Personal Finance in a Tight Economy

Go macro or go micro. In today’s gun-shy lending market, “the middle path” is mighty narrow. Look to the extremes for the future of finance.

Go Macro

If you can, “go big.” Banks with larger liquid asset pools are more likely to successfully shield their lending growth in a fickle economy. A bank with international holdings and major liquid assets can continue more favorable personal loan practices when smaller operations are tightening their lending policies (Bluedorn et al. 2009).

But these major international power brokers are often unconcerned with “the little guy.” Individuals looking for a personal loan need a leg up that’s too small to tempt the largest banks. In the current economic climate, small banks are cinching down on lending practices, treading water until the storm passes. Few people have the resources to meet today’s strict lending requirements, even with a good credit score. So what’s the “little guy” to do? 

Go Micro

More and more individuals are turning from the major banks to Alternative Financial Services (AFS) providers. Payday loans, asset-based lending, and peer-to-peer (P2P) lending are the three major alternative possibilities on the market today. When navigating the waters of your small personal loan options, steer clear of high-interest, low-reward options.

Payday Loans and Asset-Based Lending

Payday loans are short term, high interest personal loans (often around 400% interest) marketed as a way to cover expenses until the next paycheck. When that check comes in and a borrower can’t afford the interest, it’s rolled over into another payday loan. According to the Corporation for Enterprise Development, only 2% of payday loan borrowers manage to pay off the loan on the first paycheck; the average is 9 loans per year, resulting in an average repayment of $793 for a $325 loan (CFED 2009). 

Asset-based lending, best known as the “pawn shop model,” offers loans based on personally owned items rather than credit or collateral, with the stipulation that the item is forfeited if the loan is not repaid. According to the National Pawnbroker’s Association the average pawn loan is $80, so asset-based lending can be a valid alternative to payday loan exploitation when your cash flow needs a small jolt. Pawn interest rates can still be high (though capped at 36%), and bank on the trade of valuable items, often heirlooms that fall prey to a family’s changing fortunes.

These predatory lending practices are being closely examined by national and state governments, but for now conscientious borrowers should steer clear. “Steep rates for short-term small loans trap borrowers in unaffordable debt,” said Jean Ann Fox, director of financial services for Consumer Federation of America, in a 2010 press release. “As consumers struggle to make ends meet in a tight economy, they need protection against rate gouging.”

Peer-to-Peer Lending

Peer-to-Peer (P2P) lending, also known as microfinance, is a revolution in personal loans. As wary investors look for alternative investments to Wall Street stock and individuals in need of small personal loans turn away from the big banks, these demographics are coming together to revolutionize the personal loan market. 

Perhaps the best known microfinance operation is the Lending Club, which pairs competent investors with individuals searching for small loans up to $25,000. Lending Club investors buy 3 to 5 year notes and receive monthly payments as their borrower pays down the loan. 

Borrowers gain the convenience of applying and paying for their loans online. Most loan requests are received, approved, and funded within seven days of the initial application. Borrowers will pay an origination fee between 2% and 5% and receive a low interest rate, comparable to or lower than standard banking interest rates.

Other lending operations, be they multinational banks or corner payday loan outfits, have high overhead that’s passed on in their interest rates, along with mountains of paperwork. The unique nature of P2P personal loans allows the Lending Club to offer quick, convenient service, low interest rates to borrowers and a high rate of return to investors.