Payday Lending: Serving the Unbanked
The last few decades have witnessed many innovations in the consumer finance industry. Consumers enjoy a myriad of credit programs tailored to their particular needs: credit cards, home equity lines of credit, payday cash advances, etc. Unfortunately, all these options create problems too, as the attendant responsibility of money management has left many individuals struggling to service their debt. Nevertheless those who do not avail themselves of these services find themselves marginalized in an economy structured around the use of financial assets.
Enter the Center for Responsible Lending, a government think-tank dedicated to preventing consumers from making unwise choices concerning their finances. Of particular concern to the Center is a segment of society dubbed the "unbanked." Roughly 7% of families hold absolutely no financial assets (bank accounts, retirement accounts, life insurance, etc.). The unbanked are primarily comprised of the poor (51% earn under $10,000), and of ethnic minorities (53% are Black or Hispanic). By not participating in the financial mainstream, the unbanked miss out on the convenience, security, efficiency and wealth-building opportunities that financial institutions offer. Organizations like the Center for Responsible Lending seek ways to improve the position of the unbanked by forcing them into the financial mainstream.
In a recent study, the Center took to task an industry that offers services to the unbanked, the so-called "payday lenders." Payday lending refers to short-term loans designed to tide borrowers over until their next paycheck. The Center argues that payday lending companies charge "predatory" fees that ensnare the unwary borrower into a debt trap of repeated loans—each loan used to pay off the previous loan. The payday lenders are analogous to drug dealers, addicting their clients, then bleeding them dry, and ultimately leaving behind blighted communities. Payday lending, which sprang up more or less naturally from the free-market process, may thus be an example of market failure needing the remedy of government abolition or regulation.
What Payday Lending Is
Payday lending is a relatively new development in consumer finance. Payday lenders market their service as a credit instrument to bridge the borrower until the next paycheck. Popular examples are companies "Check into Cash" and "Check ‘n Go." A typical payday loan works like this: the borrower writes a post-dated check to the payday lending company. In return, the borrower receives cash, minus lending fees. For a $250 loan, the lending fee might be $50 and the loan term 30 days. That works out to a 240% APR —a hefty rate!
The Center for Responsible Lending concludes payday lending is a predatory business in that it lures borrowers into a "debt trap." The problem, the Center says, is this: borrowers take out short-term loans with high interest rates and transaction costs. The costs are so burdensome that borrowers soon find they need additional loans. This cycle traps borrowers in a situation of revolving high-priced, short-term credit. The Center’s study estimates conservatively that borrowers spend $3.4 billion dollars annually in lending fees.
Is there a solution? Short of banning payday lending altogether, the Center advocates that payday lending companies be permitted to advance no more than 4 loans per customer per year and that these loans have 90-day terms (instead of 14-30 day terms). In this way, spendthrift borrowers are prevented from abusing the service and falling into the trap of revolving credit.
The Benefits of Payday Lending
At first blush, the situation appears exploitive. Here we have masses of lower income people transferring their meager wealth via outrageous interest rates to unscrupulous moneylenders. However, despite the sizeable APRs, the lenders may not making be out as well as one might suppose. As the outstanding growth rate of the payday lending industry suggests, potential borrowers aren't exactly running in terror. Indeed, it may be the Center for Responsible Lending that is to be feared most.
Consider first the outrageous APRs (240% compared to, say, 6% for a typical home loan). The high APR in part reflects the relative size of transaction costs to the small loan amount (<$300). The lending company must run credit checks, process paperwork, etc., regardless of whether the loan is $100,000 or $100. In this way, a reasonable $50 transaction fee translates into an APR that appears unreasonable. Even if transaction fees were removed from the picture, one would still expect large APRs for payday loans because of the relative credit risk of payday borrowers. A North Carolina government report (sited by the Center's study) reveals that over 25% of check assets held by payday lending companies in the state were in the form of bounced checks! Not surprisingly, high APR’s also reflect the high risk of borrower default.
Now consider the situation from the borrower’s perspective. Most who turn to payday lending have poor or limited credit history. Although their situations may be dire, they naturally find few people stepping up to extend them a loan. Credit is a measure of the reliability of a borrower to live up to a loan contract. As economist Henry Hazlitt pointed out, credit is not "something a banker gives to a man. Credit, on the contrary is something a man already has." For a borrower with bad credit, payday lenders offer an invaluable service few banks will offer. Not only do they provide liquidity when it is most needed, payday lenders provide the borrower an opportunity to establish a positive credit history. In short, payday lenders provide a means for the unbanked to join the financial mainstream.
Finally, consider the hazardous option of government regulation via loan-amount and frequency restrictions. Regulation creates market distortions that are often the source of more problems. First, limits on loan amount and frequency, no matter how sensible they may seem to an enlightened advocacy group, necessarily ignore the nuances of individual situations. Each side in the loan transaction considers its opportunity costs by weighing price, convenience, and urgency. Loans are taken for critical needs like paying an electric bill, and for less critical needs like buying Christmas presents. Who is to draw the line between necessary and frivolous? Ultimately, the decision to take a loan reflects the subjective value and time preferences of consumers (which is more valuable to me: $250 today or $300 in 30 days?). On the margin, it is the borrower and lender who are most fit to decide the appropriateness of any transaction—not the Center for Responsible Lending, or a congressman.
Payday lending was an innovation created to serve an underrepresented market segment. To the extent that this market result is undesirable (high costs to borrower), it leaves open the possibility for other market players to create better solutions. Government regulations stifle innovation by reducing the potential for profits or by outlawing such innovation. One example of a recent development that ameliorates the need for regulation is "payroll cards". These are plastic cards that act like debit cards, but do not require the holder to hold any bank account. Many companies now pay employees by crediting their payroll cards instead of issuing a paper check. As the market evolves, expect other innovations that seek to tap into the unbanked consumer segment.
Finally, the question of whether such a thing as a "debt trap" even exists is debatable. The Center for Responsible Lending sites the high frequency of repeat business (2/3 of borrowers incur 5 or more loans per year). But the transaction frequency may simply reflect the lack of credit alternatives. And to the extent that borrowers feel pinched by the high costs of borrowing, those costs may still be preferable to the alternate cost of resorting to the underground economy. Whereas a payday loan borrower always has the protection of declaring bankruptcy, he has no such option in the face of a surly loan shark.
Julian Bond, chairman of the Board of the NAACP, says "Visits to payday lending stores—which open their doors in low-income neighborhoods at a rate equal to Starbucks openings in affluent ones—are threatening the livelihoods of hard-working families and stripping equity from entire communities. The NAACP is dedicated to eliminating payday [lending], because wealth-building and saving for the future are vital to the economic success of communities of color." Observers like Bond are attempting to alleviate a symptom of poverty by hampering the freedoms that enable people to exit it. If the government steps aside, a free market will continue to reach out and draw the unbanked into the financial mainstream.
Michael Foley studies economics at George Mason University. firstname.lastname@example.org. The author thanks Professor Mark Bender, George Mason University, for helpful comments on an earlier draft. Of course, the author holds ultimate responsibility for the facts and ideas expressed. See also Tom Lehman "In Defense of Payday Lending."
 Economics in One Lesson. Henry Hazlitt. P. 43.