> Posted by Sonja E. Kelly, Fellow, CFI
We’ve talked in this blog about on-ramps to financial inclusion—the services that get new people into formal financial services, build trust between clients and providers, and establish new financial habits in the lives of individuals. Here’s one example, for one group of potential new customers.
Payroll loans in Latin America were recently called “the coffee date” of financial inclusion by The Wall Street Journal because they’re a relatively low-risk way to let both parties—the client and the financial institution—decide how and whether to continue the relationship.
Payroll loans are disbursed by a bank to a consumer and then automatically repaid through deductions from an individual’s paycheck. Such loans are a natural fit in a formal employment setting, especially if payroll is handled through direct deposit in a bank.
Payroll loans are a convenient way to take advantage of an institutional structure in which employees already have a bank account. They yield a much higher repayment rate than credit cards. They allow individuals to establish a credit history with a small principle and small transactions. It is no wonder that payroll loans increased 16.5 percent last year in Brazil to become an $88 billion market, and 32 percent in Mexico to become a $9 billion market.
At the Center, our vision of financial inclusion includes convenience, choice, and affordability. Here’s where we see payroll loans as perhaps a good on-ramp, but not necessarily a final destination. While payroll loans are convenient because they use the same institution through which clients are already receiving paychecks, they rarely offer a choice of lender. The system does not foster a competitive marketplace for consumers. Banks may have a greater incentive to court employers than individuals. This incentive structure may bring up questions of consumer protection. Does the bank have the best interest of the consumer or the employer in mind?
Another question concerns affordability. Since payroll loans have a higher repayment rate than credit cards (97 percent vs. 95 percent), one might expect them to carry a lower interest rate. In Mexico, however, payroll loans and credit card rates, at about 35 percent per annum, are roughly equivalent.
Even the best coffee dates are seldom the basis for a long-term relationship, so the real question is whether employees whose first experience with credit is through payroll loans actually do build a credit history that they can use to access more services over time.
And as a final note, while we can celebrate the existence of an on-ramp for people with formal sector employment, it is also true that in Mexico, over 60 percent of all households operate in the informal sector, beyond the reach of payroll loans. Is anyone asking those folks out for coffee?
Image Credit: Hatch Collaborative
Have you read?
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