Alternative financial services and avoiding the debt trap

Unbanked and underbanked people are most likely to use alternative financial services.

"Unbanked” refers to an individual, family, or household without a checking or savings account at a mainstream bank or credit union. In 2015, about 9 million households in the United States were unbanked. That's about 7 percent of the population. This is according to a Federal Deposit Insurance Corporation (FDIC) survey.

People are unbanked for various reasons. They include:

• Poor credit history.
• Little understanding of the U.S. banking system.
• Language barriers.
• Incomes too low or unreliable to open an account.

"Underbanked” describes people with two characteristics. They have conventional bank or credit union accounts. But they also use alternative financial services to make ends meet.

The 2015 FDIC survey said an estimated 24.5 million households were underbanked. That's almost 20 percent of the U.S. population.

Here’s a closer look at four major types of alternative financial services. This information is from the Federal Reserve Bank of Minneapolis. And the Consumer Financial Protection Bureau (CFPB).

Payday loans

These are small consumer loans, usually $150 to $300. They are backed by postdated checks or authorization to make an electronic debit against an existing account. The check or debit is held for an agreed-upon term, usually about two weeks or until an applicant’s next payday. Then it is cashed, unless the customer repays the loan or reclaims the check.

The finance charge for most payday loans ranges from $10 to $30 for every $100 borrowed. A typical two-week payday loan with a $15 fee per $100 borrowed equates to an annual percentage rate of almost 400 percent.

If a payday loan customer does not have funds for a check to clear, the same process is followed to get another loan or extend the existing loan. This is a rollover or renewal.

Rollovers are where the cost of a payday loan starts to snowball. CFPB statistics show that 1 in 5 payday customers end up taking out at least 10 or more loans, one after the other. With each new loan, the customer pays more fees and interest on the same debt. That customer has fallen into the “payday debt trap.”

Check cashing

Check cashing outlets (CCOs) cash payroll, government, and personal checks for a set fee. This ranges from 3 to 10 percent of the face value of the check — or $1, whichever is greater. CCOs may offer extra services and products, too. These include money orders, wire transfers, bill paying, and prepaid phone cards. A growing number also are offering payday loans.

Auto-title loans

Like payday loans, auto-title loans are small consumer loans. They leverage the equity value of an automobile as collateral. An applicant must own the auto title free and clear. Any existing liens on the vehicle cancel the application.

Loan terms are often for 30 days. Failure to repay the loan or make interest payments to extend the loan lets the lender take the vehicle.

Pawnbrokering

Pawnbrokers provide financing based on the value of property brought to a store. Most brokers charge a flat fee for a transaction. They also hold the merchandise for an agreed-upon period of time.

What happens if a loan is not repaid or extended by an interest payment when the contract expires? The broker assumes ownership of the merchandise and can put it up for resale.

Manage existing fringe loans

If you must use alternative financial services, use them wisely. Pay off short-term payday loans immediately, and don't roll them over. Keep up with payments on auto-title loans.

Ironically, some people use another fringe financial service to manage existing fringe loans. They pawn some possessions. This is because pawning carries no long-term costs or penalties. At best, you may get money in enough time to reclaim your valuables. At worst, the pawnshop will assume ownership of them. Either way, you don’t take on debt.

Get help paying off rollover payday loans

What if you have built up a large debt to a payday lender by rolling over loans? Then you should explore ways to get help for paying off the entire debt. Check with non-profit or faith-based organizations in your community. They may help you refinance your payday loans Then you pay them back over time, often with no interest or fees.

Some employers and community groups also may help you pay off payday loans. Learn whether such programs are offered in your community.  

Options for managing debt

Paying off loans to alternative financial service providers is a big way to manage debt. Also consider other options for improving cash flow, obtaining small amounts of money, and/or reducing expenses. The Consumer Financial Protection Bureau lists some of those options, including:

Getting a credit card. If you have direct deposit or a stable credit history, you may be able to get a credit card through your bank. But you should avoid direct deposit or checking account advances with your bank. For more information, see My bank offers a direct deposit advance or checking account advance. What is this?)

You might also consider getting a subprime credit card. Although not ideal, subprime credit cards are still less expensive than payday loans. Pay off monthly credit card balances in full so you don’t pile up debt again.

Negotiating with creditors. Try negotiating a smaller repayment amount at a lower interest rate with creditors. These steps will improve your cash flow. They may also allow you to start saving money for the next emergency that comes along.

Applying for affordable payment plans with utilities. Arranging affordable payment plans with utilities is another way to improve cash flow. This also may let you start saving money. Check with your local utilities to see if you’re eligible for such plans.

Asking family or friends for help. Last, but not least, don’t be afraid to ask family or friends for occasional help with short-term expenses. To preserve personal relationships, handle the transaction in a business-like manner. Put the loan and plan for repaying it in writing. Also, be prompt in your repayments. For more information, see I need money now. Should I get a payday loan? What other options should I consider?

Ending your use of alternative financial services is the first step to creating a better future. Then you should work to save money and build a good credit score. If you have an account with a mainstream bank or credit union, apply for a secured credit card or credit-building loan.

If you’re unbanked, it’s difficult to build credit, but not impossible. Some non-profit organizations help with reporting things like rental payments to credit-rating agencies. Visit the Credit Builders Alliance website for more information.

Another way to build credit is through lending circles. A lending circle is a group of people lending money to each other at no interest. Each member of a circle chips in each month to provide a pool of money that is loaned to individual members on a rotating basis.

Lending circles are common throughout the world. They go by a variety of names, such as tanda, ayuuto, or hagbad.

Formal lending circles track members’ payment histories. Then they report them to national credit bureaus. This way, formal lending circles help members start or improve credit histories. This paves the way to getting access to the mainstream financial system.

Learn more about lending circles through the Mission Asset Fund, a pioneer in formal lending circles. MAF works with partners across the country. Those include CLUES (Communidades Latinas Unidas en Servicio).

Remember — your most important goal is to build wealth. Finding ways to stop using alternative financial services and avoid debt will help you reach that goal.