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The Financial Lives of Low-Income Americans
By MICHAEL S. BARR
BROOKINGS INSTITUTION PRESS
Copyright © 2012 THE BROOKINGS INSTITUTION
All right reserved.
Chapter One Introduction MICHAEL S. BARR
Low-income individuals often lack access to the type of financial services that middle-income families can take for granted, such as checking accounts, direct deposit, bank loans, or saving opportunities. High-cost or low-function financial services, barriers to saving, lack of insurance, and credit constraints increase the economic challenges faced by low-income families. Using a unique data set from a survey I designed and that was administered in 2005–06 by the Survey Research Center at the University of Michigan to more than a thousand households in the Detroit area, this book analyzes the financial constraints and choices of low-income families and describes the ways low-income families use financial services, through both formal ("mainstream") and informal ("alternative") financial institutions. It discusses policies that would help low-income families achieve more stable economic lives.
Access to affordable financial services is important to the lives of low-income families, who must deal with sometimes abrupt fluctuations in income that occur because of job changes, instability in hours worked, medical illnesses and emergencies, divorce or other changes in family composition, and many other factors. If these families have limited access to savings, credit, or insurance, even small income or expense fluctuations may create serious problems in their ability to pay rent, utilities, and other bills. That is because many low-income families often lack the financial "slack" that can permit other households to ride out tough times (see Mullainathan and Shafir 2009). Financial slack can be thought of as breathing room provided to households by the ability to make relatively costless adjustments to align resources with needs. The costlier or more difficult these adjustments are, the less slack these households can be said to have. Some amount of slack can be generated internally (as by increasing work, reducing nonessential expenditures, or selling assets), but generally speaking, households use the financial system to facilitate slack (as by holding savings, accessing credit, or buying insurance). No slack too often means that small problems can escalate rapidly and undermine the fragile financial stability of these households.
Unfortunately, families often have only limited access to the sound financial products that could help them generate financial slack. In fact, higher-cost financial services can reduce the slack available to households. For example, many low-wage individuals see their take-home pay reduced by the high transaction costs they face when using check-cashing services to obtain their income. Moreover, inadequate access to financial services—such as direct deposit to a bank account or its functional equivalent—can contribute to taxpayersâ€(tm) using refund anticipation loans and expensive check-cashing services that diminish the value of the earned-income tax credit.
Limited access to mainstream financial services can also hinder the ability of low-income families to save. Savings are important because they help to smooth short-term income and expense fluctuations. Small savings can be used to provide a buffer against unforeseen events, such as illness. Savings can also provide capital for important long-term investment opportunities. Middle- and upper-income families regularly use their savings to invest in educational opportunities, in the health of family members, in home ownership, and in pension funds for retirement; lower-income households face similar types of needs, including job training, higher education, or other strategies to improve their income prospects. Having a measure of financial stability through savings may also improve other outcomes, such as job training or education, both for heads of household and their children.
Constraints on access to mainstream financial services can also increase borrowing costs. The ability to borrow on reasonable terms can be important to low-income households for several reasons. Low-income households facing fluctuations in income and expenses may need to resort to high-cost borrowing because they lack lower-cost ways of generating financial slack. It is not easy for them to reduce expenditures; because of low asset holdings, low income, low credit scores, or thin credit files, it is often difficult for them to get access to lower cost debt; they may lack insurance; and they are less likely to have precautionary savings. They may be able to fall back on friends and family for help, but such borrowing can often put strains on those who lend, who are likely to be lower-income themselves. Access to credit can also be important beyond meeting short-term needs, for achieving educational goals, including vocational or job training. Access to reasonable terms for mortgages also facilitates more sustainable home ownership.
Generating Slack: Financial Services, Savings, and Credit
Transactional services, savings, and credit are critical for low-income householdsâ€(tm) financial stability. Because these households have no slack in their lives, small decreases in income or increases in expenses can cause major problems. Yet well-designed and appropriately regulated financial services could help these households build greater financial stability. Better access to transactional services, savings vehicles, and reasonable credit will not, in and of itself, transform the lives of low-income individuals, but better access would give households useful tools to manage their finances in order to generate financial slack. If households are able to set up a regular means to receive income and pay bills, to build savings, and to access reasonably priced credit, they would be less vulnerable to serious disruptions stemming from income and expense shocks, and perhaps better able to take advantage of new opportunities, such as job training, improved child care, or a better job.
A quarter of low-income households, and 13 percent of moderate-income households, are "unbanked," that is, they have neither a checking nor a savings account (Bucks and others 2009; FDIC 2009). In lieu of bank-based transactions, savings, and credit products, these households often rely on more costly alternative financial services. Providers offer a wide range of services, including short-term loans, check cashing, bill payment, tax preparation, and rent-to-own products, most often in low-income urban neighborhoods.
Alternative financial services providers are the only source of basic financial services for many low-income persons, but those services come at a high price. For example, while check-cashing outlets offer essential services, the fees involved in converting paper checks into cash are high, relative both to income and to analogous services available to middle- and upper-income families, such as check deposit into a bank account or electronic direct deposit. Check-cashing fees vary widely across the country and between types of checks, but they typically range from 1.5 to 3.5 percent of face value. The Federal Reserve reports that financial institutions processed checks totaling nearly $31.6 billion in 2009 (FRS 2010). Almost all of these checks are low-risk payroll (80 percent) or government-benefit (16 percent) checks (Bachelder and Ditzion 2000). While even payroll checks are not without some credit and fraud risk, average losses from "bad" checks at check-cashing firms are low and compare favorably with interbank rates (Barr 2004).
Surprisingly, it is not just the unbanked who use alternative financial services. Many low- and moderate-income families with bank accounts regularly rely on high-cost nonbank providers to conduct much of their financial business—such as cashing checks, buying money orders, or taking out payday loans (Barr 2009; Rhine and others 2001). Recent literature sometimes refers to these households as "underbanked," although that of course assumes the outcome of the empirical analysis is that these households need more banking.
The high costs of alternative financial services raise several concerns. First, the costs of these basic financial transactions reduce take-home pay (Bachelder and Ditzion 2000; Kennickell, Starr-McCluer, and Surette 2000). As discussed below, our research shows that many low-income households can often avoid those high fees in practice, but they incur other costs as a result. High fees for tax preparation and filing, check cashing, and refund anticipation loans can reduce the value of earned-income tax credits by over 10 percent (Barr 2004; Berube and others 2002). Bringing low- and moderate-income families into the banking system, if key changes were made to financial products, could help reduce these high transaction costs, substantially increasing the purchasing power of these families. Second, without a bank account, low-income households face key barriers to saving. Promoting low-income household savings is critical to reducing reliance on high-cost, short-term credit; lowering the risk of financial dislocation resulting from job loss or injury; and improving prospects for longer-term asset building through home ownership, skills development, and education. Third, without a bank account, it is more difficult and more costly to establish credit or qualify for a loan. Holding a bank account is a significant predictor of whether an individual also holds mortgage loans, automobile loans, or certificates of deposit (Hogarth and O'Donnell 1999).
Although there are many reasons why some low- and moderate-income households lack a bank account, the financial and nonpecuniary costs of account ownership are important in their decision to become and remain unbanked. Despite the need to understand how the decision making process of low- and moderate-income households interacts with external constraints, there has been little research to inform us about how these households make decisions about bank-account ownership or about the kinds of financial products that they would find attractive.
This study explores how the structure of accounts may influence household decisions. Checking accounts may be ill suited to the needs of many low- and moderate-income households. In particular, bank accounts are not structured to be low cost and low risk for low-income households. Financial institutions find low-balance accounts expensive and frequently require high minimum balances, credit checks to open accounts, high bounced-check and overdraft fees, and long check-holding periods (Barr 2004). The minimum-balance requirement on many checking accounts is a significant barrier for low-income households. In addition, households with little slack may overdraw frequently. Moreover, banks, unlike check-cashing outlets, sometimes hold checks for several days before crediting the deposit of funds; for low-income customers, this wait may not be practical. Such accounts are not designed for the lives and finances of low- and moderate-income households that live paycheck to paycheck.
Some low- and moderate-income households have had a bank account in the past but were unable to manage their finances, for example, engaging in repeated overdrafts that went unpaid. Households that have had past problems with their accounts are listed in the ChexSystems, a private clearinghouse that most banks use to decide whether to open accounts for potential customers. Thus not only does their own experience with high and unexpected fees as bank customers in the past keep some low-income households from opening an account, but they may also be formally barred from doing so by banksâ€(tm) use of ChexSystems.
These features of traditional bank accounts, and past problems households have had with managing their accounts, partially explain why many low- and moderate-income households are unbanked. In addition, as some researchers have pointed out, formal financial institutions are often less prevalent in low-income neighborhoods than alternative financial services providers (Temkin and Sawyer 2004). Still, for some households, noneconomic factors, such as mistrust of financial institutions, or inertia, may matter; and immigrant households often face documentation barriers to account ownership. Lack of financial education may also play a role in these choices. Our survey evidence helps to untangle these factors, as discussed further below.
Low-income families are less likely than higher-income households to hold significant savings or assets (Scholz and Seshadri 2009). These families often find it difficult to save and plan financially for the future. Living paycheck to paycheck leaves them vulnerable to medical or job emergencies that may endanger their financial stability, and their lack of savings undermines their ability to invest in improving their skills, purchasing a home, or sending their children to college. Yet low-income households often lack access to even basic institutional saving vehicles. High-income households receive a disproportionately large share of the tax benefits for retirement savings and home ownership (Gale and others 2009). Most low-income workers either work for firms that have no savings plans or are not covered by such plans (Orszag and Greenstein 2005). Twenty-five percent of low-income households lack a bank account, a critical entry point for saving (Bucks and others 2009). Given the low levels of assets among low-income households, most banks have historically not wanted to serve these customers. Thus saving by low-income households is depressed by the lack of sufficient income to afford saving, the low rates of return offered to the poor because of their low levels of wealth, and the lack of supply in savings products for the poor. Government tax incentives and employer-based savings plans tend to help better-off households the most, while leaving many low-income households to fend for themselves.
Yet evidence suggests that some low- and moderate-income households can and do save. For example, a high portion of low- and moderate-income workers participate in 401(k) plans if offered the chance to do so (Orszag and Greenstein 2005). From 2005 to 2006, nearly 78 percent of federal employees earning less than $40,000 participated in the Thrift Savings Plan (FRTIB 2007). Just under 34 percent of families in the bottom income quintile saved in 2007 (Bucks and others 2009). Automatic enrollment in employer-sponsored pension plans boosts participation and asset accumulation among low-income employees, as well as among African American and Hispanic employees (Choi and others 2002; Madrian and Shea 2001). If welfare-benefit asset limits were raised, low-income households might respond by saving more, although the empirical evidence to date is mixed (Hurst and Ziliak 2006; Nam 2008; Sullivan 2006). Low-income households can save, and savings are shaped in part by the institutional mechanisms that encourage saving.
Low-income households may have different uses for their savings compared with middle- and upper-income households. For example, Social Security covers a substantial share of low-income households' retirement needs, and it may be impractical to expect poor households to set aside more out of their current income for retirement. Yet there are many purposes for which low- and moderate-income households need savings, including housing, education, childbirth, divorce, emergencies, or simply managing cash flow. These households need easily accessible mechanisms through which to save and may need help in building up their savings. Many low-income households have been able to build up savings, for example, through home ownership. For some households, home ownership provides a means to build equity over time, as well as residential stability and economic security; for other households, the home ownership choice and the debt undertaken to purchase a home may be less beneficial (Bostic and Lee 2009).
Low- and moderate-income households have lower savings and fewer assets to fall back on in an emergency. At the same time, they have difficulty obtaining insurance for important life risks, including medical needs, divorce, and job loss. Insurance helps smooth consumption and protect asset accumulation while also preventing or minimizing cascading shocks. For example, an auto accident without insurance can lead to a job loss, which can have devastating consequences for family finances. Given insurance constraints, saving for precautionary reasons may be important for low-income households. At the same time, given income constraints, regular saving may put a heavy burden on consumption or contribute to high-cost borrowing for the poorest families. Government insurance programs might help provide some slack by making it unnecessary for families to rely solely on self-insurance through savings.
Excerpted from NO SLACK by MICHAEL S. BARR Copyright © 2012 by THE BROOKINGS INSTITUTION. Excerpted by permission of BROOKINGS INSTITUTION PRESS. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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