A substantial number of low-income individuals make use of services within the alternative financial sector (AFS), particularly pay-day lenders and check cashing outlets. Pay-day lending has grown over the past 20 years, as has the use of Refund Anticipation Loans (RALs). Although the number of households without a checking account has fallen, currently about 12 million households do not have a checking account, and must rely on check-cashing services. Fellowes and Mabanta (2008) indicate that non-bank establishments collected $8.5 billion in fees in a recent year. The high cost of these services has led many observers to seek policies that would reduce the use of informal financial services among lower income households. This paper briefly reviews the reasons why individuals utilize AFS outlets, then discusses the policy options that could affect these decisions.
I. Why do low-income households use alternative financial services?
Before turning to a discussion of policies that would reduce reliance on informal financial services, it is important to understand why individuals utilize AFS providers rather than banks or other formal financial institutions. There are five primary reasons typically discussed.
A. Formal financial institutions provide services that are ill-fitted to the financial needs of low-income households. About 40 percent of payday loan recipients have bank accounts, suggesting that their payday loan provides a service that is not available from their bank (Elliehausen and Lawrence, 2001). About half of payday loan recipients claim to have considered a bank loan; many of these said that the payday loan involved an easier process; some also cited the convenient location of payday providers. Short-term loans to lower-income customers are simply not available through many local banks.
High-minimum-balance checking accounts with multiple fees may be very expensive for low-income individuals who experience frequent penalties for lower balances or for overdrafts. About half of the non-banked say either they don’t have enough money to start an account or the costs of an account are too high (Berry, 2005). About half of payday loan customers say their payday loan is cheaper than the cost of returned check fees (Elliehausen and Lawrence, 2001). Caskey (2005) argues that check-cashing outlets provide much more comprehensive services than banks (including money orders), while Berry (2005) indicates that 77 percent of those using check-cashing services say they are more convenient. A significant number of low-income households use both formal and informal financial providers for their transactions (Barr, forthcoming.)
Often low- and moderate-income families need a way to cash their check, they need a way to pay their bills, they need a way to save for the future, and they’ve cobbled together an interesting mix of bank and non-bank services to do that that are often more expensive and more costly than they need to be.