Fintech startups are increasingly looking into loans for more than a third of Americans with subprime credit scores. Their vision is to turn a negative connotation into one that not only helps short-term borrowers, but builds their credit and provides financial education.
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The term “subprime” is generally applied to a borrower with less than perfect credit and a FICO score below 670, a category that 34.8% of Americans fall in, according to the credit bureau Experiential. (FICO is the abbreviation of Fair Isaac Corp., the first company to offer a credit risk model with a score.)
People in this category tend to have few borrowing options other than a subprime lender, which can lead to a cycle of debt, according to Josh Sanchez, co-founder and CEO of the financial application FloatMe.
“The big problem is that there is no alternative to payday loans,” Sanchez told Crunchbase News. “Overdraft fees are also a huge problem. Even during the pandemic, banks were charging overdraft fees knowing people were losing their jobs. “
In 2019, about 37% of Americans said they didn’t have enough to cover an emergency expense of $ 400, according to the Federal Reserve.
And when they are in an emergency, there aren’t many places people can get help with a loan, according to Nathalie Martin, Professor and Frederick M. Hart Chair in Consumer and Clinical Law University of New Mexico Law School.
“Studies have shown that people don’t shop, mainly because of the desperation involved and the fact that there isn’t much of a difference in the price of payday loans,” Martin said in an interview.
She sees two problems with current loans: loan fees are often high compared to the loan – think of the $ 50 fee for a $ 100 loan – and people often get caught in a “debt trap” where they continue to pay these fees and never actually reimburse. the principal of the loan, resulting in a much higher payment than the one originally borrowed.
Borrowers who are desperate for money often don’t look closely at the cost of the loan when looking for a lifeline, she said, only to realize that they are paying it back how bad it really is. Dear.
Invest in new methods
Since 2017, more than $ 94 billion has been invested in U.S. companies focused on financial services, according to data from Crunchbase. Between 2019 and 2020, funding increased by 29%, although the number of investments fell by almost 13%. So far in 2021, $ 19.5 billion has been invested in the sector.
Over the past six months, venture capitalists have funded a number of startups focused on alternatives to payday lending and financial literacy, including FloatMe, which in December raised a seed capital of 3. $ 7 million led by ManchesterHistory.
Other recent U.S. investments in space include:
Latin America has also become a hot market for startup innovation in the consumer loan category. Based in Mexico Graviti earlier this month, we raised $ 2.5 million in a funding round led by Active capital to develop a buy now, pay later concept aimed at millions of low-income, unbanked families in Latin America for whom purchasing household appliances is difficult.
Baubap, a mobile lending platform also based in Mexico, in March closed a $ 3 million growth round of Mexican financial services company Grupo Alfin for its proprietary technology to boost financial inclusion and education . And last November, Monashes and ONEVC led a $ 5 million funding round in a Brazilian fintech startup Facio, which is developing a financial education platform that not only offers free lectures and classes, but also payday advance services.
“I’ve seen a lot of people tap into apps that help you get your money two days early, as well as more real-time access to funds to pay bills when they get them,” Lynn told Crunchbase News. “You don’t wait for a payroll cycle, there is a cash subscription made possible by companies like Plaid, and it’s much cheaper for service users.
Lynn has spent 20 years in the credit industry, going through several cycles. She warns other investors that subprime is a dangerous category and that companies should choose companies wisely based on how transactions actually go.
In 2019, Canvas invested in Financing possible, a Seattle-based company that helps people with little or no credit history access credit and improve their financial futures “without being predatory,” Lynn wrote in her blog post.
“Possible worked well in COVID, which tested it under pressure,” she added.
Exchange cash flow for credit
Sanchez himself had his own problem with payday loans: he was in a car accident and didn’t have a credit card, so he took out a payday loan which ended up putting him in trouble. financial.
This prompted him and two co-founders to launch FloatMe in Austin in 2018 to provide interest-free, credit-free “floats” of up to $ 50, account monitoring to avoid overdrafts, and tools. savings and education.
If more people like Sanchez, who have experienced the negatives of payday loans firsthand, entered the lending space with transparency and education, that would be good for the industry, Martin said.
“We have a chance to make this work for people,” she added.
Sanchez found that when a person qualified for a $ 200 cash advance, even though a person didn’t need the full amount, they often accepted it, but then ended up in a $ 200 hole when interest and fees were piling up. Instead, smaller amounts – think $ 20, $ 30, or $ 50 – are easier to repay, he said.
“The solution proves that even a small amount can make a difference,” he added. “It could mean being able to put gas in your car or pay the minimum payment on a credit card or buy food.”
Over the past three years, FloatMe has processed nearly a million of its little “floats,” which use cash flow underwriting as the basis for lending against the traditional credit rating, which is not ” one size fits all, ”Sanchez mentioned.
The cash flow method means that the business looks at the borrower’s spending the day before and the day after someone’s payday and incoming income. This method has allowed FloatMe to make good decisions and trust a model that can complement credit. scores, he added.
FloatMe plans to expand beyond helping consumers with their cash flow shortages, Sanchez said. The company has a budgeting feature in the works which will be released in late May and is exploring other revenue opportunities for users. It may also offer credit products in the future.
“The biggest expenses a person has are rent and bills, which leaves a bit of capital for the rest of the month,” Sanchez said. “It’s difficult to get out of this situation. We need to do better as an economy to unlock the income potential and contain the rising cost of living. “
When the president Joe biden took office in January, one of his stated priorities was investigating payday loans, suggesting that the Consumer Financial Protection Bureau would have become a “consumer watchdog” under his administration.
America’s credit and loan problems will not be easy to resolve, Lynn said. She has seen different incarnations of the payday loan concept, including some that offer interest-free loans but with subscription fees.
There should continue to be options for consumers who live paycheck to paycheck to manage and improve their finances, coupled with financial literacy education, she said.
“If all the credit options were taken out, it wouldn’t allow someone to grow,” Lynn said. “Companies must also provide credit in a transparent and ethical manner. “
The interest rates for payday loans are regulated at the state level. This means that it would be difficult for the federal government to set an interest rate cap, even if a federal cap would be one way to fix the problem, Martin said. The CFPB has created rules for lenders, including the “2017 Rule,” which prohibited lenders from debiting a borrower’s account under certain conditions, and required lenders to determine whether borrowers could repay their loans.
Another would be to give the CFPB more power to investigate lenders.
“Some of the small loans may have higher interest rates and require a higher cap, but there could also be solutions like a waiting period between loans or limitations on the number of loans a person could. contract for a period of time, ”Martin added. “It’s also time to start thinking about how we might regulate the new products on offer. “
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The query used for this article was Funding of U.S. financial services companies since 2017, in which “financial services” was the industrial group and companies headquartered in the United States. This list includes companies identified as financial services, but also includes companies in other categories, such as insurance, energy, fraud detection and software.
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