Can banks deliver safe, inexpensive instant payment services to underbanked customers?

If you have extra cash in your bank account, you may not think twice about using that account to send or receive payments. Many workers receive paychecks via direct deposit, knowing the funds will be available a few days after processing. But what if you need that money to pay rent in the meantime?

For millions of underbanked individuals—cash-constrained consumers with banking relationships who also use quick-pay alternatives—such situations can be a source of frequent stress. While unbanked individuals don’t hold accounts at financial institutions, the underbanked sometimes lack immediate access to needed, deposited funds. As a result, underbanked people often turn to alternative financial services (AFS) to pay bills on time and avoid bank account overdraft fees. But as many of these alternative services charge a user fee, reliance on these services can end up costing the underbanked more over time.

The Federal Reserve Bank of Boston recently launched an Inclusive Payments Resource Center to help US financial institutions learn more about the underbanked in their market areas. Who are the underbanked, and what nonbank services do they use? What aspects of AFS appeal to these individuals? And could this information help banks offer the lower-risk, fee-free instant payment options that their underbanked customers seek?

Background: Alternative financial services and instant payments

Alternative financial services allow people to send or receive money through companies operating outside of the traditional US banking system. Common alternative services include money orders, payday loans, check-cashing services, and retail bill pay. Some workers also use earned wage access, through either employer-sponsored or direct-to-consumer models, to tap into their earned but not yet paid wages in advance of their next paycheck.

The capability that some alternative financial services offer to send or receive a payment immediately appears particularly attractive to many consumers. When you deposit a check or pay a credit card bill online using a financial institution, it may take a day or two before the transaction appears in your account. With instant payments, both payer and payee see the transaction immediately reflected in their balances, and the payee can use the funds right away.

Alternative financial services also typically offer confirmation that funds have been sent and received. But unlike most financial institution transactions, many AFS providers charge a transaction or subscription fee in exchange for the convenience and immediacy of their service. Others charge interest on repayment of funds they lend. In this way, nonbank services can be costlier than transactions through the traditional banking system.

Costly transactions using alternative financial services

Just how big is the underbanked customer base? In 2023, 19 million US households (about 14 percent) were underbanked, according to the FDIC’s National Survey of Unbanked and Underbanked Households. The FDIC defined the underbanked as holding bank accounts but also using AFS to help cover essential costs. The nonprofit Financial Health Network, which includes in its definition consumers using a broader range of AFS, estimates the underbanked comprise 28 to 42 percent of US households.

Underbanked individuals often contend with income limitations and fluctuations. Almost two-thirds of underbanked households have annual incomes under $75,000, and the underbanked are more likely than fully banked households to experience month-to-month variation in income. Researchers said the need for early or quick access to limited funds can push underbanked individuals to use nonbank instant payment services.

“There’s high consumer need and demand for immediate access to funds,” said Andrew Warren, Financial Health Network’s research manager. “New data from direct-to-consumer cash advance services shows a large majority of their users choosing expedited transfers to their bank accounts, even when there’s a fee attached and that fee is a relatively large portion of the total cost of the transfer. That’s something that bad actors can exploit.”

Recent Kansas City Fed research estimated that a consumer paying a $100 bill using an in-person nonbank service such as retail bill pay or a money order could incur additional costs of almost $13. Another study found people paid up to $14 per transaction using earned wage access services. And a portion of consumers use AFS repeatedly, which can be expensive.

“Fees may be small on a one-time basis,” Warren said. “But if consumers use these services repeatedly, the fees can add up to quite a bit over the course of the year.”

One analysis found that more than 70 percent of earned wage access service users took advances on their paychecks over consecutive pay periods, with users paying either for a monthly subscription or a fee on each transaction.

“There’s high consumer need and demand for immediate access to funds. New data from direct-to-consumer cash advance services shows a large majority of their users choosing expedited transfers to their bank accounts, even when there’s a fee attached and that fee is a relatively large portion of the total cost of the transfer.”

– Andrew Warren, research manager, Financial Health Network

“That fee per transaction is a huge chunk of a lower-income worker’s hourly wage,” said Brian Clarke, deputy director for regional and community outreach at the Boston Fed. “We surveyed AFS users about what they’re getting from the service, because there’s a reason people feel they need to be doing this.”

Why do underbanked individuals use alternative financial services?

“AFS consumers may not have access to a bank branch or broadband internet service to transact through their bank account in person or online. They may need to send money back to their family in another country. Or they might just need the money right away because they’re falling short on paying a bill.”

– Kate Hyeon, community development analyst, Boston Fed

The 2023 survey that the Boston Fed conducted with the nonprofit organization Commonwealth revealed many reasons.

“AFS consumers may not have access to a bank branch or broadband internet service to transact through their bank account in person or online,” said Kate Hyeon, community development analyst at the Boston Fed. “They may need to send money back to their family in another country. Or they might just need the money right away because they’re falling short on paying a bill.”

Fear of overdraft fees is another common motivator. More than one-third of American adults lack the cash or liquid savings to cover a sudden $400 expense. At the same time, nearly three-quarters of US workers receive their wages at the end of pay periods that stretch over two weeks or longer. Consequently, savings on hand and paycheck deposits may not align with due dates for household bills. And for some underbanked households, trying to pay rent from a bank account that lacks sufficient funds can trigger an overdraft fee of more than $30.

Federal Reserve focus groups in 2022 revealed still more reasons for using AFS. Some unbanked and underbanked consumers in Ohio and Texas told Fed researchers they distrusted banks, preferring the convenience and customer service of local retail stores where they cash checks or purchase money orders. Others said they found banks’ product terms and conditions confusing.

Fifty-five percent of the underbanked consumers surveyed by the Boston Fed and Commonwealth in 2023 had been charged overdraft fees in the previous year. Many respondents in that survey said they valued AFS as a way to pay rent and bills last-minute, and more than half of those who used earned wage access AFS tapped the services at least once per week ahead of payday.

“We had in-depth follow-up conversations with some survey respondents that helped us paint a picture of why people are using AFS,” Clarke said. “Many of them said it was the speed of transactions and the immediate confirmation that money was received. They also found the services very convenient. The AFS providers were in their neighborhood. Respondents trusted those providers, because they’d been going there for years.”

Mapping more comprehensive information about underbanked households’ AFS use

One finding in particular stood out in the Boston Fed survey: 90 percent of respondents said they would use their bank accounts more if their bank offered instant payments.

“When we asked banks about financial inclusion, they said they wanted to work on it,” Hyeon said. “But they said, ‘We don’t know who or where the underbanked are, so we don’t know what kind of product to offer them.’”

90% of respondents said they would use their bank accounts more if their bank offered instant payments.

Clarke and Hyeon drew on the FDIC survey data to develop an interactive data dashboard they hope will help answer these questions.

The Boston Fed data tool reveals comparative insights about AFS use between 2019 and 2023 by unbanked, underbanked, and banked households around the country. Underbanked households in most areas were more likely than not to have used money orders, but the tool shows how use of other AFS types varies across the country.

“If you look at the alternative financial services market, it’s almost entirely created by issues of speed or settlement. An instant payment cures both of those things, and instant payments that occur within a regulated banking system could reduce risks for consumers.”

– Brian Clarke, deputy director for regional & community outreach, Boston Fed

For example, nearly 30 percent of underbanked households in St. Louis used check cashing services. In San Jose, California, almost half of underbanked households used an international remittance to send money abroad. And more than 20 percent of underbanked households in Bangor, Maine, used tax refund anticipation loans.

“We felt the data tool could be especially valuable for regional and community banks who may not have the same resources available to look at their internal data or to buy data sets to get a better understanding of the market they’re operating in,” Clarke said.

“We hope that our resources get people to think about why instant payments might be helpful to underbanked households and communities,” he added. “If you look at the AFS market, it’s almost entirely created by issues of speed or settlement. An instant payment cures both of those things, and instant payments that occur within a regulated banking system could reduce risks for consumers.”

Offering underbanked people instant payment services at their bank

With real-time payment networks now available to regulated financial institutions, more underbanked individuals soon may be able to access instant payment services directly from their banks. That option could enable underbanked people to instantly do business with other consumers and businesses without transaction or overdraft fees piling up.

“I hope banks see the value in delivering this kind of instant payment product to their customers,” Hyeon said. “Paychecks are stretched thin these days, and many people are falling short on cash.”

For financial institutions, these instant payment innovations offer the opportunity to build deeper, more trusted relationships with their underbanked customers who use AFS.

“The underbanked population is not a monolith,” said the Financial Health Network’s Warren. “Not all of those customers have the same needs, and some face distinct risks others don’t. The bottom line is that there’s a clear advantage to consumers if financial institutions can find a way to make these services safer and more affordable.”