When there’s too much month at the end of the money

Woman reading a book

Originally Published in American Banker

By Alan Kline

For one blackjack dealer at a Mississippi casino, responsible money management requires some clever strategy.

“Janice” earns about $26,000 a year, but her income can fluctuate significantly from one month to the next. She has a checking account, but cut her debit card in half and destroyed her checks the day they arrived in the mail.

She sees an ATM card as an invitation to withdraw money that she should be saving and fears paper checks would just encourage her to go to payday lenders in those weeks when she is struggling. Writing a check for them to cash on her next payday would be a tempting — yet all too temporary — solution to her stress.

“It’s like an addiction if you have a checking account,” Janice told the authors of “The Financial Diaries: How American Families Cope in a World of Uncertainty.”

Her machinations are increasingly common for many working-class Americans, and banks are starting to recognize that they could — and should — be doing more to help consumers deal with fluctuating incomes.

While products like overdraft protection can be a godsend in an emergency — maybe the water heater bursts or your child needs stitches — it is a costly form of credit for the many households that routinely use it to meet monthly expenses.

Just 18% of consumers with bank or credit union accounts pay a whopping 91% of the billions of dollars financial institutions collect in overdraft fees each year. Most of these heavy users earn less than $50,000 annually, yet 25% of them will lose the equivalent of one to two weeks’ pay to overdraft fees over the course of a year, according to research conducted by the Pew Charitable Trusts.

It is tempting to say that these repeat overdraft offenders simply need to get their spending in check, but the reality is far more complicated.

According to some estimates, as many as half the households in this country experience what economic researchers have deemed “income volatility,” meaning their incomes can go up or down by 25% or more from one month to the next. Most high-earning households can deal with these swings easily, but meeting monthly expenses is a constant challenge for the many millions of Americans working in low-wage fields such as retail and hospitality. It’s a problem that has worsened as well-paying manufacturing jobs have disappeared and been replaced by lower-paying jobs in the service sector and as the emergence of scheduling software has allowed employers to optimize staffing levels and reduce workers’ hours. The rise of the gig economy — think Uber, Lyft and TaskRabbit — is only contributing to this volatility.

“It’s not a matter of people living beyond their means,” said Nick Bourke, Pew’s director of consumer finance, explaining what he sees as the key driver behind consumers’ use of overdraft protection. “It’s more of a mismatch of when they are getting their hours and when expenses are coming due. Even if they are making decent money, $15 to $20 an hour, if they are down 10 or 15 hours in any given pay period, that leaves a pretty wide gap.”

Economists point to erratic work hours as the chief cause of income volatility and those who study the issue expect the percentage of households experiencing these wide monthly swings to increase over the next decade. The challenge for financial services companies is coming up with the right products and services that can best serve this growing segment of the population.

“We know income volatility is a problem,” said Colleen Briggs, the executive director for community innovation in JPMorgan Chase’s office of corporate responsibility. “The question is, what can we do about it?”

The issue is top of mind at JPMorgan Chase, which over the last several years has established a think tank to study such things as income and expense volatility within its own customer base. The company also created an innovation lab, in partnership with the Center for Financial Services Innovation, that is dedicated to developing products to help consumers better withstand income and expense shocks.

The lab has provided funding and other assistance to 18 fintech startups over the last two years. Among the most successful is Digit, a San Francisco firm that helps users build savings by connecting to their checking accounts and applying algorithms to determine how much can be safely withdrawn from accounts on a daily basis. Since its launch in 2014, Digit’s mostly millennial users have saved more than $350 million.

Income volatility is also top of mind at KeyCorp, which has a suite of products designed to help customers achieve financial stability. These include a small-dollar loan that it bills as a safer alternative to payday loans and a “hassle-free” checking account that charges no monthly fee, does not require a minimum balance and prevents customers from spending what they don’t have by prohibiting debit overdrafts and eliminating paper checks.

Checks “are where most people get into trouble with overdrafts,” said Bruce Murphy, a longtime retail banking executive at Key who now heads its office of corporate responsibility.

Key also has an overdraft-protection product, tied to its more traditional checking account, that is seen as far more consumer-friendly than what most other banks offer. While other banks charge around $30 per overdraft, Key’s fee is 10% of the overdraft amount and will never exceed $10 per overdraft or $100 in a given month. Moreover, while most banks require that the overdraft be paid in full once the account is replenished, Key gives its customers the option of paying off the overdraft plus accumulated fees over time, as they would any other installment loan.

Key’s philosophy is that, with the right level of patience and commitment, banks can responsibly serve this customer segment and make money doing so. Its hassle-free checking, which rolled out in 2014, has been particularly effective in acquiring customers who have then gone on to use Key’s other products and services, Murphy said.

“Our approach to serving this segment was that it was a business decision, and not about getting Community Reinvestment Act credit or keeping the consumer advocates away,” Murphy said. “The leadership in the company didn’t say, ‘I need the return on this product to be “X” in order to keep investing in it.’ They gave us time collectively to continue to build a strategy.”

Still, there is a broad agreement — among bankers, regulators, fintech providers, economists and consumer advocates — that the mainstream financial industry can be doing more to improve the financial health of the millions of households that are largely living paycheck to paycheck.

Most of these households are not unbanked or even underbanked — they have checking accounts and credit cards and may even have some retirement savings. But they still live under a constant financial strain, and many credit products that they might use to help ease this strain can do more harm than good.

Payday loans can be a debt trap. Overdraft fees can quickly pile up. Even credit cards, which seem designed for ups and downs in cash flow, are flawed because they too often let customers borrow more than they can safely pay back, said Rachel Schneider, a senior vice president at the Center for Financial Services Innovation and co-author of “The Financial Diaries.”

Schneider and her research team spent a year studying the financial lives of more than 200 households and witnessed example after example of households struggling to pay the bills while still gallantly trying to build savings buffers or avoid taking on high-cost debt.

Apart from shredding her ATM card and paper checks, Janice, the Mississippi blackjack dealer, made it hard on herself to use savings for everyday expenses by keeping her money at a bank an hour from her home. Another participant, trying to save up enough money to move into his own apartment, kept himself on track by giving a portion of his paycheck to his frugal mother, who kept the funds locked away.

“While the U.S. financial services marketplace is large, its products and services are typically tailored to wealthier Americans and often geared toward helping families make big decisions about financial planning and investing,” Schneider and her co-author, Jonathan Morduch, a professor of public policy and economics at New York University, write at the conclusion of their book. “The marketplace for services to help struggling families balance their needs for now, soon and later — with better ways to save, spend, borrow and plan — is growing and improving, but still insufficient. We need new products and policies designed to benefit lower- and middle-class families.”

In an interview, Schneider explained why mainstream savings products are not really designed for families of modest means.

“The 401(k) is a terrific product for saving for retirement … but it doesn’t acknowledge people’s need to save for the near term,” Schneider said. “There are huge penalties for taking money out.”

Traditional bank savings accounts have no limits on withdrawals, “and that makes them insufficient in terms of providing discipline for people about how to save,” she said. “So we have this weird mismatch in which there’s too much structure around long-term savings products and not enough around saving for the near term.”

This is not to say banks are uninterested in their customers’ financial health; lots of banks offer financial education in partnership with firms like EverFi and Operation Hope or encourage saving and investing through one-on-one coaching or digital personal financial management tools. Low-balance alerts and tools to track spending also are embedded into many banks’ mobile banking apps.

But “knowledge alone is not going to solve this problem,” said Briggs at JPMorgan. “People need relevant, engaging information paired with products that are actually going to meet their needs.”

Briggs points to startups like Digit and Even, both graduates of JPMorgan Chase’s innovation lab, as examples of fintech firms that are helping low- and moderate-income consumers deal with cash-flow shortfalls.

Digit works to help its users build savings, while Even, of Oakland, Calif., provides hourly workers whose incomes tend to fluctuate with steady weekly paychecks. People tell Even how much they need to live on each week and, for a fee of about $3 a week, Even will be sure they hit the target. If it’s a down week, Even will dip into a savings pool to smooth the person’s income, and if it’s a good week, Even will bank the surplus to use at a later date.

It’s a challenging business model to be sure, but Briggs said that if Even gains enough traction, she could envision businesses offering it as a benefit to employees or perhaps even financial institutions offering it as a service to customers.

Similarly, SafetyNet, a startup in Madison, Wis., is offering cash-flow insurance to help primarily low-income or part-time workers cope with job loss or disability.

For a low monthly fee, policyholders receive a lump payment of cash should they lose their jobs or are unable to work due to injury or illness. That’s version 1.0.

Version 2.0, currently in development, will provide insurance for unexpected expenses, like a busted carburetor, that might not be covered by traditional auto insurance, said Mark Greene, SafetyNet’s director of innovation, business strategy and development.

SafetyNet is a division of CUNA Mutual, a for-profit company that develops products for credit unions. Its policies are currently offered in only two states, Wisconsin and Iowa, largely because private unemployment insurance is virtually unheard of, so most state regulators don’t yet know what to make of it, Greene said.

Still, it’s another example of how nontraditional financial firms are thinking of new ways to serve cash-strapped consumers. “Our mission is to help people with cash-flow challenges and solve paycheck-to-paycheck living,” Greene said.

In a perfect world, consumers would deal with monthly dips in their income by setting aside a portion of the income they received in those higher-earning months, and many small-business owners or high-earning contract or commissioned workers will do just that.

But that can be a huge challenge for lower-income workers, particularly if, say, a big medical expense comes due in a month when income is down 25% or more. As Fiona Greig, the director of consumer research at the JPMorgan Chase Institute, put it, “fluctuations in income and expense don’t often move in tandem.”

Greig has studied both income and expense volatility by tracking the transactions of some 250,000 JPMorgan Chase account holders. In its income research, the institute found that 55% of customers experienced at least a 30% fluctuation in income from month to month, due mostly to irregular work hours.

“That’s like adding or subtracting a housing payment,” Greig said. “People need a substantial everyday buffer to withstand that kind of volatility.”

Household expenses can be volatile too. Almost four in 10 households experience an “extraordinary payment” each year — usually a medical bill or major car repair — and in its research the institute found that many had not recovered from that financial shock a year later, Greig said.

“Their liquid assets were still down 2% … and revolving credit card debt was still elevated by 9% compared to baseline levels,” she said.

Throw in stagnating wages and housing costs that are consuming an increasingly larger percentage of household incomes and it is no wonder that, according to a recent Federal Reserve study, 53% of U.S. households could not easily come up with $400 to cover an unexpected expense. Though 38% said they could find the money by borrowing or selling something, nearly 15% said they could not come up with the money at all.

Digit founder and Chief Executive Ethan Bloch said that roughly 40% of its customers are just getting by on their paycheck and another 20% are spending more than they make. By and large they are saving not for big purchases, he said, but rather “to make ends meet in a tight month.” On average customers save $100 a month and typically draw down their Digit accounts after three months before building them up again.

Bloch said he has been obsessed with finance since he was 13 and “day trading my bar mitzvah money,” but as he was building the business plan for Digit he came to realize that finances are dizzying to most people. He believes now that if banks really want to encourage consumers to save more, then they need to do it for them.

“Most people’s brains aren’t wired for this complex financial world we’ve created around us, and people need a sidekick to help them wade through all of that complexity,” Bloch said. “The beautiful thing is now that most of finance is digital, we can do that. Our customers sign up, they connect to an existing checking account and they go back to living their lives.”

Digit uses machine learning to determine the optimal amount it can pull from a person’s checking account and move into savings each day. Users also can set their own savings goals simply by sending Digit a text message. The company gets its income from keeping the interest that accumulates on the savings.

Mainstream banks seem content, for now, to let fintechs lead the way in developing products to help consumers cope with financial instability. Even JPMorgan Chase’s innovation lab is focused on nurturing startups rather than developing products internally.

“Financial insecurity is a huge issue and we need all the best minds in the country thinking about it,” Briggs said. “That’s what the lab is trying to do.”

Still, Bloch said banks are eagerly watching and learning from Digit and other startups that are helping consumers more easily build savings buffers or extending credit to those who are maxed out on credit cards. “They get to see what we do and potentially pick the best ideas without having to do their own internal research and development,” Bloch said.

Regulators are looking to encourage more of this type of innovation through the creation of a special fintech charter.

Fintech innovations are already giving consumers “greater control over their financial lives,” Comptroller of the Currency Thomas Curry said at an industry conference in New York in March at which he outlined his vision for a fintech charter. “Consumers have been empowered with more responsive and automated tools that support payments, promote savings, smooth income volatility and provide personalized credit solutions that satisfy their lifestyle and needs. …

“It’s likely that we have just scratched the surface, and the future holds further promise because we are at the beginning of this innovation cycle.”

Pew’s Bourke, though, says the answer is to not to create a new charter but rather to modify existing bank regulation in such a way that it encourages more innovation in areas like overdraft protection and small-dollar lending.

Many banks won’t make small installment loans, for example, because they involve too much paperwork to be worth the effort. Most of that paperwork is around complying with consumer protection laws, which is important, but there “needs to be a sense of proportionality,” Bourke said.

“Smaller loans that have clear safety standards put in place by regulators shouldn’t need a ton of paperwork associated with them,” Bourke said. “Streamlining the origination process would save the banks money and lower their regulatory risk.”

Bourke pointed to Kinecta Federal Credit Union’s small-dollar loan product as one that banks, with the blessing of their regulators, should strive to emulate.

Southern California-based Kinecta began offering loans of up to $2,500 in 2013 primarily as a way to help members and nonmembers alike pay down high-cost debt, and it has since expanded the program to allow borrowing for other purposes. Loans can be approved and funded within 20 minutes, rates are capped at 18%, the minimum payment is set at a manageable 5% of outstanding principal and borrowers do not incur a fee for paying the loan off early.

The program was a money-loser at first, but Luis Peralta, Kinecta’s chief administrative officer, said the credit union stuck with it because too many of its members and people in its communities were turning to payday lenders, pawnshops and auto title lenders when they needed help meeting monthly expenses. Today, the program is profitable — thanks primarily to an investment in new credit underwriting software — and, more important, many of the borrowers are on more stable financial footing.

Fewer than 10% of the borrowers have returned to payday lenders and the average borrower’s credit score has increased by 150 points, Peralta said. Some are even starting to get loan and credit card offers from other financial services providers, “but we hope they prefer Kinecta because we were there to help them when they needed it,” he said.

Bourke said he would like to see more bankers thinking that way.

“Why would they sit there and watch them walk out the door to payday or auto title lenders,” he asked, “when they could be adding on a service, building a relationship and profiting from it?”