Payday of Reckoning

New laws aimed at kneecapping payday lenders will end up hurting the poor.

The payday loan store is white, almost antiseptic, except for the large colorful posters in English and Spanish announcing fast loans, check cashing services, money orders, and prepaid debit cards. The location is a small storefront in suburban Virginia, a few blocks from the last stop on the Washington, D.C., Metro yellow line. The scene bears little resemblance to the gritty loan-shark image evoked by the many powerful critics of "predatory lending." The only hint of seediness is the large sheet of tinted, presumably bulletproof glass separating the weary clerk from loan seekers.

Why do people here and elsewhere seek short-term, high-interest loans, using a chunk of their next paycheck as collateral? Well, what would you do if you needed $200 RIGHT NOW?

You could put it on your credit card. It's the American way! Unless, like so many Americans, you've already maxed out your cards. The average U.S. consumer carries $6,226 in plastic debt, according to the credit reporting agency TransUnion. With a potentially long financial market contraction ahead, card companies have been aggressively reducing limits and discontinuing new offers. Although the Credit Card Act of 2009 makes it harder for companies to change their terms after the fact, the availability of credit is likely to shrink further. Maybe you need that $200 to make the minimum payments on those maxed-out cards.

You could write a personal check and hope to scrounge some money for your bank account in time to cover the transaction. Such faith has a low rate of return, and dashed hopes can be awfully expensive. A bounced check from a basic Bank of America checking account, for example, costs $35, plus any fees the stiffed merchant tacks on. Many banks offer overdraft protection—they'll extract the money from you later—but charge between $10 and $35 for the favor. Repeated bounces and overdrafts have more serious consequences. American banks unilaterally closed 6.4 million checking accounts in the pre-recession year of 2005 alone. 

You could borrow money from friends or relatives. Obtaining cash from intimates may get you the best interest rate on the market, but costs are extracted through other means. Family reunions can easily become awkward investors' meetings, and as fans of Judge Judy can tell you, even a small loan can be a remarkably efficient way to destroy a friendship.

You could pay a bill late. A high-risk strategy. Utility and phone providers can be quick to cut off service and charge a disconnect and/or reconnect fee. You could be looking at an extra $40 to $70 penalty every time, not to mention costs incurred in lost productivity.

Or you could get a payday loan. Like I did.

Predatory Lending?

Payday lenders are the redheaded stepchildren of the consumer financial market. According to critics ranging from anti-poverty activists to the president of the United States, the industry exploits the poor by offering loans with bad terms to people who don't know better. During his campaign, Barack Obama promised to "work to empower more Americans in the fight against predatory lending" by capping "outlandish interest rates."

The coalition against payday lending is broad and deep, with opponents surfacing in unexpected places. In 2006 the Department of Defense issued a report slamming payday lending to soldiers, sailors, and Marines, characterizing them as "young and inexperienced borrowers" with limited ability to repay. Congress took up the cause, with Sen. Robert Menendez (D-N.J.) claiming that clusters of payday lending shops around military bases "negatively impact military readiness." The following year saw a new federal law capping the annual rate on loans to active-duty military personnel and their families at 36 percent. In addition to the 12 states that have banned payday lending outright, Virginia has prohibited payday loans to members of the armed forces and their families.

With a powerful ally in the White House, payday loan opponents started to focus their efforts on the federal level. In June 2009, as part of its response to the financial crisis, the Treasury Department proposed consolidating various financial regulatory bodies into a single new bureaucracy called the Consumer Financial Protection Agency. Payday lenders, now largely unregulated on the federal level, are likely to fall under the new agency's domain, which would make it easy for Obama to reach his goal of extending the military rate cap to "all Americans."

As new post-crisis financial regulations began taking shape, the president and others started lumping payday loans with credit-default swaps, no-documentation mortgages, high-interest credit cards, and other financial products designed to make it easy—perhaps too easy—for the poor to take on debt.

Terms for payday loans can seem onerous. Interest rates on the short-term deals, measured on an annualized basis, often reach 400 percent. Borrowers who are living paycheck to paycheck can find themselves coming up short after the initial loan, beginning a cycle of indebtedness with ever-higher interest payments. But several recent studies suggest that well-intentioned restrictions on payday lenders wind up harming the very people such laws are intended to help, reducing their access to emergency cash and prompting them to use costlier, more dangerous, and more credit-damaging options.

Repeat Customers

Approaching the Virginia payday loan store in the freezing winter wind, I'm greeted by festive green banners offering check cashing for tax rebates. Inside, the line is composed entirely of females, mostly black women in early middle age. Judging by their clothes, several are on lunch breaks from white-collar jobs. I've only just arrived, but my fellow loan seekers are getting restless. The line is 10 people deep and moving slowly.

If my line had been a more representative cross-section of payday borrowers, seven or eight of the 10 would have annual incomes higher than $25,000, and two would earn more than $50,000. There would be four homeowners and six people with major credit cards in their wallets. Half would have attended some college, and nearly everyone would have a high school diploma. All these statistics come from the Community Financial Services Association of America, an industry group, but the industry's left-wing critics at the Center for American Progress have produced strikingly similar numbers.

In that statistically representative line, you'd be unlikely to encounter more than one person over 55 years old. Six would have children at home; a narrow majority of the ones with kids would be married. And all would have jobs and bank accounts, since you can't get a payday loan without at least one of each.

The payday lending industry was essentially created from scratch over the past two decades. Back in the early 1990s, supermarkets and dedicated check-cashing outfits would convert pay stubs into dollar bills, and the odd mom-and-pop shop might make a loan to a trusted customer against an upcoming paycheck. As banks went digital and checks became more reliable, check-cashing firms such as Advance America, ACE Cash Express, and Check 'n Go found payday lending to be a logical extension of their business. Today there are more than 20,000 payday lending outlets, more than all the Starbucks and McDonald's stores in the country combined. Estimates from the industry's opponents and supporters alike put the number of U.S. customers between 15 million and 20 million annually.

I made my visit to the payday lender on the 15th of the month, so most people in line were there to repay loans, not get new ones. According to the Community Financial Services Association of America, whose numbers are similar to those of state regulators, 90 percent of loans from payday lenders are repaid by the due date. This figure compares favorably to, say, the current repayment rates for subprime adjustable rate mortgages.

Critics tend to focus on the minority who can't or don't pay back their loans on time. Kathleen Day, a spokesperson for the Center for Responsible Lending, says: "The model that the payday industry is based on is repeat borrowers. If no one in the payday industry rolled over a loan, they would not be making money. It's true that most of the customers don't roll over, but those who do pay the profit."

That sounds plausible. Everyone knows people who are bad with money, and it's easy to see how someone with cash flow problems could wind up getting suckered into re-upping over and over, taking out a new, slightly larger loan immediately after repaying the first one, eventually paying more than the principal in interest. But those aren't the people that lenders actually rely on to stay in business, according to a 2005 study from the Federal Deposit Insurance Corporation's Center for Financial Research.

"We do not find that loan renewals or loans from frequent borrowers are more profitable than other loans per se, although they certainly contribute to a store's loan volume," concludes the study, which was prepared by economists Mark Flannery of the University of Florida and Katherine Samolyk of the federal Division of Research and Statistics. Flannery and Samolyk also found that lender profitability did not increase in stores located in poorer neighborhoods—the places where you'd expect more return customers and rollovers.

The Uses of Usury

As horrifying as 400 percent annual interest sounds, it doesn't reflect the experience of the typical borrower. No one keeps a payday loan for a year; that's not how these things function. Payday lenders charge about $15 per $100 on a seven- or 14-day loan, plus another $20 or so in fees. They check your paperwork and then give you $100 in cash. You leave a post-dated personal check as insurance and promise to come back in two weeks with $135. If you show up empty-handed, or not at all, they cash your check. If the check bounces, the firm sends debt collectors after you—not the knee-breaking kind, but the same guys who interrupt your dinner when you miss a couple of credit card payments. If you miss your deadline to repay, the lender refuses to deal with you again. Nine out of 10 customers pay on time.

If the level of hostility against payday lending is disproportionate to the percentage of payday defaults, that may be partly due to cultural traditions. For much of human history, stretching at least as far back as biblical prohibitions against the practice, lending money at interest, otherwise known as usury, has been considered extremely bad form.

Trawl through online arguments against payday lending, and you're likely to come across something like this, from Americans for Fairness in Lending: "Prophet Ezekiel includes usury in a list of 'abominable things,' along with rape, murder, robbery and idolatry." The site also notes that in his Inferno, Dante "places usurers at the lowest ledge in the seventh circle of hell—lower than murderers." In Hamlet, Polonius famously advises: "Neither a borrower nor a lender be;/For loan oft loses both itself and friend/ And borrowing dulls the edge of husbandry." Charges of usury periodically inflamed pogroms against Jews in Europe. (Jewish law forbids charging interest to other members of the tribe but not to gentiles, which is the historical reason moneylending is associated with Jews.) Koranic instructions against interest are enforced in the Islamic world even today.

The traditional view of usury as morally corrupt changed only during the Enlightenment. As a young man in 1787, the philosopher Jeremy Bentham wrote a controversial defense of usury in which he attacked the aging Adam Smith for supporting legal limits on the rate of interest, noting that to restrict people's choices was to reduce the overall welfare. The British author G.K. Chesterton has pointed to Bentham's essay as the moment when "the modern world began." Capitalism isn't possible without capital, and accumulating capital in a world without interest-bearing loans is almost impossible. Hatred and fear of usury still lingers in the industrialized world in the attenuated form of vague moral outrage at high-interest loans. 

Payday lending is currently regulated in 37 states, plus the District of Columbia, and banned in a dozen more. Many of the laws include references to this ancient sin. "Most states have usury laws," says Day, the spokesperson for the Center for Responsible Lending. "This is a very old Judeo-Christian idea, that it's a bad thing to bury people in debt." But the contemporary definition of usury has always been fluid. Sometimes charging any interest at all is enough to qualify. Other times it's more a matter of what's perceived as a fair deal. These days, 36 percent is the typical maximum legally allowed interest rate for states where loans are regulated, but there are and always have been multiple exceptions, especially when politicians want to get things done.

Extinction by Regulation

My first attempt at a payday loan came at ACE Cash Express in the gentrified Adams Morgan neighborhood of Washington, D.C. Since it was in the middle of a cold snap, I was grateful I didn't have to travel far for my cash. But when I got inside, the elderly woman behind the counter told me the shop no longer offered payday loans, and as far as she knew, neither did anyone else in the city. "Not since they banned them here," she explained, with the air of someone who has answered the same question many times.

In fact, the District of Columbia didn't explicitly ban payday loans, but the city's Payday Loan Consumer Protection Amendment Act of 2008 did cap total costs of loans in the city at 24 percent, which amounted to the same thing. Major payday lenders promptly pulled out of D.C., citing a lack of profitability. Former mayor Marion Barry, now a city councilman, initially co-sponsored the bill but ended up casting the only vote against it. "We are putting this industry out of business," Barry warned. He was right.

At the Virginia lender, a group of women—two of whom were there to pay off loans and one of whom was picking up Chinese food next door—gossiped about the state of the industry. One woman, who kept her fur hat firmly in place while waiting, used to do her loan business downtown at a store near her office. But the interest cap ended that. "They only cash checks and do money orders there now, which doesn't do me a bit of good," she said.

Other than the limits on lending to members of the armed forces, there is no federal regulation specific to the industry, although that will change if President Obama gets his way. Payday loan opponents are using the ban on lending to military families the same way pro-lifers use partial-birth abortion—to make small, uncontroversial headway on a big, controversial issue. "The trend is toward the recognition that this is an abusive product," says industry critic Day. "If it's not good for active duty military, why is it good for anyone else?"

As federal regulation moves along, battles continue at the state level. In Ohio and Arizona last November, residents voted to impose maximum rates of 28 percent and 36 percent, respectively. Arizona's Proposition 200 reapplied the state's usury rate cap to payday lenders, who had previously enjoyed an exemption. In North Dakota, a similar bill was rejected by a legislative vote of 88 to 5.

What happens when a rate cap is imposed statewide? Dartmouth economist Jonathan Zinman looked at the payday lending industry in Oregon, where in 2007 an effective cap of $10 per $100 borrowed was imposed along with a minimum borrowing term of 31 days. (In neighboring Washington, by contrast, the standard is $15 per $100 and there is no minimum term.) Oregon's Consumer and Business Services Department reported 346 licensed payday lending outlets at the end of 2006, six months before the cap kicked in. Seven months after the cap took effect, that number had fallen to 105. In September 2008 it was 82. In a December 2008 working paper, Zinman concluded that former payday customers in Oregon ended up using less desirable alternatives such as overdrafts and utility shutdowns, and that "restricting access caused deterioration in the overall financial condition of the Oregon households." In summary, "restricting access to expensive credit harms consumers."

A February 2008 study for the Federal Reserve Bank of New York found similar results: "Compared with households in states where payday lending is permitted, households in Georgia [after a May 2004 ban on payday lending] have bounced more checks, complained more to the Federal Trade Commission about lenders and debt collectors, and filed for Chapter 7 bankruptcy protection at a higher rate," wrote Federal Reserve research economists Donald P. Morgan and Michael R. Strain. In North Carolina, where payday loans were banned in December 2005, "households have fared about the same. This negative correlation—reduced payday credit supply, increased credit problems contradicts the debt trap critique of payday lending, but is consistent with the hypothesis that payday credit is preferable to substitutes such as the bounced-check 'protection' sold by credit unions and banks or loans from pawnshops."

Two weeks before I got my loan, new restrictions took effect in Virginia, including a rate cap of 36 percent. As predicted, payday lending chains are now fleeing the commonwealth. Check 'n Go stopped originating loans in Virginia and will soon close its 68 storefronts and fire its 100 employees. The State Corporation Commission counted 630 payday lending stores in April, down from 786 in December.

A Borrower Be

After I waited in line, my transaction took seven minutes and 32 seconds, a time prominently displayed on my receipt. Of course, I'd come prepared. To qualify for a loan, I had to bring a recent pay stub, a current bank statement, a utility bill from the current month, a recent phone bill, a Social Security number, and a blank check.

My $200 loan came in $20 dollar bills, with a side of paperwork. The terms of my particular loan—I was to pay $251.31 in 30 days—were spelled out very carefully in one pile, with generic information about Virginia lending laws in a second one. In large type, outlined in a gray box, was the amount of money I would have to pay the company when my loan came due. My personalized paperwork also told me that the "cost of my credit as a yearly average" was 292.63 percent.

Even with all that large print, interest rates can be confusing. "When you go into these places where people are holding two jobs and they're desperate for money and someone says that they can roll it over for another week," says Day, "they don't realize they're paying $45 on a $100 loan." But in my line, people were very aware of the rates, grumbling about them and, in one case, asking detailed questions to figure out the cheapest way to carry some debt for an additional month.

In a bid to encourage educated decisions about borrowing, President Obama has said he would like to nudge traditional banks to get back into the small loan business. This would give borrowers an alternative to payday lenders and drive them toward institutions with more historical layers of regulation and reporting requirements. But if the recent mortgage crisis is any indication, the banks aren't even particularly adept at helping people understand the terms of their home loans. Furthermore, they seem to be far less efficient than payday lenders, something they recognized when they got out of the business years ago. According to the most recent estimate available—a 1999 Commercial Bank National Average Report from the Federal Reserve—the cost for a small bank to originate and maintain a simple loan for one month is $174. As more of Obama's lending restrictions come into effect, that cost is likely to increase. By comparison, Steven Schein, spokesman for the Community Financial Services Association of America, says it costs payday lenders $12 to originate a $100 loan.

But giving up the dream of poor people obtaining quick loans in marble lobbies is tough for opponents of payday lending. So the FDIC has created a program called the Small Dollar Loan Pilot Program in an effort to meet that demand while routing around payday lending companies. Thirty-one banks with a total of 550 branches are participating, a tiny fraction of eligible institutions. Goodwill Charities has partnered with a credit union in Wisconsin to offer payday loans based on paperwork and processes identical to those of a typical payday lender but charging just $10 per $100. These ventures are minuscule compared with their fully commercial counterparts. And they aren't growing, despite offering an identical product at subsidized rates.

The Freedoms of Payday Lending

I'd happily lay out 50 bucks, the net cost of my payday loan, to avoid awkward interactions with my phone company, my doctor, my friends, my colleagues, my bank, or, worst-case scenario, the boys in blue.

But $50 is also a lot of money, especially for someone who periodically has trouble coming up with $100 or $200. So why don't people flock to experiments like those by Goodwill and the FDIC? "You have to attend a financial literacy class," says Schein, the spokesman for the Community Financial Services Association of America. "You have to keep a certain amount of money in the savings account. The nonfinancial requirements really annoy the customer. It all has to do with the notion that banks are going to be charities now." In the white, tiled storefront of the payday lender, no one hassles you. No one asks questions. It's fast and relatively anonymous. You don't have to put on your Sunday best and go down to the bank hat in hand, like they do in old movies.

Payday lending is essentially off the record. As with pawnshops, the money you get from a payday loan doesn't enter into your credit rating, unless things go catastrophically wrong—i.e., you fail to pay your loan on time, your check bounces, the company can't track you down, and it sends your name to a collection agency.

A 2004 survey by the Cypress Research Group, conducted on behalf of the Community Financial Services Association of America, found that while 65 percent of customers said they chose payday loans because of convenience (less paperwork, quick and easy process, fast approval), 85 percent said they had savings accounts and 35 percent had credit cards with credit available. A 2009 study from the Center for American Progress found that people taking out payday loans were overwhelmingly doing so to purchase necessities or cope with emergencies, not to engage in discretionary spending. Payday borrowers are full participants in the American financial system. They happen to have selected the services of a payday lender to meet their particular needs.

Maybe the women in line with me at the payday lending store weren't trapped or tricked. Maybe they weren't usuriously sinned against, or sinning. Maybe they just needed some cash, looked at their options, and made the best decision they could. As more and more people find themselves in need of a little extra money, why take away the best of a bad set of choices?

Katherine Mangu-Ward ([e-mail]) is a senior editor at reason.