Startups raise $4B to serve those left behind by the big banks

Personal Loans and Installment Loans

Personal loans have become more popular as lending has moved online. Most consumers use personal loans to consolidate high-interest debt, such as that from unpaid credit card balances, or to pay for unforeseen expenses, such as medical bills. Similarly to credit cards, consumers generally need to have at least fair credit and a Social Security number to qualify for a loan. Until recently, consumers who lacked these things were generally out of luck when it came to getting a personal loan.

However, numerous companies have now cropped up to address these issues—in fact, we found more than 10 companies that offer installment or payday-type loans to underbanked or subprime consumers. These companies have also attracted the interest of venture capitalists, raising almost $4 billion in both equity and debt funding to date.

Some of the companies offer vanilla personal loans in the same vein as a bank or credit union would. Others offer loan products that are more similar to payday loans with small-dollar loan amounts, short terms and exorbitant interest rates. LendUp, for instance, advertises APRs as high as 1,300% on its loans of up to $250 for up to 31-day terms. These loans are an online version of a payday loan, and they’re no more helpful to consumers than a traditional payday loan. In fact, the Consumer Financial Protection Bureau (CFPB) estimates that 20% of payday borrowers end up defaulting. What’s more, the average borrower pays $185 in hidden costs, such as bank overdraft fees resulting from payday lenders debiting their bank accounts. This figure is on top of the fees that the payday lender charges for borrowing.

Borrowers should generally avoid loans with APRs in excess of 36%, which—in many states—is the legally allowed maximum rate on a personal loan. Rates above this are considered unaffordable and unmanageable for borrowers. If you can’t qualify for a loan with a rate under 36%, consider these alternatives first: Obtain financial assistance from a nonprofit or religious organization. Add a co-signer or collateral to your loan application. Borrow money from family or friends.

Banking and Prepaid Debit Cards

Many people find it difficult to fulfill the strict requirements for opening a traditional bank account. These underbanked consumers may have lower average balances or lack the documentation needed to take advantage of the banking system. Several of the companies we looked at focus on making critical banking services, like debit cards and electronic transfers, more affordable and accessible to the underbanked.

Based on recent investment trends, prepaid debit cards appeared to be the most popular alternative to traditional banking. While they aren’t technically bank accounts, prepaid debit cards can be used exactly like a debit card linked to a checking account. Users can make cash deposits at designated places to reload their prepaid balance, somewhat like a gift card. Other companies—such as the app, Dave—seek to provide tools that help people avoid the excessive penalties associated with overdrawing a traditional account balance.

Among the companies we looked at, five organizations have received a combined $36.6 million in funding for extending banking and prepaid debit services to underbanked users. This accounts for less than 1% of the total funding we tracked in the study, which covered investments going back to 2010. While it has attracted far less investment than the personal loan space, alternative banking services represent a significant area of potential growth—provided it can persuade a diverse set of consumers to adopt a new way of managing their money.

However, users should also be on the alert for companies that charge substantial amounts in service fees. While many of the prepaid debit cards we found charge no monthly fee—a common pain point among underbanked consumers—they do charge lesser fees each time you withdraw cash from an ATM or reload your balance. In the long term, these fees could end up costing prepaid cardholders as much or more than a carefully managed account with a standard bank.

According to the various service agreements we reviewed, the best way to avoid these extra fees was to use direct banking services such as direct deposit. However, such services aren’t entirely well-known to consumers who lack a traditional bank account.This results in something of a chicken-and-egg problem when it comes to eliminating the fees on these alternative financial products. And with only a few companies declaring underbanked audiences as their chief focus, it seems less likely that the industry would act to reduce its fee revenues by educating customers on practices like direct deposit.