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Competing Interests

When Trudy Robideau needed to finance a car repair, she decided to take out a payday loan. When she couldn’t afford to pay it back after the loan expired, she had to take out another one. She described the experience as being hooked: “You can feel the hook right in your mouth. And you don’t know it at the time, but it gets deeper and deeper.” Payday loans are short-term, high interest loans that lenders offer with the expectation that the borrowers will repay them by their next payday. Payday loan fees can be a percentage of the borrowed amount or based on certain increments of the borrowed amount. A typical payday loan is $300 for two weeks with an additional service fee of $45; the general rule is to charge a fee of $15 per every borrowed $100. Over the course of a year, the typical payday loan will accrue an annual percentage rate (APR) of 400 percent, an astronomical rate compared to a credit card’s 12 to 30 percent.

Robideau isn’t the only American consumer to be ensnared by what critics of payday loans call “predatory debt traps.” In fact, she’s just one of an estimated 12 million American adults who use payday loans every year. Despite coercive practices, payday loans provide underbanked consumers with key financial benefits, requiring any regulations to be sensitive to this nuanced relationship. Over the past two decades, the payday loan industry has mushroomed into a popular source of short-term finance for low-income Americans. A rare sight in the early 1990s, payday loan storefronts are now 24,000 strong, outnumbering McDonald’s and Starbucks locations combined. And these payday lenders are quite popular — as evidenced by the 12 million people who use them annually, accounting for an estimated $8.7 billion in yearly interest and fees for payday lenders.

Despite their prevalence, payday lenders lack substantial regulation. Of the 36 states with payday lenders, 13 regulate the burgeoning industry. The federal government’s broad consumer finance laws also provide little consumer protections; the Truth in Lending Act requires payday lenders to provide the borrower with both a total dollar amount and APR before the borrower signs for the loan. Unfortunately, this lack of effective payday lender regulation comes at a price to consumers. Four out of five payday borrowers have to renew their loans, and one out of five are forced to renew their loans at least seven times. These borrowers end up wading further into debt in order to pay off their loans. For borrowers that renew at least seven times, the borrowing fees alone often exceed the amount originally borrowed. This pernicious spiral ultimately forces a typical customer to borrow 8 to 12 times per year. When put in the context of the millions of Americans who take out these short-term loans, payday lenders collect $3.4 billion annually. Those results explain payday loan critics’ nickname for the exploitative service — predatory debt traps.

The problems payday lenders pose to consumers aren’t surprising to those familiar with the industry. Hilary Miller, president of the Payday Loan Bar Association, conceded, “In practice, consumers mostly either roll over or default; very few actually repay their loans in cash on the due date.” Unfortunately for the average borrower, who will take out eight different loans each for $375 per year, that trend translates into spending a ludicrous $520 on interest alone. Unsurprisingly, drowning in a debt sinkhole is not a particularly pleasant experience. An article published by the Journal of Banking & Finance shows that individuals caught in such a vicious cycle are more likely to be victims of involuntary bank account closures.

Similarly, a study published in the Quarterly Journal of Economics found no evidence that payday loans actually alleviate economic hardship. In fact, Northwestern Professor Brian Melzer found that access to payday loans correlated with “increased difficulty paying mortgage, rent, and utilities bills.” Among families within the $15,000 to $50,000 annual income bracket, payday loans increased the difficulty of paying bills by 25 percent. Families dependent on payday loans are more likely to overdraft, “over-extend household budgets,” and fail to pay important bills, causing them to cut back on necessary family needs, such as medical care, meals, and phone service. Although many payday lenders tout themselves as helpful in times of financial hardship, the loans often lead to the economic collapse of struggling families.

But not all research paints payday loans as an endless feedback loop of spiraling debt. A study from Dartmouth analyzed and compared household surveys on payday loan behavior and usage in Oregon to those in Washington. Unlike Washington, Oregon enacted policy in 2007 that restricted payday lenders to charging no more than $10 per every $100 borrowed, maxing out the APR at 150 percent. Restricting access to payday loans caused borrowers to make up for shortfalls by overdrafting on accounts and paying bills late, contradicting results from the studies in the Journal of Banking & Finance and the Quarterly Journal of Economics. Dartmouth Professor Jonathan Zinman suggests that when the cap was mandated, borrowers were significantly more “likely to experience an adverse change in financial condition,” because payday loans were no longer available for consumption smoothing and investing. Eric Dortch benefited from such consumption smoothing. To pay his son’s college tuition on time, Dortch took out a payday loan after being turned down by other traditional banks. He said, “I know that if these loans were not an option in my financial portfolio then the completion of my son’s college degree would not have been possible.”
But the benefits of payday loans are not just limited to one-off anecdotes. Between 2004 and 2005, Georgia and North Carolina shuttered all payday loan storefronts, believing that they were exploiting consumers and, in the process, harming their state economies. The Center for Responsible Lending, one of the leading crusaders in the fight for tougher regulations in the payday loan industry, predicted that banning payday loans would save Georgia and North Carolina’s consumers $147 million and $153 million respectively. Unfortunately, the Center drastically overestimated the benefits of closing the stores. After the ban, the number of bounced checks statewide jumped dramatically; the Federal Reserve check processing center in Atlanta returned 1.2 million more checks than in the previous year when payday loan storefronts were still operating in Georgia. Instead of saving, consumers were paying a total of $36 million per year, at a fee of $30 per bounced check.

While some may take issue with usury, payday lenders provide a crucial service to the estimated 34.4 million unbanked or underbanked households in the US. Georgia and North Carolina’s experiments in banning payday loans showed that heavy-handed incursions upon consumer freedom in the industry can and do produce unwanted consequences. If states can regulate the lenders instead of banning them outright, they may be able to preserve some of the positive benefits while still limiting the harms.

The United States can tackle this problem in several ways. While the Center for Responsible Lending recommends that Congress impose a 36 percent interest rate cap, like it did in the Military Lending Act, the Consumer Financial Protection Bureau has released a more detailed, less one-size-fits-all proposal. Last year, the agency proposed designating two classes of short-term loans and assigning each its own regulatory framework. For one, with the “prevention” framework, lenders would be required to determine the probability of the borrower being able to pay back the loan. If the borrower were to default, she would not be able to get another loan within a 60-day period, which would end the possibility of a debt trap, and have the right to sue the lender for improperly judging her ability to pay the loan. In the other method, known as the “protection” option, payday lenders would be required to screen the borrower’s income and financial history before extending credit; currently, borrowers only need to show evidence of employment and bank account. In addition, the protection requirement would mandate that payday lenders verify that, in the event the borrower were unable to pay off a loan, she would be in debt for no more than a total of 90 days within the next 12 months. As a final safeguard, the maximum loan would be $500 to be paid back in 45 days.

However, in enacting either policy — banning payday loans altogether or strong regulation such as that offered by the CFPB and CRL — the United States would inadvertently eliminate access to loans for millions of Americans who, for whatever reasons, can’t secure traditional lines of credit. For one, many low-income families would be left without the final resort of payday loans because of the new requirement to prove an ability to repay. Second, the CFPB published a report that examined the potential effects on the payday loan industry if the regulations were to be enacted. According to the report, fees charged by the industry could be reduced by an estimated 60 to 75 percent, but such a decrease would “decimate” the industry. Moreover, a study published by Harvard Business Law Review states that the regulations suggested by CFPB “run contrary to the principles of free-market economics and would thus further increase the cost of loans to borrowers.” By requiring payday lenders to go through a more rigorous screening process, transaction costs would increase and then be passed onto the borrower. That is, it could actually be more expensive for borrowers were the CFPB regulations to be passed.

But there is a middle ground. Norbert J. Michel, a research fellow at the Heritage Foundation, and Tim Worstall, a contributor to Forbes magazine, suggest reforming the payday loan system by promoting good old-fashioned competition. Applying the basic economic concepts of supply and demand, Michel and Worstall suggest encouraging entry into the payday loan market as a mechanism to drive down APR rates. It’s classic economic logic: If there’s abundant supply of a particular good (in this case, payday loans) and it faces constant demand, prices (or in this case, interest rates) will naturally drop. And this classic economic logic seems to work in the real world; according to a study from the International Journal of Banking, an additional payday firm per thousand residents is associated with an estimated $4 reduction in fees. Heightened competition in the payday loan industry would not only bypass the drawbacks experienced in “ban states,” such as Georgia and North Carolina, but would also bring down the robber-baron interest rates that have made payday loans so controversial.

In a Harvard Business Law Review article, Eric J. Chang argues that the best way to actually utilize competition is to create an online platform where borrowers could “shop” for payday lenders. Filling in the information deficit would drive down APR rates since consumers would be able to identify which lender offers the best deal. There’s no one right way to handle payday loans, and that uncertainty is only augmented by conflicting research. But a balanced analysis understands that payday loans serve a vital economic function and shouldn’t be regulated out of existence. Instead, the United States should take a gentler approach that ensures consumers are informed, encourages competition, and helps everyone find a regulated way to payday.

Art by Julia Pantak