Wednesday, July 6, 2011

Could Restrictions on Payday Lending Hurt Consumers?

When teaching about price ceilings and price floors, I often toss in a bit about usury laws as an example of a price ceiling. But the usury example never seemed to me very pedagogically effective: it has a whiff of anachronism. A much better example for connecting with students is to discuss payday lending. Kelly Edmiston of the Kansas City Fed raises many of the key issues in: "Could Restrictions on Payday Lending Hurt Consumers?"

A payday loan typically involves a borrower writing a check for, say, $200, and then receiving $170. The lender promises not to cash the check for a couple of weeks. As Edmiston says: "While payday lenders often charge fees rather than interest payments, in effect these charges are interest. Comparing the terms of varying types of loans requires computing an effective, or implied, annual interest rate. For payday loans, this computation is straightforward. A typical payday loan charges $15 per $100 borrowed. If the term of the loan is two weeks, then the effective annual interest rate is 390 percent."

Many states have regulated or banned payday loans. "By the end of 2008, 10 states and the District of Columbia had instituted outright bans on payday lending. Other states have passed regulations that indirectly ban payday lending by making it unprofitable. For example, in Massachusetts, the Small Loan Act Caps interest at 23 percent per year. In states that allow payday lending, regulations may indirectly restrict or effectively ban the practice. A variety of such regulations exists. Most states legislate maximum loan amounts, usually from $300 to $500. The limits that states impose on fees vary widely."

The key point for public policy in this area, and a useful theme for teaching about price ceilings and regulation, is that banning or limiting payday lending doesn't alter the underlying reasons why people seek out such loans. Restricting payday loans pushes users to other options, which have tradeoffs of their own. For example:

  • Running down available cash balances in a bank savings account is surely cheaper than a payday loan in the short run. But it leaves people exposed to other risks--like not being able to pay the rent. "Some researchers argue that households recognize a need to have money readily available when using a credit card is not an option—for example, when making rent payments ... Similar logic may explain why some borrowers resort to payday loans even if they have credit cards."
  • Cash advances on credit cards are pricey, too. "Most credit card fees on cash advances, if considered short-term loans, are costly as well. The fee for cash advances on many credit cards has recently climbed to 4 or 5 percent .... In addition, higher interest rates, which average 25 percent, generally apply to cash advances ... Thus, on a two-week loan, the effective annual interest rate would average from 129 to 155 percent. In addition, cash advances are typically not subject to the interest grace period associated with purchases."
  • Without a payday loan, the would-be borrower may end up paying late charges on other bills--or having to pay extra to have electricity or heat reconnected. They may exceed their limits for credit card borrowing and face penalties. They may bounce checks and face those fees.  "In 2010, bounced check fees averaged $30.47. ... One study calculated the median interest rate on these loans to be well in excess of 4,000 percent, or up to 20 times that of payday loans. ... The highest rates result from bouncing multiple checks for small amounts, where a fee is charged for each bounced check. Further, knowingly passing a fraudulent check is illegal and could result in substantial civil and criminal penalties."
  • Loan shark often charge 20% per week, along with threats of violence.
  • Pawnbrokers are costly, too. "A 2006 analysis of pawnbroking compiled a list of monthly interest rate ceilings for all 50 states and the District of Columbia. ... The median cap on interest rates was 15 percent monthly, which is similar to the typical payday loan charge. Many of the caps were much higher, however."
  • Payday lenders typically don't report to credit agencies, so being slow in paying back a payday loan, or defaulting on such a loan, won't affect your credit score. Being late or defaulting on many other payments will.
  • Payday loans are much more convenient than trying to get a bank loan, or dealing with many of hese other alternatives 

Of course, these tradeoffs don't prove that banning or regulating payday loans in various ways is a bad idea. But they do suggest that advocates of regulations need to consider with brutal honesty what is going to happen if payday loans are less available or unavailable.

The lower-risk reforms of payday loans would be to increase information and options. For example, there is a suspicion that for a lot of people, paying 15% on a loan of $100 probably like 15% interest. But of course, a two-week interest rate is not an annualized rate! Requiring more clear information might help. In addition, helping low-income people build a better connection with the banking system, so that they have some flexibility to get short-term liquidity loans through their bank, would probably come at a lower cost than most payday loans. There may also be other options, like emergency assistance programs from the government in certain situations, or advances from employers, or alternative payment plans. Expanding the information and the choice set is often a more reliable way of having a positive result than limiting choices.

For those wishing to get up to speed on payday lending, I can recommend two other useful starting points. One is an article by Michael A. Stegman, "Payday Lending," published in my own Journal of Economic Perspectives in Winter 2007. The other is a useful summary of the evidence in an October 2010 working paper from the Philadelphia Fed from John Caskey, called "Payday Lending: New Research and the Big Question."