Can Other Lenders Beat Back Payday Lending?

It's easy to have a knee-jerk reaction that payday lending is abusive. A payday loan works like this. The borrower writes a check for, say, $200. The lender gives the borrower $170 in cash, and promises not to deposit the check for, say, two weeks. In effect, the borrower pays $30 to receive a loan of $170, which looks like a very steep rate of "interest"--although it's technically a "fee"--for a two-week loan.

Sometimes knee-jerk reactions are correct, but economists at least try to analyze before lashing out. Here and here, I've looked at some of the issues with payday lending from the standpoint of whether laws to protect borrowers make sense. It's a harder issue than it might seen at first. If the options are to take out a payday loan, which is quick and easy, or pay fees for bank or credit card overdrafts, or have your heat turned off because you are behind on the bills, or not get your car fixed for a couple of weeks and miss your job, the payday loan fee doesn't look quite as bad. people can abuse payday loans, but if we're going to start banning financial products that people abuse, my guess is that credit cards would be the first to go. Sure, it would be better of people had other options for short-term borrowing, but many people don't.

James R. Barth, Priscilla Hamilton and Donald Markwardt tackle a different side of the question in
"Where Banks Are Few, Payday Lenders Thrive," which appears in the Milken Institute Review, First Quarter 2014. The essay is based on a fuller report, published last October, available here. They suggest the possibility that banks and internet lending operations may be starting to provide short-term uncollateralized loans that are similar to payday loans, but at a much lower price. In setting the stage, they write: :

"Some 12 million American people borrow nearly $50 billion annually through “payday” loans – very-short-term unsecured loans that are often available to working individuals with poor (or nonexistent) credit. ... In the mid-1990s, the payday loan industry consisted of a few hundred lenders nationwide; today, nearly 20,000 stores do business in 32 states. Moreover, a growing number of payday lenders offer loans over the Internet. In fact, Internet payday loans accounted for 38 percent of the total in 2012, up from 13 percent in 2007. The average payday loan is $375 and is typically repaid within two weeks."

Barth, Hamilton, and Markwardt collect evidence showing that across the counties of California, when there are more banks per person, there are fewer payday lenders per person. They also note several experiments and new firms which seem to be showing that slightly larger loans for several months rather than several days or a couple of weeks may well be a viable commercial product. For example, the Federal Deposit Insurance Commission ran a pilot program to see if banks could offer "small-dollar loans" or SDLs.

"The FDIC’s Small-Dollar Loan Pilot Program has yielded important insights into how banks can offer affordable small-dollar loans (SDLs) without losing money in the process. Under the pilot program concluded in 2009, banks made loans of up to $1,000 at APRs of less than one-tenth those charged by payday loan stores. Banks typically did not check borrowers’ credit scores, and those that did still typically accepted borrowers on the lower end of the subprime range. Even so, SDL charge-off rates were comparable to (or less than) losses on other unsecured forms of credit such as credit cards. Note, moreover, that banks featuring basic financial education in the lending process reaped further benefits by cutting SDL loss rates in half. The success of the banks’ SDLs has been largely attributed to lengthening the loan term beyond the two-week paycheck window. Along with reducing transaction costs associated with multiple two-week loans, longer terms gave borrowers the time to bounce back from financial emergencies (like layoffs) and reduced regular payments to more manageable sums. ... In the FDIC pilot, a majority of banks reported that SDLs helped to cross-sell other financial services and to establish enduring, profitable customer relationships."

What about if the financial lender can't use the small-dollar loan as a way of cross-selling other financial products? Some companies seem to be making this approach work, too.

"Another newcomer, Progreso Financiero, employs a proprietary scoring system for making small loans to underserved Hispanics. Progreso’s loans follow the pattern that emerged in the FDIC pilot program – larger loans than payday offerings with terms of many months rather than days and, of course, more affordable APRs. Moreover, the company has shown that the business model works at substantial scale: it originated more than 100,000 loans in 2012. LendUp, an online firm, makes loans available 24/7, charging very high rates for very small, very short-term loans. But it offers the flexibility of loans for up to six months at rates similar to credit cards, once a customer
has demonstrated creditworthiness by paying back shorter-term loans. It also offers free financial education online to encourage sound decision-making."

In short, the high fees charged by payday lenders may be excessive not just in the knee-jerk sense, but also in a narrowly economic sense: they seem to be attracting competitors who will drive down the price.