NB Financial Innovation
How Small Savings Can Replace Small Borrowing: A well-designed savings product can help low-income consumers avoid costly short-term credit
Everyone is taught that it’s good to save money for a rainy day. And for people with low incomes, “rainy days” – due to everything from costly health issues or car repairs to sudden unemployment – come a lot more often. But for a number of reasons, low-income people often struggle to save, leading them to turn to more expensive options like high-interest payday loans.
That’s why recent research from Doorways to Dreams (D2D) is so exciting – it shows that a well-designed savings product can dramatically help low-income consumers reduce their reliance on costly short-term credit.
In 2011, prepaid provider BankingUp (formerly Plastyc) partnered with D2D, a Boston-based nonprofit, to design a savings feature for their UPside prepaid card called the “Rainy Day Reserve” (RDR)*. Prepaid cards are widely used by underserved consumers as alternatives to traditional banks and credit cards. They are reloadable debit cards, and can be reloaded with direct deposits from paychecks. During the first seven months of the pilot, D2D analyzed how cardholders used the savings feature. The findings were recently published in a fascinating report available here.
D2D found that cardholders used the Rainy Day Reserve as a revolving savings account to smooth cash flow and manage expense shocks. Users regularly added money to the savings bucket and then withdrew these funds to meet short-term needs. Of the cardholders who withdrew money from the savings bucket; 52 percent used the money to pay monthly bills; 44 percent paid for weekly expenses; 46 percent paid for household emergencies; and 17 percent used the funds to help a friend or family member with a financial emergency. (People could report multiple reasons for withdrawals.)
However, after drawing down their savings, cardholders were generally able to rebuild it the following month – hence the revolving nature of the savings pocket.
Research suggests that this kind of product could serve the same function as short-term credit for many consumers. A 2012 CFSI study of small-dollar credit users found that the top three reasons people borrowed were to manage living expenses that consistently exceeded income, to pay a bill that came due before a paycheck, and to cover unexpected events such as emergencies or drops in income. The savers in D2D’s study had precisely the same needs as the small-dollar credit users in CFSI’s study, but they were able to avoid payday loans and other forms of costly short-term credit because they had a reserve of savings to fall back on.
D2D found exactly this: Of the RDR users who had previously relied on alternative financial services, 40 percent relied less on payday loans; 25 percent on pawnshops; 17 percent on check cashers; and 12 percent on cash for gold. Instead of seeking out expensive short-term credit, these cardholders were able to dip into their savings to cover both the expected and unexpected expenses that arose throughout the month.
While the individuals in D2D’s study did not significantly increase their net savings over time (the average balance in each account at the end of the study was slightly over $52), the study demonstrates how a savings bucket tied to a prepaid card can help people build a financial cushion that can be used to address needs otherwise served by credit. While we may wish that the RDR users had been able to build up a larger reserve of savings, it’s important to acknowledge how valuable even a modest reserve of emergency savings can be for people struggling to lead financially stable lives. The success of this pilot and others suggests that tying savings accounts to prepaid cards and other transaction vehicles holds real potential for improving the financial lives of underserved consumers.
* Full disclosure: BankingUp is a portfolio company of CFSI’s strategic partner Core Innovation Capital, and D2D is a previous CFSI grantee.
Thea Garon is a Research Analyst, Insights and Analytics at the Center for Financial Services Innovation.
Editor’s Note: This post was originally published on CFSI’s blog. It was adapted and cross-posted with permission.
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