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New RAL Model Emerging

Adam Rust's picture

Posted December 16, 2014

Several non-bank institutions are putting forth similar iterations of a new type of refund anticipation loan. The model, which on its face addresses many critiques of the classic RAL, is certain to challenge how we think about getting an advance on a tax refund.

It is safe to say that the historical RAL was troubled. When examined from a dollars and cents framework, the RAL was obviously attractive to banks seeking margins on deposits. True, there were liquidity issues, but a bank could always buy brokered deposits and then generate a lot of alpha in a short amount of time.  

But even if the business model of the classic RAL was profitable, it came with so much baggage that it was ultimately shut down by regulators. As a clear cut loan, banks were responsible for how thousands of non-bank employees were implementing required disclosures. There were other problems, too: the RAL seemed to attract fraudsters and bank regulators could be convinced that the model posed reputational risk.

The odd thing about it was the RAL was largely supported by the federal government. Those loans were usually made possible by the Internal Revenue Service's debt indicator. The DI allowed a bank to underwrite for potential claims on a refund. Likewise, most RAL consumers were taking loans on a refund that was made possible by a refundable tax credit. 

When the IRS pulled the debt indicator, banks re-designed a new version that put caps on loan amounts. The banks developed underwriting algorithms to protect their assets. It appeared that their quants were more than able to predict which loans would go bad. In fact, one of those banks was very public about their ability to create models that did a very good job of predicting loan performance. The banks claimed that they were able to demonstrate a loss rate  in the neighborhood of one percent. 

Resolution thus became a question of regulatory action. When two OCC-regulated banks withdrew from RALs, the FDIC became the only regulator of the remaining bank issuers. Soon thereafter, two dropped their tax loan programs voluntarily. Only one - Republic Bank of Kentucky - persisted. The FDIC pushed back and eventually the issue was settled. Bank RALs were a thing of the past. 

While a few non-banks began to offer iterations of the classic RAL in a few states, volume dropped. The liquidity required to disperse so much cash in only a few weeks created a demand for capital that the current non-bank preparers could not meet. 

A New Model

This year, however, several companies will be offering RALs as a service to smaller preparers. The services generate their cash flows from preparers and not from filers. Possibly because it creates a degree of safety against large losses, these non-banks put low ceilings on refund loan amounts. They are non-recourse, too, so non-bank lenders take all the risk. In some instances, the businesses may be using the opportunity as a low-cost means of finding customers for other products.

One example of company using this method is Refundo. Although Refundo has been around prior to this year, their product is still the "new, new thing." The Refundo product is marketed to preparers who want to offer a loan service as a means of increasing customer volume. The loan is capped at $500. As is the norm, it is a non-recourse loan, so if the refund doesn't happen, Refundo takes the loss. Refundo charges a fee for each bank product. There is a stipulation in the contract between Refundo and a preparer that any filer opting for a refund must not be charged an extra fee. From the perspective of the consumer, the advance has no fees and no interest. It is a zero-cost product.

News of similar products offered at other companies has come across my desk recently. The others are basically the same:

  • Preparer pays for the service
  • Loan size is greater than prep fees but still far less than a typical refund.
  • Non-recourse

Good or Bad?

At this point, I believe that advocates are forced to confront a difficult question. Is this a less bad version of a bad product? Alternatively, would it be better to laud this trend as a good thing? Is it fair to even call the products a new RAL?

Assuming that these non-banks are held to the same laws that govern other forms of credit, the conclusion comes down to cost and safety. If it turns out that claims by Refundo and others are true and thus that consumers pay nothing for the product, then consumer cost is not a legitimate concern. If all risk is taken by the non-bank, then issues of safety and soundness are not well-founded, either. What this predicts is an approach where preparers recover the cost by spreading the bank product fee among pricing for all customers. 

A reader has highlighted a potential downside specific to the Refundo product: What happens when a preparer whose target consumer is typical of the type drawn to a bank product? Preparers can vary widely in their pickup rates for bank products, but there are at least a few that are said to have sold RALs to more than half of their customers. Assuming that a preparer shifts the entire cost of the bank products out among his or her set of clients, then the average real cost will be: 

Sum Cost to Preparer of all bank products/# of filers 

If a filer sells a loan product to 5 percent of filers, then the average cost is less than a few dollars. If it is sold to 50 percent, then the average cost is more than fifteen. If sold to all, then the average cost is high - and possibly higher - than a traditional RAL. Those numbers could be less for high volume businesses. 

One concern specific to Refundo is its linkage with online consumer installment lending. In addition to bank products, Refundo is also engaged in providing introductions to LendUp's installment loan product. There's also the issue of scale: Refundo is no Republic Bank of Kentucky. The latter could offer credit in every strip mall in the country. Refundo...not quite. 

Probably the greatest danger that could result from these offerings is that they may make consumers more susceptible to falling for the entreaties of a payday loan lead generation service or a car title loan lead generation service. This could happen if people write search queries for a tax refund loan. If you google search for a "refund anticipation loan," the majority of the top-rated search results (and all of the paid search results) point toward online payday or consumer installment lenders.  Lead gen folks are very concerned about bait-and-switch. But that kind of result will be fairly limited unless these small alternative RAL providers manage to develop incredibly successful marketing campaigns.