Are banks the ‘bad guys’? Overdraft fees are crushing low-income customers

Payday lenders have long been portrayed as villains for charging consumers sky-high interest rates, leaving borrowers living paycheck to paycheck struggling to repay loans. But conventional banks are equally guilty of using fees to penalize consumers, hurting low-income customers the most, research shows.

Despite scrutiny of overdraft fees during the financial crisis more than a decade ago, some banks still reorder debits from checking accounts so that the largest amounts, rather than the earliest recorded debits, are withdrawn first. Researchers at Harvard Business School found that this practice can result in banks charging consumers with multiple overdraft fees instead of just one, draining a significant amount of cash from people living on the edge of their means. a time when inflation is further reducing your purchasing power.

“The misconception is that checking accounts are commodities that don’t screw people over.”

“The misconception is that checking accounts are vanilla products that don’t screw people over,” says Marco Di Maggio, the Ogunlesi family associate professor of business administration at HBS. “Well, overdraft fees are a form of credit. The bank is lending you money for a very, very short time. That, I think, escaped the regulatory net.”

Imagine a checking account with $400. A bunch of debits are posted, with the bank passing the biggest one first, a $500 rental check. That triggers a $35 overdraft fee. Two checks for $50, which technically arrived before the larger check, then go through, bounce, and charge the account another $70 in overdraft fees.

Failure to pay those multiplier fees can lead the bank to close accounts, a stain on a consumer’s record that can have lasting ramifications. ChexSystems, the main consumer reporting agency used by banks, records when a bank closes accounts, which often happens if a customer doesn’t pay overdraft fees and other outstanding balances for two months. That black mark can prevent a consumer from opening a bank account elsewhere for up to five years, the authors write, limiting a customer’s ability to obtain credit, write checks, or use convenient banking products and services such as debit cards. and direct deposit.

This possibility induces some low-income clients to pay the bank with high-interest loans of payday lenders, the researchers suggest. But that can mean getting caught in a downward spiral of debt.

Di Maggio examines the practice, known as “largest-to-smallest ordering,” with HBS assistant professor Emily Williams and doctoral student Angela Ma in a working paper titled In red: overdrafts, payday loans, and the unbanked.

“Overdraft fees can be much more expensive than even payday loans. We always think of banks as the good guys and payday lenders as the bad guys,” says Williams. “We’re saying it’s not as simple as that. The banks are a bit like the bad guys here.”

Banks make billions from overdraft fee

The bank’s logic for ordering from largest to smallest is that the largest bills, which are often more important, are paid first according to the system.

But banks also reap the rewards. In 2018, overdraft fees accounted for $33 billion of bank revenue and two-thirds of deposit account fees earned by banks, the researchers say, citing data from Moebs Services. About half of the 50 largest banks organized deposits in order of largest to smallest as of 2016, according to a report by Pew Charitable Trusts.

“We always think of banks as the good guys and payday lenders as the bad guys.”

At least a quarter of US households are classified as unbanked or underbanked, the authors note, citing 2017 figures of the Federal Deposit Insurance Corporation. Consumers without bank accounts often say bank fees are too high, according to the FDIC. In fact, the data suggests that low-income people pay three times what everyone else pays just to maintain their checking accounts.

When fees end, consumers’ financial health improves

The researchers looked at the link between high-low orders and payday lenders and found a direct relationship between the two.

They compiled data from alternative credit bureau Clarity Services, which covers 1 million people who use lenders as payday services, and data from Equifax, a major consumer credit bureau that offers information on installment loans for borrowers from low income. They supplemented that data with hand-collected information on lawsuits against top-to-bottom realignment that ultimately led to a ban on the practice at 23 banks.

The researchers found that when lawsuits forced banks to stop the practice from high to low, consumers benefited. After the bans, payday loans fell 16 percent, or about $84 per borrower per quarter. Installment loans fell 6 percent, or about $200 per borrower, the researchers found.

The general financial health of consumers also improved. Two years after the high-to-low reordering bans, borrowers’ current balances increased by approximately $431, credit card limits increased by $190, and their FICO scores rose significantly. These findings suggest that overdraft practices implemented by banks could have serious consequences for consumers who live paycheck to paycheck.

About 14 percent of bank customers incur five or more overdraft fees a year, according to the FDIC. The researchers estimate that 4.2 million customers have benefited from the bans. The defendant banks that had to stop reordering from high to low saw overdraft revenue decline by $1.3 billion per year, which has translated to $330 in savings per customer, the researchers estimate.

“The message is: ‘Check your individual bank and look at the fees, and make sure you know what you’re getting into.'”

One unintended consequence of the ban is that once traditional banks are ordered to stop using the large-to-small practice, they often close branches in neighborhoods where low-income people live, research shows. This finding suggests that these fees are somewhat necessary to make it worthwhile for banks to serve this less affluent segment of the market.

How consumers can protect themselves

For consumers, the message is clear: make sure you know your bank’s policy on how and when overdraft fees are charged.

“Community banks do this too,” says Di Maggio. “If anything, overdraft fees could represent a larger portion of your total income. So the message is not, ‘You should go to your credit union instead of Wells Fargo.’ The message is: ‘Check your individual bank and look at the fees, and make sure you know what you’re getting into.'”

Banks should find other ways to make a profit instead of charging exorbitant fees on low-income checking accounts, the researchers say. Instead, they should “focus on lowering their costs,” Williams says.

In addition, policymakers should take a closer look at which financial services best serve the needs of low-income consumers, rather than striving to get everyone into the mainstream banking system, the authors suggest.

“A blanket push for people to bank may not be the most effective policy response to help these consumers,” says Williams.

Comments or ideas to share? Email the Working Knowledge team at [email protected]

Image: Unsplash/Eric Muhr

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