Sunday, October 25, 2015
The Myths About the Evils of Payday Loans
The first complaint against payday lenders is their high prices: the typical brick-and-mortar payday lender charges $15 per $100 borrowed per two weeks, implying an annual interest rate of 391 percent! That’s expensive, to be sure, but is it unfair? For economists, the answer depends on whether payday credit markets are competitive: with healthy price competition, fees will be driven down to the point where they just cover costs, including loan losses and overhead.
Judging by their sheer numbers, payday lending is very competitive. Critics often fret that payday lenders outnumber Starbucks as if they—payday lenders, not Starbucks—were a plague upon the land. But shouldn’t competition among all those payday lenders drive down prices? They seem to. This study estimated that each additional payday firm per 1,000 residents in a given Zip code was associated with a $4 decline in fees (compared with a mean finance charge of about $55). In the later years of the study, the authors found that prices tended to gravitate upward toward price caps, but that seems like a problem with price caps, not competition. And of course, payday lenders also have to compete against other small dollar lenders, including overdraft credit providers (credit unions and banks) and pawnshops.
Competition seems to limit payday lenders’ profits as well as their prices. This study and this study found that risk-adjusted returns at publicly traded payday loan companies were comparable to other financial firms. An FDIC study using payday store-level data concluded “that fixed operating costs and loan loss rates do justify a large part of the high APRs charged.”
Even though payday loan fees seem competitive, many reformers have advocated price caps. The Center for Responsible Lending (CRL), a nonprofit created by a credit union and a staunch foe of payday lending, has recommended capping annual rates at 36 percent “to spring the (debt) trap.” The CRL is technically correct, but only because a 36 percent cap eliminates payday loans altogether. If payday lenders earn normal profits when they charge $15 per $100 per two weeks, as the evidence suggests, they must surely lose money at $1.38 per $100 (equivalent to a 36 percent APR.) In fact, Pew Charitable Trusts (p. 20) notes that storefront payday lenders “are not found” in states with a 36 percent cap, and researcherstreat a 36 percent cap as an outright ban. In view of this, “36 percenters” may want to reconsider their position, unless of course their goal is to eliminate payday loans altogether.
A central element of the debt trap critique against payday loans is their “spiraling” fees: “When borrowers don’t have the cash come payday, the loan gets flipped into a new loan, piling on more fees into a spiral of debt for the borrower.” It’s certainly true that payday loan fees add up if the borrower extends the loan (like any debt), but do they spiral? Suppose Jane borrows $300 for two weeks from a payday lender for a fee of $45. If she decides to roll over the loan come payday, she is supposed to pay the $45 fee, and then will owe $345 (the principal plus the fee on the second loan) at the end of the month. If she pays the loan then, she will have paid $90 in fees for a sequence of two $300 payday loans. Payday lenders do not charge refinancing/rollover fees, as with mortgages, and the interest doesn’t compound (unless of course she takes out a new loan to pay interest on the first loan). Perhaps it is just semantics, but “spiraling” suggests exponential growth, whereas fees for the typical $300 loan add up linearly over time: total fees = $45 + number of rollovers x $45.
It’s well documented that payday lenders tend to locate in lower income, minority communities, but are lenders locating in these areas because of their racial composition or because of their financial characteristics? The evidence suggests the latter. Using Zip code-level data, this study found that racial composition of a Zip code area had little influence on payday lender locations, given financial and demographic conditions. Similarly, using individual-level data, this blog post showed that blacks and Hispanics were no more likely to use payday loans than whites who were experiencing the same financial problems (such as having missed a loan payment or having been rejected for credit elsewhere). The fact is that only people who are having financial problems and can’t borrow from mainstream lenders demand payday credit, so payday lenders locate where such people live or work.
(Note: The economists added that rollovers are a bit more problematic but in the end concluded:
Critics see these chronic rollovers as proving the need for reform, and in the end it may. A crucial first question, however, is whether the 20 percent of borrowers who roll over repeatedly are being fooled, either by lenders or by themselves, about how quickly they will repay their loan.)
at 10:35:00 AM