Payday lending

Photo: Flickr/stallio

This week on Need to Know, we look at the world of payday lending and a ballot initiative in Missouri that looks to cap the interest on these type of subprime loans.

Here, we’ve highlighted five things you should know about payday lending.

1. What are ‘payday loans?’

Payday loans are a form of subprime lending where a person (usually without access to credit) borrows against a future paycheck, typically in small amounts and over a short period of time. Once the borrower has been paid, she is expected to repay the lender the amount of the loan, plus interest.  These types of loans typically cost 400 percent annual interest (APR) or more, and the finance charges range from $15 to $30 on a $100 loan, says the CFA.

Nearly 19 million households in the U.S. use payday loans; industry analysts say this adds up to more than $30 billion in short-term credit every year.

And The New York Times reports, “the Federal Deposit Insurance Corporation estimates that about nine million households in the country do not have a traditional bank account, while 21 million, or 18 percent, of Americans are underbanked.”

2.     What is the risk associated with this type of borrowing?

Because individuals who are in need of a payday loan are often living paycheck to paycheck, there is often a high rate of recidivism or “roll-over” debt associated with these types of loans.  

Consumer groups typically warn borrowers against taking loans with interest rates higher than 36 percent, which is substantially lower than triple-digit payday interest rates.

As Megan McArdle wrote for The Atlantic,

The biggest problem with payday loans is not the one-time fee, though that is steep; it’s that people can get trapped in a cycle of rolling them over…  Unfortunately, since payday borrowers are credit constrained, have little savings, and are low-to-moderate income, they often have difficulty coming up with the principal when the loan is due to pay off.  The finance charges add up, making it difficult to repay the loan.

Additionally, in a study conducted by the Center for Responsible Lending, one of the leading groups opposing payday lending, data showed that the loan amount was increased by the borrower over time.  Initial loans were often taken out in relatively small amounts (an average of $270). Compare this with an average loan amount over the whole two-year study of $466 and a 67 percent increase was incurred.

3.     Are payday lenders regulated?

Regulation of pay lenders differs from state by state. To review each state’s law, refer to this reference guide. In 17 states, payday loans are restricted by state law, namely New York, Connecticut, Pennsylvania, and New Jersey.

The new Consumer Financial Protection Bureau, which was created by the financial reform bill in 2010, has the authority to examine nonbank lenders and has begun to examine payday lending, including looking at whether lenders are in compliance with federal laws. However, the Bureau is specifically not allowed to set interest rate caps.

At a field hearing on payday loans in January, Bureau Director Rob Cordray said, “We recognize that there is a need and a demand in this country for emergency credit. At the same time, it is important that these products actually help consumers, and not harm them.”

Large banks, such as U.S. Bank and Wells Fargo, have begun to traffic in the payday loan market, in large part due to the untapped market of lower income lending atop the state of the weakened U.S. economy. According to the New York Times, the CFPB is also “examining whether these banks ran afoul of consumer protection laws in the marketing of these producted.”

The hazards of high interest, short term loans have even amounted to a national security risk. Congress capped lending for military persons at the industry standard of 36 percent, after the Pentagon qualified this kind of lending as ‘an issue of military readiness’ in 2006. Though military personnel only make up 1.3 percent of the industry’s revenues, a rate cap measure was supported by the Department of Defense after it issued a report “finding many payday lenders are clustered around military bases.”

4.     Does this kind of lending happen in countries outside of the U.S.?

Yes, the payday lending model also exists in a number of foreign countries including Great Britain, Australia and Canada. Legislation in those countries has attempted to curb the maximum interest rate charged to borrowers.

In Australia, for example, the government has capped interest at 48 percent yearly. And in the U.K., the growing concern over the expansion of these types of loans has moved the government to begin discussing their own cap on rising interest rates. The Guardian reported in 2011 that, “one study found that 1.2 million Britons each year tide themselves over with temporary payday loans, which can charge more than 2,500 percent APR.” Though as U.K. lenders assert, if paid back on time, such rates do not weigh so heavily on the borrower.

5.     Are there alternatives to payday lending?

The Federal Trade Commission calls payday lending “very costly” and urges consumers to consider alternatives to the loans. But filling the void of an industry that provides more than $40bn in yearly credit is no small feat.

The Center for Responsible Lending directs borrowers to a number of loan alternatives, including:

Credit Union Loans:

Many credit unions offer small, short-term loans to their members.

Some credit unions also offer free financial counseling and a savings plan to help members get back on their feet.  Many other credit unions offer very low interest rate loans (prime to 18 percent annual interest) with quick approval on an emergency basis.

Cash Advances on Credit Cards: 

Many payday borrowers have credit cards.  Credit card cash advances, which are offered at about 30 percent APR plus the cash advance fee, are much cheaper than getting a payday loan.  Secured credit cards tied to savings accounts are another option.  One study found that payday borrowers who also had a credit card had substantial liquidity in the credit card on the days they took out payday loans.

Small Consumer Loans:

Small consumer finance companies offer double-digit APR small, short-term loans.  Charges for these loans typically range from 25-36 percent APR.  These loans are also much cheaper than payday loans; a person can borrow $1,000 from a finance company for a year and pay less than a $200 or $300 payday loan over the same period.

 

Comments

  • Steven

    The wording of the first answer makes it seem like the borrower may have borrowed the money for a sex change operation.

  • Derek

    Section 3 contains a small omission: ”
    In 17 states, payday loans are [NOT] restricted by state law, namely New York, Connecticut, Pennsylvania, and New Jersey.” 
    The four listed states do not restrict payday loans.   

  • Senior Producer, Need to Know

    Thanks Derek.  We’ll correct that.

  • Abuelo

    The program was thought provoking.  But it’s not clear to me why the interest rate cap is the only solution.  If the business model of the pay day lender doesn’t work with an interest rate cap, perhaps it would work for another kind of constraint.

    The first episode in the program was the fellow who took out $2500 in payday loans and made a total of $30 thousand in payments over three years at 450% interest.  As he put it, once he got into this arrangement it was like quicksand and he couldn’t get out.  Only a disability check enabled him to pay the whole thing off.

    In this case it was not the 450% interest so much as the multiplier of 12 on a $2500 loan.  He was paying nearly $900/month for three years.

    Instead of an interest rate cap, why not have a rule that looks at the total payments.  The rule could be that if the total payments reach twice the amount of the loan, then the loan is paid off.  The pay day lender could still charge fees for short term loans.  These fees are what the borrower sees clearly, and set the bar for what the borrower figures he can pay back on biweekly basis. 

    If there is a market for short term loans with high fees, the problem is not those loans that are paid back in the short term but the loans that keep on getting extended, like the poor fellow who shelled out $30K in three years on pay day loans totalling $2.5K.  If the lender, instead, has to use a business model that allocates a portion of payments to principal on a schedule that pays off the loan entirely after total payments reach twice the face amount of the loan, that might prevent the worst abuses (with borrowers who keep extending, for six months or longer) while still serving the short term market.

    Have legislative options like this been considered anywhere?

  • Mitch

    There is NO reason to regulate the interest rate charged.  The regulations now in place requiring the lender to clearly outline, and explain the rates are all that are needed.  Let the marketplace determine the rate.  No one is forced to take out a payday loan.  If we have the respect for the freedoms of individuals, we will let the individual make borrowing decisions.  Other existing regulations regarding default, collections, etc., can remain in place to protect those that get in over their head.

    We let people smoke.  We let people drink, gamble, overeat, and have children that they can’t afford.  All costing society much. 
    We allow these behaviors because in our guts, we know that we can not flourish without the freedoms to make our own decisions.  Even when we know that some will make bad decisions

  • Anonymous

    This TV show segment was bit one-sided (for more regulation). They could have found a random economics professor to give the loan company side that its a free market and that the fees/rates are high because the costs are high. I would guess that 95% of economics professors chosen randomly would give the same explanation.
    Note that the state of MA does cap interest to 23% and fees to $20 (similar to proposed regs), and there’s not one payday loan store in the state,  but plenty just over the border in NH.