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Friday, June 24, 2016

Upper-income Preferences Are Blocking Low-income Choices on Payday Loans

New regulations might cut off the supply of credit to terribly under-served communities.

What would you do if your car transmission failed on the day your rent was due? If at the same time you were facing an outstanding medical bill from an emergency hospital visit? What if you were also facing jail time for outstanding taxes and child support? What if you have already borrowed from your family and friends? What if you had nothing of value left to pawn or sell?

Most of us are lucky enough to never face such dire financial circumstances. But for many others, they might be a daily reality. That’s where payday loans come in. A payday loan is a short-term loan, generally of $500 or less, that is due on the next payday. To receive the loan, the customer must write a check for the amount of the loan plus the finance charge or provide the lender with checking account access. Depending on how the loan is structured, it must either be paid back in a lump-sum or over a period of time. Sometimes, for an additional fee, the borrower might roll over the loan to the next payday.

The media often sensationalize payday loans by highlighting that the charge for a typical two-week payday loan equates to an annual percentage rate of almost 400 percent. However, these are short-term loans, so it’s more relevant to look at fees collected in two weeks. Typically, you need to pay $10 to $30 for every $100 that you borrow.

Often, this is a less expensive option than penalties on other already-accrued debt or bounced checks. For example, if your landlord charges $20 for every day you’re late, waiting two weeks until the next pay day would cost you $280. Instead, a $500 payday loan will cost at most $150. That’s how payday loans help people manage financial challenges.

Unfortunately, this solution might no longer be available. The Consumer Financial Protection Bureau proposed a new regulation aimed at protecting consumers from what the bureau considers predatory lending practices. If the regulation goes into effect, lenders would need to conduct an upfront “full-payment” test to determine if borrowers will be able to pay the loan without compromising other financial obligations and without needing to continue borrowing month-to-month.

The CFPB also wants to make it harder for lenders to re-issue or refinance loans and to curtail lenders’ ability to access a borrower’s bank account to collect payments. As reported by the New York Times, if implemented, both sides agree that the proposed rules would radically restrict access to payday loans: loan volume would fall by at least 55 percent. That means more than half of the people who currently rely on the payday loans would no longer be able to do so. What options will they have then?

Regulators at the Consumer Financial Protection Bureau are not alone in going after the payday lenders. As reported by the NPR, President Obama also supports tougher regulations for payday lenders: “If you’re making that profit by trapping hard-working Americans into a vicious cycle of debt, you’ve got to find a new business model.” Google took a similar stand by announcing that the company will stop allowing ads for payday loans.

It is easy to see where the negative perceptions of payday loans come from. For those with a decent credit score, who have never experienced a truly serious cash squeeze, it is easy to take access to credit for granted. If you have never faced dire financial circumstances, you have no appreciation for the service the payday lenders provide. But before we impose middle-class preferences on the choices of low-income individuals, it’s important to understand why the interest rate on payday loans are so much higher than on an average credit card.

Assume for a second that you are a lender. Under what circumstances would you lend money to someone with no collateral and no credit history? Your borrowers have poor credit scores, so you can expect that a significant percentage of loans won’t be repaid. Since the default rate on payday loans is significantly higher than on other types of loans, the interest rate also must be higher than on any other loan. Also, as argued by Tim Worstall, payday loans are expensive to process because they involve lending small amounts of money, usually less than $500, for short periods of time. Plus, payday lenders understand that their borrowers usually have other urgent debt and financial obligations. Since borrowers typically pay off their most expensive debt first, the high interest rates keep the borrowers from delaying the payment until other debts are paid off.  

As for Google, of course, the company is free to adopt any policy it likes. But what is Google really trying to accomplish? Without a doubt, the ban on payday loan advertising is good for Google’s reputation: it makes the company appear socially responsible.

But if Google really wanted to help payday borrowers, it should instead invest in creating competition to payday loan providers. Nothing brings down prices— or, in this case, interest rates — like competition. If Google truly believes that payday loans are exploitative — that it is possible to provide loans to the same number of individuals on better terms at lower interest rates — then they have found a great business opportunity.