Taking An Interest
Growing up the son of Mexican immigrants, James Gutierrez, 32, saw how hardworking people paid twice as much to predatory lenders because they didn’t have bank accounts or credit histories. “If you don’t have a credit score, it’s like you don’t exist,” he says. If your power is going to be shut off or your child is sick and you need money, you’ll have to go to a payday lender that makes small, short-term loans. And you’ll pay a sky-high interest rate—usually between a 400 and 1,000 annual percentage rate.
After graduating from business school at Stanford University in 2005, Gutierrez set out to prove those rates weren’t justified. He opened a lending company called Progreso Financiero that provides loans of up to $1,600 at a 36 APR. He has 52 locations in California and Texas.
Progreso Financiero, along with other startups such as San Francisco-based Billfloat.com, is part of a fledgling industry. These companies are engaged in a grand experiment to serve the 60-million-and-growing subprime market. By offering more affordable loans, they hope to attract loyal customers, rehabilitate their credit histories and turn them into “prime” borrowers. Down the line, the companies hope to sell them other financial services, such as life insurance and student loans. “We’re taking the long-term investment view on our customers,” Gutierrez says. “It’s not driven by how we can make a profit in six months.” The problem is, Gutierrez has yet to turn any profit at all.
Traditional payday lenders are making millions. They are often referred to as modern-day loan sharks because of their predatory business model. The recession has been a boon to the industry. Some of its biggest players, like Cash America International Inc., reported $115.5 million in profits last year—its best ever. To borrow from these lenders, you need a job. It usually works like this: The borrower gives the company a check for the amount being borrowed, plus interest and fees. The lender keeps the check for the term of the loan—typically two weeks—then cashes it on the borrower’s next payday. But more than 70 percent of borrowers can’t pay their loans and fees in two weeks. They have to pay a fee from $60 to $500 to renew their loans. Typically, the fee isn’t applied to the principal. The average borrower will roll over a loan at least five times, according to the nonprofit Center for Responsible Lending.
Among these borrowers are millions of people who can pay back their loans, but traditional credit scores don’t identify them. “They pay their bills on time, but they’re still denied credit, so they’re paying through the nose in fees,” says Arjan Schutte, Managing Partner of Core Innovation Capital. The firm invests in market-based financial services for low-income borrowers, including Progreso Financiero. “It’s not only a social justice issue,” he says. “It’s also a commercial opportunity.”
Most of Gutierrez’s clients are recent Latino immigrants who don’t have bank accounts. Others have blemished credit histories. Most don’t have traditional “FICO” credit scores, generated by the nation’s three largest credit rating bureaus. The trick is finding out who’s a reliable borrower and who isn’t. Gutierrez took many ideas for his risk model from the nonprofit microfinance industry in Latin America, which has few defaults. Most borrowers, he says, are able to pay back their loans, provided they’re given enough time. “The poor in the world are more responsible with their obligations than wealthier people.”
Gutierrez went to Mexico to study the microlending programs. He used those insights to create his risk model, which he likes to call his “special sauce.” Part of it involves an E-Harmony type, in-depth online questionnaire. The other part consists of buying nontraditional data such as rental and utility payment histories. The Gutierrez model looks at 1,300 attributes, such as home and car ownership. It’s a throwback to 1950s banking, when bankers knew clients, but with a technological twist. The process is labor-intensive, and it’s not cheap, he says. But it works. Credit card company losses for subprime borrowers range from 15 to 30 percent. His default rate is in the single digits.
Progreso Financiero isn’t the only company trying new approaches. Billfloat.com caters to anyone with access to the internet. Started six months ago, the company provides loans for utility payments of up to $225 at 36 APR. Billfloat pays the utility company, then collects repayment within 30 days. Shelling out $21 in fees for a $200 loan to pay your utility bills isn’t the best deal, but Billfloat says it’s better than what an average payday lender will charge—about $65.
Billfloat’s average customer is 36 and employed, but lives paycheck to paycheck. These employees are being squeezed tighter and tighter, says company CEO Ryan Gilbert. Utility companies, especially deregulated ones, are more cutthroat about timely payments than they used to be.
As with Progreso, the Holy Grail to profitability for Billfloat is getting its default rates down to a single digit. Like Gutierrez, Gilbert is banking on technology to create a risk model that accurately determines a borrower’s ability to pay. The company buys lots of alternative data showing everything from lawsuit settlements to vehicle ownership. “We’re taking the slow-grow approach rather than expanding too quickly and making a lot of mistakes,” he says. “If we can drive down the defaults, we can save money.”
To date, the company has approved 2,000 loans. It keeps its loan agreements simple and doesn’t let clients take out more than one loan at a time. The company tries to promote budgeting for its clients. “Ultimately, we want to help consumers plan ahead and budget and not wait until the last minute to pay a bill because that costs more,” Gilbert says. Like Gutierrez, Gilbert is focused on rehabilitating clients into “prime” borrowers. Every time a borrower pays off a loan, it’s reported to the credit bureaus, which helps improve their credit scores. Gilbert would like to partner with other financial companies to provide traditional loans to these rehabilitated borrowers.
Companies like Billfloat bristle at being called payday lenders. Some consumer advocates point out that while the 36-percent annual percentage rate is more affordable than payday lenders, it’s still too high. Mohammed Yunus, a microcredit pioneer and Nobel Laureate, warns in a recent editorial in The New York Times against the commercialization of microfinance. He writes that it’s “been a terrible wrong turn for microfinance, and it indicates a worrying ‘mission drift’ in the motivation of those lending to the poor. Poverty should be eradicated, not seen as a money-making opportunity.”
Arjan Schutte says developing a fair business model is the only way to meet the growing subprime demand. Nonprofit microlenders, typically funded by charitable foundations and donors, will never be large enough to serve 60 million subprime borrowers. Schutte says a market-based solution that is profitable and self-sustaining is the most logical solution. “Nonprofit microlenders do wonderful work,” he says. “But I don’t think it’s acceptable to serve a thousand people. It needs to be a million or tens of millions to really make a difference.”
His investment firm is willing to take the long-term risk on companies like Progreso Financiero, but many venture capitalists want a quicker return on their money. There’s constant pressure on CEOs like Gutierrez to hike the APR and start raking in profits. “CEOs like James Gutierrez are damned if they do and damned if they don’t,” Schutte says.
Gutierrez seems determined to make his brand of payday lending work. In Texas, where he has a partnership with the Fiesta grocery chain, he has a total of seven kiosks in Houston and Dallas—nowhere near the 2,700 storefronts payday lenders have statewide. To become profitable, he’ll have to expand. He’s made 100,000 loans and says he’ll need to make a million to turn a profit.
He could charge more, but he won’t. He wants to prove that an affordable payday lending model can be self-sustaining. Thanks to the economic recession, he won’t lack for new customers. Gutierrez says Progreso Financiero could become profitable by the end of next year. Traditional lenders, no doubt, are watching. Can a more ethical payday lender make it in the cutthroat world of subprime lending? “I like to think so,” Gutierrez says.
This is the second article in an occasional series on the business of poverty.