By Peter Bergman (MoneyAmped.com)
Payday loan providers are often portrayed as antagonistic because they charge exorbitant interest rates to individuals, making it difficult for borrowers who depend on their regular income to repay the loan. According to studies, traditional banks also use fees to penalize consumers, which negatively affects low-income people.
Banks Are Prioritizing the Withdrawal of Larger Amounts of Money
In light of the consideration of overdraft fees during the financial crisis more than a decade ago, some banks continue to adopt the practice of reordering current account debits, favoring larger withdrawals over earlier debits. According to a study conducted by Harvard Business School researchers, this approach leads banks to charge not one but many overdraft fees. This can significantly reduce funds for people already struggling financially, especially with current inflation, further reducing their purchasing power.
“People Think Current Accounts Are Easy and They Won’t Get Scammed.”
According to Marco Di Maggio, Assistant Professor of Business Administration at HBS, Marco Ogunlesi, there is a common misconception about current accounts. It is often believed that these financial products are uncomplicated and have no negative impact on the individual. Overdraft fees can be seen as a form of credit. The credit organization allocates funds for a short period. This escapes the attention of the regulator.
Consider a hypothetical checking account with a balance of $400. Several debits have been made, with the bank initially favoring the most significant transaction, a $500 condo payment. In such cases, a $35 overdraft fee is charged. Two $50 checks received before the more extensive check are subsequently processed, resulting in a shortage of funds and an additional $70 overdraft charge to the account.
Banks Are Closing the Accounts of Non-paying Customers
Failure to comply with cumulative fees can result in the bank terminating the account, leaving an indelible mark on the consumer’s financial history with possible long-term consequences. ChexSystems, a well-known agency used by financial institutions to collect information on consumers, has recorded cases of banks closing accounts, usually when customers cannot repay debts, including overdrafts, within two months. The existence of a black mark can limit a consumer’s access to alternative banking options for up to five years, according to the authors. This restriction prevents customers from obtaining loans, writing checks, and using convenient banking services such as debit cards and direct deposits.
The researchers suggest that the potential in question encourages some people with limited financial resources to reimburse the financial institution through high-interest loans from payday lending institutions. However, this scenario can lead to an individual becoming cyclically dependent on financial obligations.
Overdraft fees can lead to significantly higher costs compared to payday loans. Banks are traditionally perceived as profitable organizations, while payday lenders are often associated with less favorable connotations,” says Williams. The case is not clear-cut as it first appears. Financial institutions in this context resemble antagonistic figures.
Prioritizing the ordering of banknotes by importance is prioritizing large bills, generally considered more important in the system.
Overdraft Fees as a Major Part of Banks’ Revenues
However, financial institutions also benefit from this activity. According to researchers at Moebs Services, overdraft fees accounted for a significant portion of banks’ revenue in 2018 – $33 billion. These fees also accounted for two-thirds of deposit account fees earned by banks. According to a Pew Charitable Trusts report, as of 2016, approximately 50% of the 50 largest banks used a high-to-low deposit organization system.
Banks are traditionally perceived as positive organizations while lending institutions are often associated with negative connotations.
According to the authors, it is worth noting that about 25 percent of households in the U.S. are categorized as unbanked or underbanked, according to 2017 data from the Federal Deposit Insurance Corporation. According to the FDIC, unbanked individuals often express concern about exorbitant bank fees. Based on the available data, lower-income individuals incur costs three times higher than others when maintaining their checking accounts.
Consumers’ Financial Situation Improves When Fees Disappear
The study analyzed the relationship between high- and low-income streamlining practices and payday lending, revealing a clear and direct link.
Data was obtained from Clarity Services, an alternative credit bureau with a significant user base of approximately 1 million people accessing payday lenders. In addition, data were obtained from Equifax, a well-known consumer credit bureau that provides information on installment loans targeted explicitly to low-income borrowers. The data were supplemented with manually collected information on lawsuits against re-sorting high-to-low transactions, eventually leading to a ban on the practice at 23 financial institutions.
According to the researchers’ observations, the cessation of high-to-low practices due to lawsuits resulted in favorable consequences for consumers. Following the regulatory action, there was a notable 16% decline in the use of payday loans, averaging about $84 per borrower per quarter. There was also a 6% decline in installment loans, which the researchers found resulted in a reduction of about $200 per borrower.
Consumers’ overall financial health improved. There was a marked increase of about $431 in the balances of favorable borrowers after the ban on high-to-low installment loans was enacted. At the same time, credit card limits increased by $190, and the FICO score increased significantly. The above results suggest that overdraft practices by financial institutions can have severe consequences for people who rely on regular income to cover expenses.
According to the Federal Deposit Insurance Corporation (FDIC), about 14% of customers with accounts at financial institutions experience five or more overdrafts in a year. Researchers estimate that a significant number of customers, about 4.2 million, have experienced positive outcomes due to the bans. Banks sued to stop overdrafting have seen a marked reduction in overdraft fee revenues, amounting to approximately $1.3 billion annually. Subsequently, the researchers estimated this result saved roughly $330 per customer.
The report emphasizes the importance of researching one’s financial institution and carefully evaluating associated fees to understand financial obligations fully.
One of the unintended results of the ban is that after traditional banks were ordered to stop using the high-to-low methodology, branches are often closed in low-income neighborhoods, the study shows. This finding means that such fees play an important role in incentivizing banks to target the underserved segment of the market.
What Steps Customers Can Take To Protect Their Interests
Individuals must be well-informed about their financial institution’s policies regarding overdraft fees, including the specific methods and timing of charging them.
According to DiMaggio, municipal financial institutions have similar practices in place. Regarding financial operations, overdraft fees could likely represent a significant portion of their overall revenue. The proposal suggests looking at the credit union as an alternative to Wells Fargo rather than a personal recommendation. Communication involves:
- Learning about one’s financial institution.
- Evaluating its associated fees.
- Fully understanding the resulting obligations.
The researchers believe banks should look for alternative ways to generate revenue rather than imposing excessive checking account fees on low-income individuals. According to Williams, the recommended approach is to shift their focus to cost-cutting.
In addition, policymakers are advised to scrutinize the financial services that best meet the needs of low-income people rather than actively advocating for universal inclusion in the traditional banking system, as the authors suggest.
According to Williams, the policy interventions that may produce the most effective results in helping such consumers would not necessarily be to force people into wholesale banking services.
