If the rules are right, digital microlending could play role in subprime market


Well-functioning credit markets are essential tools for many people in times of personal economic instability or emergency. Unfortunately, some prospective borrowers with subpar credit ratings and credit histories do not qualify for the standard options of credit cards, secured loans or personal loans.

Credit unions frequently are the best available choice for those who have difficulty obtaining credit through traditional banks. But for some, digitally coordinated peer-to-peer lending agreements—inspired by microfinance arrangements for economically fragile communities internationally—also are proving to be an emerging option.

However, before these kinds of lending arrangements can be expected to expand domestically, digital rules will need to be established to give certainty to lenders and borrowers alike.

Subprime borrowers may have practiced poor financial habits or failed to meet their obligations, but this does not change their need for emergency credit when things get tight. Locked out of the prime credit market, these borrowers resort to payday loans, title loans and other products that come with very high interest rates and dubious collection methods. If they default on these loans, the interest and fees skyrocket, leaving them even worse off than before they took the loan. Most lenders must charge these high rates to compensate for the enormous risk they have undertaken to underwrite the loans.

Peer-to-peer digital microlending has the potential to fill a portion of the gap by providing this cohort with small, short-term loans that typically range from $100 to $500. While traditional peer-to-peer lending sites such as Lending Club target prime borrowers, other platforms are helping subprime borrowers.

One of the largest such peer-to-peer digital microlending platforms is the “R/ Borrow” section of reddit.com. This subreddit uses the reputational ecosystem within reddit to identify worthy borrowers, banning users who default or violate the terms of use. The subreddit facilitates the microloans and acts as a central database of transactions, coordinating more than $780,000 in loans in 2015.

If it can be properly scaled, peer-to-peer digital microlending could be a worthy option over payday loans for subprime borrowers. Unlike the latter method, digital borrowers are not necessarily assessed hefty fines or fees for late payments. Instead, they negotiate directly with lenders to find an amicable solution. True enough, some borrowers will default on their commitments and walk away without harm to their credit scores. To compensate, most lenders on microlending platforms (including the “R/Borrow” subreddit) charge high interest rates, ranging from 10 to 25 percent over several weeks or months. This isn’t a problem for most borrowers, as most of their needs are for short-term, small amounts to get them through until their next source of income.

Barriers to the expansion of these platforms come in the form of the myriad usury laws on the books in most states. While banks and other financial institutions are exempt from such laws, individual lenders are not. Digital microlending transactions often happen over state lines, making it very difficult for lenders and potential borrowers to determine their proper jurisdiction and the interest rate restrictions that apply to them. This may be an opportunity for Congress to pre-empt such laws as a matter of interstate commerce. Legislation could provide a consistent standard for digital microlenders to follow, such as through the proposed Uniform Electronic Transactions Act (UETA).

While admittedly there are other challenges to overcome, such as developing a scalable peer-to-peer enforcement mechanism, additional legal certainty would help expand this credit option for borrowers who find themselves locked out of traditional credit markets.

Image by designer491


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