Pity the Payday Lenders

I recently got an e-mail from someone who works for the Community Financial Services Association, the national trade group of payday lenders. She is unhappy that Congress wants to put a cap on the rates that payday lenders can charge. The proposed cap is 36% APR.

If this legislation were passed, the CFSA woman writes, “Payday advance lenders could not even meet employee payroll at that rate, let alone cover employee payroll, other fixed business expenses and make a profit.” In other words: in trying to protect poor people from usurious loans, Congress will shut down one of the few legal avenues for poor people to get short-term loans.

To which I thought: 36% APR! I haven’t read Merchant of Venice in a while, but I’m pretty sure Shylock didn’t get anywhere near that much. According to Using “The Merchant of Venice” in Teaching Monetary Economics, Jewish and Christian doctrines concerning usury were even less permissive than standing Roman law, which allowed up to 12% APR interest on cash loans.

But the payday lenders can’t survive on 36%? If that’s the case, I don’t know how the poor credit-card companies are scraping by, to say nothing of financial advisors, book agents, and even Realtors. It even makes the I.R.S.’s recent move to hire collection agencies look pretty reasonable.

For what it’s worth, here’s the entire e-mail:

Senator Jim Talent has sponsored an amendment to cap the APR of payday loans to military personnel at 36%. It passed the Senate. The DOD also supports the 36% cap.

The unintended consequences of the proposed legislation:

At a 36% APR, the fee on a $100 payday advance would be $1.38, less than 10? per day. Payday advance lenders could not even meet employee payroll at that rate, let alone cover employee payroll, other fixed business expenses and make a profit.

The result would be that lenders would be prohibited from offering payday advances to members of the military, limiting credit availability for service members and restricting their ability to choose what products and services are best for them.

The fact is, traditional banks no longer offer small, unsecured short-term loans, due to their high cost structure. According to a report by the Federal Reserve, it cost small banks about $174 to originate and service a loan for one month. They certainly couldn’t offer these loans for less than 10? per day-and neither can payday advance lenders, who have similar fixed costs. A 2005 study by the FDIC reported the cost to originate and service the average payday advance is approximately $32.

Ultimately, the amendment eliminates consumer choice and outlaws the use by military personnel of a short-term loan option that is regulated in 37 states and the District of Columbia. Customers, including those in the military, say a payday advance is often cheaper and more desirable than their alternatives. Elimination of regulated storefront lending to the military will only force them to more expensive (bounced checks/overdraft protection) and even unregulated alternatives, like offshore Internet lending.

The more appropriate way for Congress to protect members of the military would be to enact legislation that essentially incorporates protections such as those in CFSA’s Military Best Practices and applies them to all creditors, including finance companies, title lenders and small loan companies, as well as payday advance lenders. Doing so would provide appropriate protections for military customers and allow reputable lenders to stay in business and service growing demand for this credit option.


garycarson

You can get a $100 withdrawel at an ATM with a credit card for a couple of bucks (it's usually going to be more than $1.38) but you can't get a cash advance on a credit card at a teller window for that. I don't know exactly what it is, but it's more like $12 -- plus interest charges.

The transaction cost for the payday lender is fairly high, and the period of the loan is usually less than a week.

She's right, it's a bad law.

The ones they should pass a law about is the furniture rental places -- not for their overpriced stuff and rentals which are essentially usery disguised as rental agreement, but to stop their ability to use criminal laws to collect payments. If you default on a rental agreement it's treated as theft if you don't return the merchandise, where default on a secured not requires civil action to recover the merchandise. That should be outlawed.

But, very small short term loans have high transaction costs and should not be treated as usery. Lenders should be allowed to recover transaction costs.

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prosa

I am suspicious of the "high transaction costs" claim given the way the payday loan companies operate. Typically, borrowers cannot afford to pay off existing loans when they come due on payday. They have to take out new loans to pay off the existing ones and, usually, get some additional cash. In other words if a payday loan outfit makes 100 loans on a particular day, it almost certainly is not dealing with 100 new borrowers, as many (or most) of the 100 loans are refinances of existing ones. And it's reasonable to assume that the transaction costs associated with refinancing a loan are lower than those associated with a new loan.

David Johnston

Insanity: doing the same thing over and over again and expecting different results. -- Albert Einstein

While I do not discount the fact that repeat business is the norm, I would offer that lenders take this for granted and actually have less profit than needed on the intital transaction (on a per unit basis) and actually set their prices assuming a repeat customer. Either way, a lot of the cost is fixed (rent, employees, utilities) and the semi-variable costs (bookkeeping, etc.) are semi-variable only because of economies of scale, which payday lenders generally do not have. This law is grandstanding for social righteouness and does little to improve (and will probably hurt) those that are trapped in the system. It would be better to use the tax money from the profits to institute programs that allows the trapped to increase their income generating capability and thus help them to escape.

While I have not read "Merchant of Venice" my limited understanding of the times was that most lenders did not offer "payday style" loans, they were more of "small business" style loans; probably for this very reason.

If you feel that current economic profits are too high when the going APR is > 36%, then why haven't more shops opened that aim to undersell the competition. A entrapenuer with a decent business plan and location should be able to get a business loan for a lot less than 36% on longer terms.

In the end, no one has a right to borrow money. While abuse may occur, there are already mechanisms available to investigate and remedy such abuse. Government needs to make tools/programs available that those in need can use to HELP THEMSELVES break free of the circle.

"Caveat Emptor"

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jroane

There are other options, especially for military personnel. Credit Unions have traditionally made small unsecured loans. What I think this bill would do is consolidate the industry, for one. The current pricing/cost structure allows for many lenders to enter the market. A lower regulated price would mean only those firms with the knowledge and desire to drive down costs would survive. One reason for the high cost is that too many players are trying to cover duplicate costs. Reduce the duplicate cost and innovate on the delivery and my guess is that it still could be profitable. I make no claims for desirability.

David Johnston

jroane: I have already agreed that the market is one for competition. Does government really need to spend their limited resources on micro-managing the market and speeding it to consolidation? Whenever regulation is involved unintended consequences happen. And while market mechanisms are not always smooth and painless our ability to correct that is not proven.

An example of "duplicate costs" would be helpful, since none come immediately to mind.

The realities of payday loans is that branch count is very important, since most people who need these loans cannot travel far from their homes and/or jobs to cash their checks. This combined with the stigma of running such an outfit undesirable for many. While this in itself would argue for more regulation to compensate, doing so would more likely result un-covered areas.

RichYancy

Perhaps there should be more rules on disclosure instead of caps. I have seen the commercials for some of these types of loans. The commercials always make the borrowers appear to be living luxurious lifestyles because it was so easy to borrow the money. Nothing is ever mentioned about payments, rates, or consequences for default. If the lenders would make it clear that the loan is very risky and rates are much higher than a standard loan, then I think the lenders should be able to charge whatever the current law permits. The most important thing is that both parties to the contract should understand the terms of the contract.

jroane

The government does have some responsibility to regulate, after all we are talking about real people, not just economic principles. Unregulated competition also has consequences, all of which are not positive for a modern society. The duplicate cost I speak of are the "backroom" costs, administrative staff, IT, executive pay, etc.

douglaskarr

The interesting thing is that my bank allows me to overdraw my account by up to $700, charging a $30 fee with each withdrawal into my 'overdraft protection'. Isn't that the same as an exhorbitant payday loan?

Since all fund transfers are now electronic, I'd like to also know why banks are allowed to put 'holds' on checks. The old days of processing those are long gone... it's simply a way to siphen a couple more bucks of interest off of my money.

David Johnston

RichYancy, the cool thing about a contract is that both parties can agree to specific terms without requiring government approval. Now, contract law is very broad and has very specific requirements in order to protect both parties to the contract.
If the government wants to help the buyer understand the contract, and require the seller to provide ready access to such materials, then I am ok with that. To allow the government to step into a contract situation and dictate the terms of that contract just fixes the symptoms and leaves the public no better off should they come across a similiar yet unregulated situation.

Jroane, while unregulated competition can involve (often short-term) pain, I as an individual can say no and walk away and choose someone else. When government gets involved it becomes less easy to walk away, and if an unintened consequence is to lessen competition and options then said regulation actually hurts me.

"Give a man a fish and you feed him for a day, teach a man to fish and he will eat for a lifetime." -- Chinese Proverb

Government can help the most people using the least resources by helping them learn, not by sponsoring Friday fish frys.

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DW

For a while I lived in the Philippines, where 5/6 was the norm. If I lent you 5 dollars, you paid me back six the next day.

I do not have my calculator handy, but that is a pretty high interest rate.

What was notable was that there were no barriers to entry in this business since it was in the informal sector, so you would have expected the interest rate to be lower unless (a) it reflected the actual cost, including risk of non-repayment; or (b) there is some type of "stickiness" related to cultural norms.

Since I went to grad school in the mid-1980s, I am required to endorse the rational expectations approach and go for explanation (a).

keyrouse

assuming these payday loan places would go out of business, would crime increase if people couldn't get these loans ? what cost does that imply ?

David Johnston

The question to ask, assuming that legislation is necessary and/or good, is Federal legislation the best place for implementation. These transactions are local to the point of a single neighborhood, city laws or at most county laws would be the proper forum to bring this up, with a restriction that lenders can only lend to those in the same city/county. A single law that covers Little Rock, AR and New York City, NY seems to be unrealistic if they are trying to impose a "market" rate, since those two markets are total different (while I may be able to survive asking 20% in AR, I would need 30% for a similiar size customer base in NY just because of issues like default rate, average loan amount and the like.) Even a State law seems out of place (and if the only realistic place to put the law is State or higher then maybe the law should be reconsidered in the first place).

In this case they are trying to affect only military personnel, which are under the jurisdicion of the Federal government, but don't laws apply to the "person" the law affects not the beneficiary?

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pkimelma

I think the problem is just terms (words). The cap is on APR. So, the solution is to add "fees" which are not origination fees (or using whatever terms you do not have to legally count into the loan to add it to APR), or let these people setup "accounts" with account charges. This is how the banks get away with usuary on overdraft and other short term loans. They could charge a sliding scale of charges based on the amount (sliding down relative to the amount), so the setup on a $100 may be $5 and $15 for $500, etc, but hidden as account fees and charges to not count in the APR. Sad that this kind of issue exists.

Jtapp

It's a bad law. Anytime government tries to set up a wage or price control it shackles the efficiency of the free market and eliminates consumer choice. If someone wants to be charged 36% interest, why shouldn't they be allowed to? Surely a Chicago boy like Levitt is familiar with Milton Friedman.

theberle

DW:

If I lent you 5 dollars, you paid me back six the next day.

Sounds to me more like a rounding error is the biggest reason that interest rates weren't lower.

rdrutherford

I think you are forgetting that when usuary concepts were established that there was none or little chance of inflation. Before 1900 there was nearly zero inflation.
Of course now we have stable inflation rates, but that can change. You do remember the early 80's? My grandfather was also upset by the limit on 36% interest on a mortgage he backed at 36% interest.

Developing countries in rural also experience high real as well as nominal rates of interest on loans. Although for other reasons than here.

But no, I will not shed a tear for them!

Ken D.

My personal view is that most of the defense of payday lenders here is extreme libertarian claptrap, akin to arguing that crack and meth should be legal and unregulated because it is none of society's or the government's business if adults choose to purchase and utilize such products. In high-stakes financial markets, whether the players acutually are sophisticated, there are many regulations hugely more intrusive than a usury limit at (bad joke) 36 percent. But I detect a shortage of evidence, especially considering that this blog arises directly out of the academy. Has some fine energetic Levittian academic researcher parked him or herself in a payday lender's storefront, interviewing all, studying the books and determining how this world really works? If so, citations please. If not, point a good grad student in that direction.

Jbho

While reading the Merchant of Venice is not a bad idea, even latent sympathy a reader may have for the deceived lender Shakespeare portrays does not help to explain lending economics. Likewise, although libertarian "clap trap" as described by a commenter above may actually have its merits, believing in laissez faire economics, is not a prerequisite to understanding lending economics. However, understanding the cost of running a lending business is relatively simple.

If a lender charges $3.60 on a $100 loan, then to recoup the $100 lost on each default, the lender would need to recover full repayment on about 28 loans. In other words, just to recoup the money lost on one default, the lender needs to make the $3.60 fee on 28 new loans ($3.60 x 28 = $100.80) to break even. So to simply be in the same position the lender was in before each default (to break even, not profit), default rates cannot exceed a rate of 1 default, for every 28 loans. This means that when the lender charges such fee, if the default rate is higher than 3.5%, (1 unsuccessful loan / 28 successful loans = 3.5%) the lender will end up handing out more money than it brings in. When you add the standard fixed costs for running any storefront business (rent, employee costs, etc.), the default rate needs to be even lower.

This is why whenever states propose a 36% rate cap, payday lenders close their doors. This is why banks charge more than 36% (and charge far more than payday lenders) for bounced checks. When states pass legislation limiting payday loan costs below the market rate, lenders have not responded by offering less expensive loans, they can't afford to do so, and the customers won't repay at rates justifying the lower costs. Likewise, banks have not responded to payday loan rate caps by lowering their bounced check fees. Utility companies have not lowered the cost to get service reinstated. Instead, legislating low payday loan price caps only forces regulated lenders to close their doors and stop offering loans.

While some advocates would assert that closing payday lenders is a desirable solution, eliminating credit providers is not a solution for consumers with unanticipated financial needs. When states institute these rate caps, persons living paycheck to paycheck are forced to decide between bounced check costs which are more expensive than payday loans, having their utilities turned off, or using “unregulated” offshore Internet payday lenders.

It would be far better to have consumers use a viable alternative to bounced check fees and utility restart fees, and to have such alternative regulated by state officials. It would be far better for state legislatures to allow a fair market rate, and to mandate state regulations, so that regulators can monitor short term loans. It would be far better for legislatures and local leaders to find ways to encourage lender competition, then to simply legislate these consumers into the hands of unregulated, offshore Internet lenders.

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Bruce

I recently read a Reuters news article, written by Nick Carey, Mar 23rd, 8:15pm ET, titled, "'Pay day' loans exacerbate housing crisis". I would like to clarify that there are some great inaccuracies and bias in this story that really must be pointed out.

I have had extensive experience with pay day loans, and, though I agree that the APR (annual percentage rate) is quite high, and people can get into trouble when they do not use these loans as they are designed to be used, this news report highly exhagerates the cost of a loan. Read from the article as follows;

"A pay day loan is typically for a few hundred dollars, with a term of two weeks, and an interest rate as high as 800 percent. The average borrower ends up paying back $793 for a $325 loan, according to the Center."

This is not accurate! And there was much more inaccuracy than this in the article.

A pay day loan from a legitimate financial retailer generally costs about $15 for every $100 up to $500. This means that for a loan of $100 for 15 days the charge will be $15, totalling the loan at $115, which must be quoted as an APR of 365%. the actual total pay off for a $300 loan is $345.

In reality it is only a fee that is being paid, not interest. However, government regulations require that it be quoted as interest, as an APR.

The only way that a short-term loan, a pay day loan, could build up to the absorbitent amount qouted in the news story, is if the loan were to be "rolled over", which is highly illegal in nearly every state that regulates these loans, so, thus, it would be highly improbable that there would be an average of borrowers that pay such amounts.

Pay day loans are for exactly what they are named. A short term small loan to be paid off by the next pay date of the borrower.

These loans have saved many a borrower, in a temporary financial pinch, to pay some bill(s), from much harsher penalties and costs that are incurred by banks and credit institutions if checks do not clear or payments are late.

The proper use of a pay day loan actually shows a personal and professional level of responsibility when it is used properly.

Yes, people do mis-use these loans, people get into trouble, people borrow beyond their means, and there are less than savory lendors who do not do what is right in order to avoid such disasters for their borrowers.

Pay day lendors must exercise great responsibility to protect borrowers and potential borrowers from becoming victims of borrowing beyond their means. That might even mean turning down a less than able and questionably qualified customer from borrowing.

I am disturbed to also hear lawmakers and politicians who are buying into mis-information and threaten the reasonable management and existence of a very useful and helpful service to many people.

Bruce - Washington

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garycarson

You can get a $100 withdrawel at an ATM with a credit card for a couple of bucks (it's usually going to be more than $1.38) but you can't get a cash advance on a credit card at a teller window for that. I don't know exactly what it is, but it's more like $12 -- plus interest charges.

The transaction cost for the payday lender is fairly high, and the period of the loan is usually less than a week.

She's right, it's a bad law.

The ones they should pass a law about is the furniture rental places -- not for their overpriced stuff and rentals which are essentially usery disguised as rental agreement, but to stop their ability to use criminal laws to collect payments. If you default on a rental agreement it's treated as theft if you don't return the merchandise, where default on a secured not requires civil action to recover the merchandise. That should be outlawed.

But, very small short term loans have high transaction costs and should not be treated as usery. Lenders should be allowed to recover transaction costs.

Read more...