In Defense of Alternative Lenders

Commentary, Disruption, Caitlin Rose Morgante

The media often portray alternative lenders as slippery, unethical loan sharks who exploit the poor. When targeting the sector and not just a few bad apples, such stories are easy, cheap hit jobs.

A New Brunswick Liberal senator, for example, recently described alternative loans to CBC Marketplace as “an abusive financial process that needs to be curtailed.”

The irony is that alternative lenders are the little guys of the financial sector. They have a thankless, high-risk task serving people who have bad or no credit and get no love from major financial institutions.

A Marketplace investigation found lenders offering personal loans at rates of up to 46.96 per cent, while the Bank of Canada’s wholesale interest rates are below one per cent. Another Marketplace concern was rollover loans—banned in some provinces—which can perpetuate a tragic cycle in which someone borrows from one payday lender to pay back another.

The knee-jerk response from critics is to ban alternative loans or regulate them out of existence to prevent predatory practices. Although alternative lending is icky and undesirable for politicos and the middle class, crackdowns fail to recognize that alternative lenders are the last hope for Canadians shut out of the traditional lending market. The ever-expanding regulatory landscape, with higher compliance costs and barriers to entry, exacerbates the problem.

Canadian banks rationally seek to minimize risk and have raised their credit standards, making it more difficult for business owners with poor credit to access financing options at reasonable rates. In fact, TD Canada Trust and Scotiabank have loan rejection rates of 25.7 per cent and 18.8 per cent, respectively. That leaves a lot of people seeking credit and not finding it, along with those who have lost hope and do not bother. RBC senior economist Robert Hogue said in 2016 that tightening the rules on getting a mortgage from financial institutions prompts many borrowers who are being shut out to turn to lenders in the less regulated space.

That is why quoting what appear to be exorbitant annual rates is clickbait and silly, especially when many of the loans have extremely short terms, such as a few days. Most payday loans are due in two weeks. In Prince Edward Island, the longest term is 61 days. Further, vilifying alternative lenders overlooks the risk of extending small amounts of uncollateralized credit. 

These disadvantaged borrowers cannot get credit from conventional lenders for a reason. Low income is associated with poor credit or a lack of it altogether. Customers who use payday lending services are more likely to have had one or more bounced checks in the past five years, and to have been contacted by a collection agency for overdue bills.

At present, there are approximately 1,400 payday-loan locations in Canada. They tend to be concentrated in low-income neighbourhoods where many banks have been shutting down branches. If there are concerns about a lack of competitive interest rates in this space, there need to be more lenders, not fewer. That way, they will have to offer more favourable terms or lose clientele.

Provincial governments regulate unsecured, small-value loans of up to $1,500, usually due at the next payday. The maximum charge is about $15 to $21 for every $100 borrowed for two weeks, equating to annual 391–652 per cent interest rates. Quebec is distinct and does not permit any rates over 35 per cent, which essentially pushes payday loans off the books.

Although these rates appear high, they simply reflect the relevant risk premiums and could go even higher in some instances. Consider that bankruptcy is common in Canada, and it has spiked in recent years, leaving lenders without collateral in the lurch. Simply put, the loans cost more for borrowers because lenders face a higher cost to provide them.

Keep in mind the fixed costs involved in providing and underwriting a small loan are the same as a larger one. However, with a larger loan, a lender can more easily spread his costs and make a profit by charging a lower annual percentage rate over a longer period of time. Small, short-term loans cannot generate sufficient returns from low rates to cover costs.

For the majority of Canadians who live paycheque to paycheque, alternative financing is time-efficient. It allows them to receive their loans almost immediately rather than waiting weeks to hear whether a loan application has been approved.

More broadly speaking, the faster pace of economic change is increasingly rendering conventional financial institutions obsolete relative to sleeker, newer options. Consider that in 2017 Canada’s alternative business-lending market increased 159 per cent from the previous year, reaching $867.8 million.

A 2019 study, “The State of Alternative Lending in Canada,” collected feedback from 2,415 alternative-lending customers in Canada. Approximately 21 per cent of respondents requested their first loan from an online provider in 2019 with 30 per cent of them first consulting with a traditional financial institution before seeking an alternative lender.

These individuals are trying and failing to find options from conventional institutions, which are unwilling to engage. That is precisely why alternative providers have a role to play, and shutting them down will hurt those who often desperately need them.

Caitlin Rose Morgante is a research associate with the Frontier Centre for Public Policy.

Photo by Scott Graham on Unsplash.