CFPB’s Next Target: Subprime Credit Cards

If the topic is consumer protection, alternative financial services or financial inclusion, one thing is certain: At some point or another, the term “subprime borrowers” is going to come up in the conversation.

How to help them, how to protect them from the predations of rapacious lenders and card issuers, how to limit their numbers, how to better educate them about credit scores, how to better predict what they will do when they borrow and how to prevent lending to them from accidentally destroying the entire world’s economy again. These questions are now a primary pastime of regulators, editorial writers, entrepreneurs and mainstream financial services players.

Which makes it rather odd that two fairly elemental questions in this discussion are often left pretty hazy.

Question 1: What exactly constitutes a subprime borrower?

The sort of classic definition is a consumer with a FICO score of 699 or less, but over the last two decades, there has been some rather spirited argument about whether that bar is too high. An oft-used alternate definition is a FICO score of 629 or below, as 630 is the magic number for purchase of mortgage-backed securities issued by government-sponsored enterprises, such as Ginnie Mae, Fannie Mae or Freddie Mac. Equifax’s magic number for prime lending is 660.

The picture is further clouded by the fact that there is in increasingly loud and convincing contingent of voices that maintain the FICO standard is an outdated credit ranking system that does a particularly bad job of evaluating subprime applicants.

The answer, in this case, seems to be hazy, though it seems worth noting that the CFPB defines a borrower with a score below 700 as subprime and a score below 500 as deep subprime.

Question 2: How many U.S. consumers are subprime borrowers?

Hard stats are hard to come by. According to Credit Sesame‘s latest count, the simple answer to that question is a lot. The average American credit score is subprime by all counts — 604. Among the four states with the best ratings — Massachusetts, Hawaii, Washington and New York — only two broke 630 (MA-636, HI-632).

To get averages north of 700, one has to break it down by zip code and city. The big winners’ list will not surprise anyone with any passing familiarity with where the most affluent parts of the United States are: Mountain View (748), Sunnyvale (730), Gramercy Park (720), Seattle (719), Brooklyn Heights (716) and San Francisco (707).

But Credit Sesame uses the VantageScore system instead of FICO, which tends to trend a little lower. Adjusted for that difference, the average American credit score is almost 630, which still falls short of prime.

FICO is a bit more positive on this subject. According to its figures, only about 45 percent of Americans have FICO scores below 700, and only about third have a score below 650.

However, FICO does not count dormant credit reports toward those averages, which means it tends to select for higher scores, as consumers with scores below 650 are more likely to stop utilizing credit products and thus fall out of the rankings.

Why Does This Matter?

Those two very basic questions — and the fact that they aren’t explicitly called out very often — leads to a very specific conflation problem, demonstrated by The Atlantic, about the CFPB’s year-end report on the consumer credit market.

The Atlantic headline:

“The Unfair Opacity of Credit Cards Peddled to the Poor”

The lede:

“When a company takes on the task of providing financial services to people overlooked by large banks, that would seem to be a good thing: Such customers need bank accounts, debit cards and credit, just like everyone else.

In 2013, nearly 10 million American households didn’t have any interaction with a bank, and nearly 25 million households had bank accounts but used alternative financing options (such as prepaid debit cards, alternative credit cards or payday loans) to make ends meet.”

The problem:

The Atlantic is writing about four different groups of people in the United States like they are all the same group — the 11 million unbanked, the 25 million underbanked, the 46.7 million American adults living below the poverty line and the 101 million to 138 million subprime borrowers in the U.S. There may be overlap there, but given that the first group is 10 times smaller than the last group, using the terms subprime, poor and un/underbanked interchangeably is a little misleading.

But it is not uncommon. And while it is easy pick on The Atlantic, it is a conclusion that is easy to take away from its source material, which also writes about subprime borrowers and underprivileged borrowers interchangeably as it identifies the problems with subprime card issuing. It also doesn’t offer a definition of subprime borrower past a footnote that says it is “consistent with previous definitions” and, at no point, distinguishes between subprime and deep subprime in the report — other than to note that there is a range of scores represented by the classification.

The report does note some specific evidence that low-income borrowers are being specifically targeted by subprime card issuers via paper mailings that offer pre-approval, but the report also notes that such mailings are still a common facet of marketing and customer acquisition throughout the credit card industry. A clear pattern of targeting may be noticeable in the future, according to the CFPB, if mainstream credit products continue their march toward digitally based customer acquisition, while subprime players continue to focus heavily on paper mailings.

The obvious question is asked by The Atlantic in its lede as well: If subprime borrowers are getting more access to credit, isn’t that a good thing, even if they are being targeted by the marketing departments of those lenders?

Not so much, according to the CFPB, if those subprime customers are getting a bum deal.

The Problem With Subprime Credit

Unsurprisingly, the CFPB does not think those subprime customers are getting a very good deal from those issuers and run the risk of getting an out-and-out terrible one.

The difference, according to the regulatory watchdog group, is the structure of the card agreements, which are often quite a bit more complicated and expensive on the front end than those issued by mainstream issuers.

Monthly account fees, sign-up fees. These are all far more common to the profit structure of subprime lenders than their mainstream counterparts (who CFPB data indicates rely far more on good, old-fashioned late fees). The CFPB notes these are all expenses that are essentially baked into the cost of the card for the consumer, meaning no matter how religiously they pay off their balance (and thus avoid interest payments, which are also usually quite a bit higher on subprime-focused cards), they will always be paying a high premium for card ownership.

Worse, notes the report, consumers who use their card and pay a portion of their balance can soon find themselves trapped in the sort of debt cycles more common to payday lending, where monthly payments are quickly eaten up by debt service and fees, thus creating card bills that are impossible to pay down.

The cherry on the problematic cake, the CFPB notes, is the aforementioned way the material is targeted and the unnecessarily baroque terms the deals are spelled out in.

“Despite offering longer and more complex credit card terms than mass market issuers, they send those mailings disproportionately [sic] to consumers with lower levels of formal education,” the CFPB report found. “Specifically, agreements for credit card products marketed primarily by subprime specialist issuers are particularly difficult to read.”

The report notes the CFPB will be looking into the matter more closely in 2016 to see if additional regulation needs to be placed on lenders to reign in subprime lenders, particularly around charging fees.

Restricting Access

“The problem is the non-sinister explanation for this is that lending products for subprime, and particularly deep subprime, consumers are somewhat more complex because of risk issues,” Boston-based consumer advocate Claire Miller noted.

“Predators exist, but there is a concern about access, particularly as we are trying to move consumers away from payday lending products.”

Payday lending, Miller noted, is a much more expensive form of money than any subprime credit card is issuing and “about a thousand times more likely to yield debt cycles of the kind we worry about.”

Credit cards, she noted, have the tendency to improve customer credit ratings when used properly, whereas prepaid and payday lending products usually do not.

“My goal is often to get consumers, particularly low-income, underbanked ones, away from payday lending products, and subprime credit cards, by and large, are excellent gateway products for that.”

Abuses, she said, need to be watched for, but in this case, even she worries that regulation might do more harm than good.

“I can’t move consumers into mainstream products if there aren’t sort of borderline mainstream products to act as a bridge.”

Solving the problems of subprime borrowers is an important but complicated area, mostly because it is both less specific and much larger than most people think it is. But it is an area that would be benefited greatly by two things.

One is specificity, as conflating one group with another then making policy for it probably isn’t helpful. The other is flexibility, or else it will just keep getting harder for subprime borrowers to become prime borrowers going forward.