The Unintended Consequences of Cracking Down on Payday Lenders

Payday lenders aren't the demonic entities they're made out to be.

Four years ago, Virginia lawmakers cracked down on payday lending. They limited borrowers to one payday loan at a time, and doubled the length of time they had to pay the money back. It worked. Payday loans plunged more than 80 percent. A few lenders left the state completely.

But it also didn’t work.  The reforms created a vacuum being filled by a new form of short-term lending: car-title loans.

In a payday loan, the borrower writes a post-dated check to cover the loan amount,   plus fees. In a car-title loan, the borrower puts up a vehicle as collateral. Since 2010 the number of car-title lending companies in Virginia has more than doubled. Last year, they made more than 128,000 loans, worth an aggregate $125 million. They also repossessed nearly 8,400 vehicles.

Legislation to cap interest rates on payday and car-title loans died last year. It likely will come up again. But some localities don’t want to wait. Officials in Chesterfield  want to ban such lenders from the county entirely. This is probably a fool’s errand; shutting down lenders won’t make demand disappear. Borrowers in need of quick cash may just cross jurisdictions – or turn to even more risky sources, such as the Internet.

It’s easy to understand Chesterfield’s position when you hear stories like that of Manassas resident Brenda Ann Covington. A while back she borrowed $1,500, and put up her 2005 Chevy Silverado as collateral. Somehow she ended up owing $4,100 – and could have lost a vehicle worth much more. On the other hand, there is no shortage of horror stories about commercial banks, either – as anyone burned in the recent housing bubble can attest.

What’s more, defaulting on a mortgage can destroy your credit rating. Defaulting on a payday or car-title loan won’t touch it. That’s one reason borrowers like storefront lenders: They “keep my payday borrowing separate from my other banking.”

There are other reasons: According to the financial-services journal American Banker, “borrowers may prefer to pay higher rates for small, short-term loans than to participate in credit union programs that have strings attached, such as a savings component. . . .  Borrowers also dislike that credit unions generally have shorter operating hours.” As a recent article in Regulation magazine – a publication of the libertarian Cato Institute – puts it: Storefront loans have “non-price benefits” that make up for the higher interest rates.

Yet those higher interest rates lead many to believe such “predatory” lenders are little better than leg-breaking loan sharks. Is that charge sustainable? Again, comparison is instructive. The banking industry’s profit margin is 5.2 percent. Payday lenders’ profits are only 2.4 percentage points higher. Both traditional banking and storefront lending are less profitable than pharmaceuticals, railroads, mining – or even regulated gas and electric utilities.

But wait: If, as critics allege, storefront lenders charge ridiculously high rates, then why aren’t they raking in money hand over fist? For one thing, they endure much higher rates of default than banks do. Just as hospitals must charge paying customers more to cover charity care, payday lenders must charge more to cover the welshers. (Banks avoid this problem by simply refusing to lend to bad credit risks. How does that help poor people?

Still, critics insist the interest rates charged by storefront lenders are so high they’re immoral. But it’s the critics, not the lenders, who are being dishonest. Here’s why:

Suppose Milton borrows $250 from a storefront lender and pays it back two weeks later. The lender charges a standard $15 fee to pay his employees, his utility bill, and so on. That is 6 percent of the loan amount. Yet critics want to express that as an annual rate – which, in this case, would be 156 percent.  This sounds outrageous. What it really tells us is not that the lender’s greed is huge – but that the loan amount is small. A $15 charge on a two-week, $10,000 loan has an APR of only 3.9 percent, even though the transaction charge is exactly the same.

Banks and credit unions don’t usually offer the sort of financial services storefront lenders offer. When they do, they end up charging similar sums. StretchPay, an Ohio-based credit-union alliance, charges an annual fee of $35 for loans up to $250. That’s an APR of 364 percent on a two-week loan.

Then there is microcredit – a Third-World financing revolution that began with the Grameen Bank in Bangladesh. The idea is to lend very small amounts to poor people so they can start businesses. Microlenders have been criticized because, given the small loan amounts, the effective interest rates they charge also turn out to be pretty high – anywhere from 70 to 125 percent. But they don’t ask for collateral, either. That makes them look a lot like payday lenders.

There’s one big difference, though: While payday and similar lenders are reviled for preying on the poor, Grameen Bank and its founder Muhammad Yunus were awarded the 1996 Nobel Peace Prize.

This column originally appeared in the Richmond Times-Dispatch.

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  • Metazoan||

    I recently discussed payday lending with a friend. It apparently blew his mind that if you cap interest rates, some people won't be able to get any loans!

  • Fist of Etiquette||

    Can we finally admit it's time to outlaw credit scoring?

  • flye||

    Interesting choice of Chuck Schumer as the advertising model holding bundles of cash.

  • R C Dean||

    Say it with me, people!

    Foreseeable consequences are not unintended.

  • Pro Libertate||

    I used to support a subprime operation. A lot of the same issues came up, and legislators acted like it was a sin to charge higher rates to people with bad credit, low incomes, etc. A wave of legislation followed, greatly restricting the use of risk-based pricing and other mechanisms for dealing with the high rate of default for and/or the expense of collecting such loans (in subprime world, you have to jump quickly on a first payment default, or you'll lose out to other creditors and expenses.

    I think this kind of meddling was an important part of the bubble and the following bust. Lots of pressure to get people into mortgage loans, also lots of pressure to make loans with unreasonable terms. Not to say that some lenders weren't, in fact, engaging in dishonest practices, but it was the government interference that caused the most trouble.

    Also, with payday, auto-title, and other short-term lenders, a lot of people freak out over high annualized rates. But using an APR to define a two-week loan for a small amount of cash is a little misleading. And it's not like these people, many living paycheck to paycheck, have access to much credit.

  • SugarFree||

    "Drunk driving? Silly poor people. Why not just have your chauffeur take you out when you want to drink?"

  • Pro Libertate||

    Poverty sucks. Especially when meddlers decide to cut off your credit or otherwise mess around in your business.

  • SugarFree||

    Given the principle that the government will always do the worst thing to fix anything it sees as a problem, I assume the eventually all loans will be made to anyone at the same artificially low interest rate and the inevitable wave of defaults will result in all loans to be made unbankruptable. Which will destroy all private banking and bring back debtor's prison or indentured servitude. (Gotta work off that money you borrowed from The People, dontchaknow.)

  • Pro Libertate||

    Back when I was in the lending business and all of the anti-subprime legislation was going on, it wasn't uncommon to joke (half-kidding jokes) that the goal was to have "A" and "B" borrowers pay the highest rates to subsidize the "C" and "D" borrowers. In other words, a redistribution of interest rate risk.

  • sarcasmic||

    Which will destroy all private banking and bring back debtor's prison or indentured servitude.

    It will destroy private banking and then the government will take over.

    We'll have single-payer health care and single-lender banking.

    It's not like it will really matter if people pay the debt back, because the money will be fresh off the printing press.

    What could possibly go wrong?

  • Public Citizzen||

    We are already seeing this happen with student loans. Many of these loans, when looked at from a lifetime perspective, amount to a permanent indenture given the inability of many graduates to find employment commensurate with their degree.
    Since the loans are 99% owned by the government and are non-dischargeable through bankruptcy they amount to a permanent state of servitude to the government.
    And people used to think that the DRAFT was bad - it was only for 2 years.

  • Whiterun Guard||

    You're not going to write a song about this one, Hinkle? You could use Daydream Believer instead of Payday Lender, if you shoe-horn some syllables in there.

  • SanDimas||

    Any comparison between a short term lender and a bank is going to draw false parallels.

    Banks use other people's money to back the checks they write, and can in effect loan out more money than they have on deposit due to fractional reserve banking. If a bank has about 20% reserve (well above the reserve requirements) they are in essence getting 5x the interest on the loans, and that money is derived from others' deposits. This has a multiplier effect on their earnings and allows them to have higher margins at lower interest rates.

    Payday lenders and other short term lenders, however, can only loan out cash they have in reserve or from "warehouse" credit granted by fractional reserve banks. There are additional costs in time in dealing with customers after the loan is made. If you owe on a mortgage odds are the bank can find you at the property you bought. If they need to foreclose they are spending money on legal fees to take possession of an asset worth thousands to hundreds of thousands of dollars. A $500 loan often costs well over that amount in legal fees to seek restitution in the courts. The sole reason any lender even carries out such action is to refrain from getting a reputation as an "easy charge-off."

  • robc||

    If a bank has about 20% reserve (well above the reserve requirements) they are in essence getting 5x the interest on the loans,

    Ummm...no.

    If they have a 20% reserve, they are loaning out 80% of the money.

    So, they are loaning out .8x of what they are bringing in.

    The only way to get 5x from that is to charge 6.25x in interest on the loans as you pay on deposits. The ratio between loan rates and deposit rates isnt that large (well, actually, right now it might be, but just because they are paying so close to zero).

  • SanDimas||

    Allow me to reword: as written what I said was wrong. A commercial bank can write checks on reserves at the central bank (i.e. high powered money) at a multiplier rate which IIRC is 9:1. Deposits it can only loan out 9/10s at a 9:1 reserve requirement. This is highly leveraged compared to a lender not part of the Federal Reserve System.

  • SanDimas||

    Having worked in the industry I can tell you that there is tremendous risk with almost every loan. I'd say 80%+ of borrowers could be justifiably turned down for "delinquent credit" or "excessive obligations." When someone shows up at your door at closing time looking for a loan to pay a bail bondsman or needs money to get their car fixed to go to work it is not because you are a predatory lender, but you are a lender of last resort.

  • Speedy Loan Search||

    I’ve no doubt that a large percentage of payday loan customers don’t have too much complaint – people aren’t stupid, and the costs of payday lending are common knowledge…. I expect Wonga to enter the English language any time now, in a similar way to McJob. Take the money, pay it back, moan about how much it cost, repeat.

    But what does this poor excuse for ‘research’ actually tell us? The fact that customers were treated “with dignity and respect” is meaningless. How is that defined? It can mean completely different things to a customer or a regulator and I suspect the ambiguity in the question is deliberate. Of course payday lenders treat you with dignity and respect when you’re borrowing from them… that’s just basic customer service. If they didn’t, people would just use a different payday lender.

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    Better to go to bed supperless, than to rise in debt--Benjamin Franklin

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  • Kris||

    Thanks for a great post about payday loans.

    Are there any news about this topic?

  • شات عراقنا||

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  • Bruce Majors||

    Reason covers this topic better than most but it is always assumed that only poor people have cash flow problems and make use of these loans. I know realtors get solicited constantly by companies that give you advances on commission for a hefty fee. I assume other commission based sales people do as well. See for instance http://www.netadvance.com/

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