Personal Loans are Growing Rapidly, but at What Cost to Consumers?

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Personal loan debt was the fastest-growing type of consumer debt in 2018, reaching $291 billion in the fourth quarter of 2018 and growing at more than twice the rate of other types of consumer debt according to Experian.

There were 36.8 million outstanding personal loan accounts, consisting of secured or unsecured credit, held by 10.8 percent of adults in the United States – that’s over 27 million people.


What is driving this new wave of consumer lending?

A major factor contributing to the increase in consumer lending in recent years has been the rise of marketplace lending platforms, or MPLs. An MPL is a non-bank lender that heavily leverages technology to provide consumers a faster lending experience, and, to fund its lending operation, often provides individuals with the opportunity to invest in the loans it underwrites. FinTech companies offering MPL’s are fueling the rapid growth of personal loan originations.  Many of them are based in Silicon Valley and have been funded by venture capital investors who are used to pushing for hyper-growth in everything they do.  

Five years ago, FinTechs accounted for just 5% of outstanding balances. Now, FinTech loans comprise 38% of all unsecured personal loan balances, the largest market share compared to banks, credit unions and traditional finance companies. A July 2018 report published by the U.S. Department of Treasury says that more than 3,300 FinTech companies started from 2010 to 2018. These companies are venture and private equity-backed and face aggressive growth mandates from their investors.

Meantime, the amount of tappable home equity is at an all-time high, passing $6 trillion last year, according to Black Knight. That’s 21% higher than in the pre-crisis peak, from 2006. In total, 44 million homeowners have equity available to them to help pay education costs, pay down debt, or renovate their home. However, there is a reluctance to tap home equity, as increased regulation and tighter lending standards make it difficult to qualify for home equity loans. According to a recent study by Mintel, nearly half of consumers are turning to personal loans to consolidate debt, rather than using their home equity after the credit crisis.

Personal loan offers to less qualified consumers are on the rise

In an article last August (Lenders Shunned Risky Personal Loans. Now They’re Competing for Them), the Wall Street Journal explored how banks and FinTech companies are diving into the personal loan space with a new vigor. The piece highlighted how lenders are stepping up offers of consumer loans with few strings attached, often to individuals with mediocre credit histories who they all but ignored in the years after the financial crisis.

In fact, over the past year, consumers have seen a huge increase in the number of personal loan solicitations delivered to their mailboxes.  That is because personal loan direct mail surpassed credit card solicitations for the first time in history in the second quarter of 2018.  Over the first half of 2018, over 1.2 billion personal loan solicitations were mailed to U.S. households.  This translates into a little more than 9 direct mail pieces for every household in America in the first half of the year.

Growth like this in a lending business should give us pause.  Lending is different from many other businesses, and when you mix the hyper-growth mentality of Silicon Valley with the credit risk inherent in lending, bad things can happen. As I have said before, it is very easy to grow a lending business “Here is some money, do you want it?” On the flip side, it is very easy to control credit risk “No money for you! (or anyone else).” Doing both – growing a lending business while controlling credit risk – is a real challenge – one that takes a combination of people, processes, technology, analytics and humility in order to succeed.

In a typical venture-backed company, the drive for growth trumps everything. That mindset often makes sense – by growing at all costs, you are risking only two things – the time and opportunity cost of the founding team and the equity investment from the venture capitalists. That is a smart and fair trade. Whether it implodes or takes off, the founders’ and VCs’ losses or gains are commensurate with the risks they took. So put the pedal to the metal and see what happens. When you bring that mentality to lending, the game – and the associated risks – are completely different.  The repercussions of an implosion expand dramatically to lenders and their counter-parties, and most importantly to over-leveraged consumers stuck with loans they can’t afford to pay back.

Personal loans: is innovation a help or a hindrance to consumers?

The good news for consumers is that with more competition and innovation, they should benefit from the increased accessibility and lower interest rates that MPL’s provide. The use of technology to streamline cumbersome loan origination processes should reduce the costs of loans, driving more loan choices and lower fees for consumers.  These loan products are good for consumers who responsibly use the proceeds to pay off higher-interest debts and at the same time convert revolving debt to fixed amortizing debt with a finite (and relatively short) payoff period.  But only if they can afford the higher monthly payment.  An amortizing personal loan will almost always have a significantly higher payment than a revolving debt, even if the interest rate on the personal loan is lower.

However, despite the rapid growth of the personal loan market, we are not seeing the reduction of credit card balances that we would expect from loans that are, for the most part, categorized as consolidation loans. In fact, revolving consumer credit debt ballooned to $1.05 trillion in January.

At a more micro level, at Freedom, we are seeing some troubling trends with clients enrolling into the Freedom Debt Relief program – specifically, more financially-stressed individuals carrying large unsecured personal loans and increased liabilities overall. The percentage of our FDR clients with an MPL has grown by 37% since 2015. In 2018, 36% of our FDR enrollees had an MPL on their credit report, and of them, more than half had at least two personal loans and 30% had at least three. In addition, those clients carry over 20% more in unsecured debt versus clients who don’t have an MPL.

All of the above data leads to some interesting questions.  Have some consumers been using personal loans not purely for the worthy purposes of lowering interest rates, but rather as a way to take on more debt and delay a coming reckoning?  Are benign credit card loss statistics being bolstered by the aggressive growth of MPL “consolidation” loans?  When the music stops, how many chairs will be missing?

Bottom line: The risk to the consumer and to the lending ecosystem is real

Consumers face enormous financial challenges today. According to the Federal Reserve, 41% of Americans can’t cover an emergency $400 expense. In a recent survey for Freedom Debt Relief, 42% of respondents said that everyday expenses were driving their credit card debt. For these consumers, even relatively small increases in monthly payments can trigger a series of financial stressors, driving them to either default on their personal loans or run up more high-interest credit card debt. Or both.

In 2018, most of the growth in the personal loan space was at the lower end of the risk spectrum. The subprime tier grew the fastest at 4.3 percent year over year, according to TransUnion, with 34.5% of loans originated falling into the subprime category.

So what does it all mean?  The bottom line is that personal consolidation loans can be a very good consumer value proposition:  Consolidate unsecured debt into a single loan with a single payment, lower the average interest rate on your unsecured debt, and turn revolving debt into fixed amortizing debt with a clear payoff date.  All good – but only if the loans are underwritten to tight standards and issued to consumers who can afford to make the inevitably higher monthly payment (and who do not intend to use the personal loan as a way of increasing their overall debt burdens).  Unfortunately, from our vantage point much of the data we are seeing suggests there are many players in the personal loan space that are not taking this long-term perspective, and instead are chasing growth without regard to the consequences.

Andrew Housser co-founded Freedom Financial Network in 2002 and Bills.com in 2005. Andrew sits on the board of directors of several startup companies as well as two independent school boards.