursements of less than the monthly payment amount, meaning that borrowers received less cash than they paid per month before refinancing. Another 14 percent received an amount that was less than two monthly payments. This indicates that these loans were refinanced before borrowers had repaid a substantial share of principalâthat is, most of the money they had paid to that point was applied to fees and interest.63 As a result, frequent refinances are harmful to consumers because they substantially increase the cost of borrowing and prolong indebtedness.
Lenders charge maximum allowable fees
Most states permit lenders to charge borrowers a fee to cover the cost of originating a loan, and some allow additional fees, such as monthly maintenance, recording, and administrative. In the contracts Pew analyzed, lenders generally charged the maximum allowed under state law, with origination fees and related charges ranging from 1 to 46 percent of loan proceeds for loans under $1,500.64 One reason for this substantial variation is that some state regulations allow fees in fixed-amount terms rather than as a percentage of the amount financed. Therefore, those fees can represent a disproportionately large share for small loans. For example, Louisiana lenders can charge $50 origination and $10 documentation fees for any loan under $3,000;65 thus a $130 loan contract reviewed by Pew carried fees that amounted to 46 percent of the proceeds. Those same fees would be just 6 percent of a $1,000 loan.
This also explains the more moderate variation of origination fees and related charges for loans greater than $1,500, which range from 1 to 12 percent of proceeds. For example, the highest origination and maintenance fees in this study totaled $240 on a $2,049 loan, or 12 percent of proceeds, and were paid by a borrower from Georgia. The same lender, however, issued loans in other states, such as Kentucky and Alabama, with loan fees constituting only 3 and 2 percent of proceeds, respectively, suggesting that fees are driven by state limits rather than lender costs.
By allowing front-loaded fees, states encourage refinancing
Although most state laws prohibit prepayment fees, certain clauses effectively penalize borrowers for repaying early or refinancing. For example, at least 25 states allow lenders to use the ârule of 78s,â also called the âsum of digits,â as their rebate methodâthat is, the process for calculating how much of a loanâs total finance charges they will receive from borrowers who repay early.66 The rule permits lenders to collect a disproportionate share of interest and fees for loans repaid in the early months, enabling lenders to earn more than 70 percent of the loanâs total revenue, when a loan is refinanced halfway through the term, rather than the 50 percent they would receive by that point if all costs were spread evenly over the loan term.67 This creates a strong incentive for lenders to encourage borrowers to refinance.
Origination or other upfront fees also give lenders a strong incentive to refinance loans because they can charge these fees every time the loan is issued or refinanced. For example, origination fees in Alabama are 10 percent of the amount financed and are not refundable upon prepayment, so a lender that issues a $500 loan can collect a $50 origination fee each time the loan is refinanced, substantially increasing the costs for borrowers.
(See Figure 11.)
In addition to generating more revenue by prolonging a borrowerâs indebtedness and collecting front-loaded fees, refinancing provides lenders with a more predictable revenue stream than acquiring new customers, which entails added risk and acquisition costs.68
Lender-driven refinancing is widespread
The incentive to refinance is so strong that companies have policies requiring employees to actively market refinancing. For example, Colorado officials found that one firm instructed its employees to encourage customers to refinance 60 days after a loan was issued,69 and one loan in Oklahoma was renewed 37 times.70 Similarly, a borrower from Texas who refinanced 16 times ended up paying more than $1,980 in fees on a $200 loan.71 Focus group participants confirmed that marketing of renewals was widespread, and some described it as intrusive.
Some executives have been explicit about the importance of renewals to their business.72 Similarly, one lender disclosed in federal filings that it âactively markets the opportunity for qualifying customers to refinance existing loans prior to maturity.â73 The internal operations manual for one of the consumer finance companies stated: âThe bulk of company profits are obtained from renewals,â âRenewals are SOLD, not bought,â and âThe majority of [your] loans are to be renewals if your office is to obtain the percent collections and turnover that is required for a substantial profit.â74
St. Louis Customers Are Repeatedly Asked, âWould You Like to Refinance?â
Lendersâ filings show that most of their revenue comes from refinancing. The top three consumer finance companies report that on average, almost two-thirds of loan originations were refinances, about a fifth were issued to new borrowers, and the rest were new loans made to existing customers.75 (See Figure 12.) These findings are consistent with regulatory data from North and South Carolina, which show that 63 and 69 percent of existing loans, respectively, were refinanced.76 Similarly, the Colorado attorney generalâs office determined during an investigation of one installment lender that at least 85 percent of the companyâs loans were refinanced.77 In the contracts Pew analyzed, 73 percent of loans were refinanced, which is consistent with state regulatory data and company reports.78
To alleviate the problems identified in this report and improve outcomes for consumers who use installment loans, lenders and policymakers should embrace sensible safeguards that align the interests of borrowers and lenders:
- Spread costs evenly over the life of the loan. To minimize lendersâ incentives to refinance loans and avoid harm to borrowers who refinance or repay early, ensure that origination or acquisition fees are nominal, proportional to the amount financed, and pro rata refundable.
- Require that credit insurance function like other standard insurance policies. Prohibit upfront assessment of premiums and require instead that they be charged on a monthly basis. Extend to all loans the existing federal regulation that bars the financing of credit insurance for transactions secured by dwellings,79 allowing lenders to offer insurance but requiring that premiums be paid monthly. These changes would improve the accuracy of disclosures and reduce inappropriate charges when loans are refinanced.
- Require that the sale of ancillary products be a separate transaction from the issuance of credit. Ensure that credit insurance and products unrelated to the loan transaction are offered only after a loan contract is completed and the borrower has received the proceeds or has been notified that the loan has been approved. State regulators should strictly enforce minimum loss ratios for credit insurance, where applicable.80
In states without them, regulators should introduce a minimum loss ratio of 60 percent for credit insurance, as recommended by the NAIC. If minimum loss ratios are not met, regulators should require lenders to refund excess premiums to borrowers.
- Continue to set maximum allowable charges. Policymakers may reasonably prohibit high-interest credit. But if they choose to allow finance charges that are higher than those for mainstream loans in order to provide liquidity to people with low credit scores, they should embrace research-based price limits, such as those in states that have alternative rate structures and prohibit the sale of credit insurance, to promote reasonable costs while enabling efficient lenders to operate profitably.
Consumer finance companies serve borrowers who in many cases have limited access to credit. The installment loans they offer generally have affordable payments and lower prices than do other subprime credit products, such as lump-sum payday and auto title loans and the installment loans issued by many payday and title lenders.81 However, this analysis indicates that many state regulatory regimes have led to unsafe installment lending practices, preventing consumers from easily comparing prices or evaluating the cost of borrowing, and creating incentives for lenders to refinance loans frequently. In particular, many state laws enable the three practices that contribute the most to consumer harm: charging front-loaded fees, selling credit insurance and low-value ancillary products with upfront premiums, and issuing loans with stated APRs that do not reflect the true cost of borrowing.
Appendix A: Methodology
Installment loan locations
The largest national providers were defined as those that operate in at least four states and have more than 50 stores. In all, 20 lenders fit these criteria. Exact store addresses, including ZIP codes, were downloaded from the companiesâ websites. For four companies that did not list this information in downloadable form, the researchers used Google Maps to determine the precise locations and reconciled those findings with information from public filings and state regulatory data.
Store density is a ratio of the total number of stores operated by the largest national installment lenders per state to the total adult population in that state and is expressed as the number of stores per 100,000 people.
In May 2014, Pew conducted four focus groups with installment loan borrowers: two each in St. Louis and Houston. Participants were recruited by employees of the focus group facilities. Groups were conducted in person, lasted two hours, and included eight to 11 participants in each. All borrower quotations in this report are drawn from the focus groups.
Installment lending contract analysis
Contracts from loans issued by the 14 largest national installment lenders were randomly selected and downloaded from the Public Access to Court Electronic Records (PACER) portal, a bankruptcy records database. The final sample consisted of 296 contracts from 26 states and was drawn to be approximately proportionate to each companyâs share of branches in the national market. Contract information, including stated APR, total finance charges, amount financed, number of payments, and monthly payment amount, were logged into a spreadsheet for further analysis. Additional informationâsuch as cash disbursed; prior loan balances; insurance products sold (credit life, disability, involuntary unemployment, auto, property, accidental death and dismemberment, and miscellaneous insurance); motor club memberships sold; and origination, acquisition, and handling feesâwas recorded along with total interest. The researchers did not conduct complex statistical analyses of the data because loan contracts were randomly selected from bankruptcy records, which could differ from a larger pool of contracts. However, the sample did support the identification of common market practices that were consistent with findings from complete regulatory data, company filings, and other research.
A summary of the analyzed contracts is presented in Tables A.1 and A.2.
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