The market for small quick loans has long been insufficient. Because banks would rather lend $50,000 than $500 and tend to require strong credit histories to borrow, options for families who are broke or a little behind on their bills are limited. This is where payday lenders come in. Although they may seem like a quick fix, high interest rates coupled with low current incomes among their clients can create a cycle of debt far worse than the financial problems that force families to seek out such loans in the first place. square.
A story my colleague Derek Thompson told last year sums it up perfectly. Alex and Melissa were young parents living in Rhode Island who got stuck in a cycle of debt after taking out a loan from a payday lender. It happened quickly: Alex was diagnosed with multiple sclerosis and had to quit his job. Shortly after, their son was diagnosed with severe autism. They were earning a lot less than before and the medical bills started piling up. Cash-strapped and without a credit history strong enough to secure a bank loan to tide them over, Melissa turned to a payday lender, taking out a meager $450.
When they weren’t able to pay off the debt within weeks, the amount soared to $1,700 thanks to high interest rates, fees, and rollover loans (loans that turn into new, larger loans). important when a borrower is unable to repay their original loan).
There are plenty of stories like Alex and Melissa’s, and they’re disturbing. The potential harm that such debt cycles can cause is clear and widely acknowledged. But what is not yet agreed is what to do about the payday loan industry.
One of the strongest criticisms is that the loans unfairly target and take advantage of economically weak Americans. Payday storefronts are frequently found in poor neighborhoods, almost never in wealthy neighborhoods. To address this concern, there are strong voices calling for swift and severe regulation, if not the eradication, of payday lenders, including the Consumer Financial Protection Bureau. The Office has proposed settlement for the industry that would require lenders to do greater due diligence on the borrower’s ability to repay, and cap interest rates and rollover loans to ensure customers don’t not get trapped in a cycle of debt. But critics argue that the loans, while perhaps not optimally structured, play an important role in helping the most vulnerable families. They say that by capping rates and lowering returns to lenders, no one will be around to offer a family with a low credit score a $300 loan to help pay the rent, or a $500 loan to cover a sudden medical expense.
This prospect was recently advanced in an essay on the New York Federal Reserve Liberty Street Blog. Researchers Robert DeYoung, Ronald J. Mann, Donald P. Morgan, and Michael R. Strain suggest that there is a big disconnect between what academic research on payday loans finds and the public narrative about the products. The paper begins with what it considers “the big question” about payday loans, namely whether they help or hurt consumers. Part of that question, they say, is whether borrowers are unwittingly drawn into a cycle of debt, or whether they are rational actors making the best choice available to them. The paper finds that borrowers may be more aware and rational than believed, and that based on academic evidence, there is no definitive answer as to whether products are all good or bad. To that end, the paper concludes that perhaps the meanness and calls for aggressive regulation are a bit premature.
Is this the right conclusion to draw? Paige Skiba, professor of behavioral law and economics at Vanderbilt University, agrees that the academic literature is mixed, but says the question they ask – whether products are all good or all bad – is largely irrelevant. , “For some people loans are good, for some people borrowing on a payday loan turns out to be a really bad thing. Instead, she says, it’s important to look at people’s motivation and behavior. borrowers, as well as the actual results.
When people apply for a payday loan, they are already in dire financial straits. Skiba says his research reveals that the average credit score for payday loan applicants is 520. The average for the general population is 680. This means the likelihood of being approved for any other type of loan is weak at best. “They’ve sought and refused credit, run out of credit cards, been in secured and unsecured credit default, so by the time they show up at the payday location, it’s their best hope of getting credit. “, she says. . The decision, at that moment, is completely rational, just like the Liberty Street suggest the authors of the essay. But what happens after the borrowers get the loan is where things go wrong, and whether they were rational about getting the loan in the first place seems a bit irrelevant. “I don’t agree with the idea that people are very far-sighted in predicting their behavior,” says Skiba.
As the name suggests, a payday loan is meant to help bridge the time between paydays. Terms are meant to be short, equivalent to one pay period or a few weeks at most. But borrowers are typically in debt for about three months, Skiba says. With incredibly high fees and interest rates, which can vary between 300-600% when annualized, failure to repay within this short period of time can cause debt to mount quickly.
Research from Skiba shows that the default rate on payday loans is around 30%, and a study by the Center for Responsible Lending puts the default range between about 30 and 50 percent as the number of rollovers increases. (The Liberty Street (the authors don’t mention default rates in their essay.) But those defaults don’t come until after multiple interest payments and multiple efforts to stay current on debt—proof, Skiba says, that these borrowers are probably overly optimistic (and therefore not particularly rational) on their ability to repay loans. (If borrowers knew they were going to default, they wouldn’t waste time or money making payments.) “They don’t know how hard it will be to repay half their salary plus 15-20% interest in a matter of days.”
John Caskey, professor of economics at Swarthmore College, also agrees that the literature on whether these products are helpful or harmful is mixed. But he doesn’t think that should stand in the way of their improvement. “Unfortunately, it’s a very difficult thing to test and get solid answers to, so you have to make your best judgment in terms of regulations,” he says. Caskey argues that part of the problem with anti-federal regulation sentiment is that a plan to leave regulation to individual states leaves too many loopholes for borrowers, lenders and lobbyists who would try to remove all constraints. With a state-by-state approach, an applicant who is denied in their own state because the loan might be too heavy could simply head to a border state where regulations are much more lax, or head online. However, they would run the risk of getting bogged down in a cycle of bad debts.
Continuing the argument that these mixed academic results are not reason enough to try to stop changes in the industry, a recent survey speak Huffington Post calls into question the validity of some of the most favorable studies. In emails obtained by the news agency, it is clear that the repair industry had both financial and editorial influence over the findings of at least one Arkansas Tech academic study, with an attorney of the Payday Loan Bar Association providing line edits and suggestions directly to searchers. That document was cited in documents filed with federal regulators, the reporters noted.
While payday loans are a potentially destructive solution to a person’s immediate financial crisis, they still represent a temporary solution. They allow families to borrow a few hundred dollars that can help them put food on the table or keep the lights and heat on. Some worry that regulation will mean the end of payday lenders, Skiba says, and that other options, like pawnshops and installment loans, will be increasingly used. This too will have its costs.
That’s because payday loans are ultimately a symptom of a bigger problem: lack of access to the financial system or some other form of emergency financial insurance. While a tough month of unexpected expenses or lost income can weigh on most households, for the millions of Americans without savings or access to credit, it can mean bankruptcy, eviction or starvation. Most experts agree that it’s only a matter of time before payday loan regulations are approved. While this will protect some consumers from bad lenders and themselves, it still won’t guarantee them access to the types of credit and resources they need to get security.