Author: John Lynch
A payday loan is a financial tool. Like all tools, financial or otherwise, used responsibly and in the way for which it was intended, it works well. Unfortunately, for borrowers and lenders alike, that’s not always what happens; sometimes borrowers use payday loans for purposes they were never intended to serve. When that takes place, when, for example, borrowers use payday loans as long-term financial instruments, people can often find themselves in straitened budgetary circumstances. Payday lenders understand this and they’ve vigorously warned their customers against ill-advised use of their loans. Regrettably, such warnings don’t always dissuade customers from using short-term loans for extended periods of time.
Blaming the product
When consumer advocacy groups see the distressed situations some borrowers get themselves into, they don’t attribute the problem to user error. Instead they automatically assume that there’s something wrong with the product itself—that the way loans are structured in effect force borrowers into a financial tailspin.
The main fault consumer advocates see with payday loans is the amount of interest that lenders charge for loans. They claim that payday lenders make loans with exorbitant interest rates, often in the triple-digits. With terms like these, advocates say, borrowers find it impossible to pay back their loans.
Thomas Sowell, the eminent economist and philosopher at the Hoover Institute at Stanford University, says this argument is evidence of a serious misunderstanding on the part of the people who make it, one which distorts their view of the payday industry.
Payday loan basics
First, some necessary background: a payday loan is a small dollar, short-term loan that the borrower typically uses to pay for an unexpected expense, like a car repair or medical bill. The borrower takes out the loan and is obligated to repay the principal plus a flat fee when they next get paid, usually in two weeks. The fee attached to the loan averages around $20 for a $100 loan.
The interest rate on a loan like this is 20%. So how do critics make the claim that payday loans involve excessive interest rates, often in the hundreds of percent? They base that claim on the annual percentage rate, or APR, that would apply to a payday loan, if the borrower were to theoretically keep the loan open for a whole year.
Capped out by APR
You’re probably familiar with the APR as a measure of interest paid on a loan. Credit card companies use it and you’ve also seen it printed on advertising for new cars. It’s a perfectly legitimate and helpful way to calculate interest on a long-term loan. That’s because it measures the amount of interest someone pays on a loan over the course of a year.
The APR is calculated by multiplying the installment total by the number of payment periods in a year. So to get the APR for a payday loan of $100 we multiply 20 (the fee) times 26 (the number of two-week periods in a year), giving us 520.
Though 520% appears to be an astronomical amount of interest to pay on a loan, especially for a small loan taken for emergency purposes, you have to understand that it’s outside the norm for a borrower to actually pay that much interest on a payday loan.
There are two main reasons for this. First, regulations in many states stipulate lenders cannot keep a loan on their books for that period of time. In those states a borrower must pay back the loan much faster. Second, responsible members of the payday lending industry follow rigorous best practices and those guidelines say payday loans are best used temporarily. (Industry best practices can be viewed at the website of the Community Financial Services Association of America.)
Best interest of the consumer?
Critics of the payday loan industry routinely propose capping interest rates for payday advances at an APR of 36%, which means lenders could only charge around 1-2% in interest for a payday loan. A number of states have enacted laws with these terms.
Dr. Sowell argues that these critics have misapplied important economic and financial principles in their criticisms of payday lending. One aspect of payday lending that they’ve misunderstood, he says, is what portion of the fees charged for payday loans is taken up by interest.
“What is called ‘interest’ by the media includes things that an economist would not call interest,” Sowell writes. “The fees charged must also cover the cost of processing the loan, which is to say the pay of people doing the work, the rent of the premises and other overhead expenses, as well as the risk of default.”
Invariably the enforcement of these restrictive interest statutes has led to injurious results for consumers in need of short-term unsecured credit. Lenders cannot afford to make loans when they receive such small return on their investment. They then stop making loans available and borrowers in need of emergency funds either don’t get the help they need or they are forced to get funding from unregulated sources. Neither of which is truly in their best interest.
Results of Fed study
An analysis conducted by the Federal Reserve Bank of Kansas City entitled “Could Restrictions on Payday Lending Hurt Consumers?” supports this finding. Kelly D. Edmiston, the economist who authored the study, summed up the study results this way:
”The results of [this] empirical analysis support the idea that restricting payday lending may indeed have costs. The evidence showed that consumers in low-income counties may have limited access to credit in the absence of payday loan options. As a result, they may be forced to seek more costly sources of credit. The evidence also showed that, in counties without access to payday lending, consumers have a lower credit standing than consumers in counties with access…The preponderance of evidence suggests that some consumer will likely face adverse effects if payday lending is restricted.”
Choosing the best rates
Sowell likewise argues that advocacy groups and other outside interests should not be invested with the power to decide for consumers the relative utility of the credit options they have to choose from. He says “taking decisions out of the hands of those most directly affected” and transferring them to third-party groups will not aid borrowers.
Payday advances are financial tools that are designed for certain purposes. The answer to abusive borrowing isn’t in abolishing the availability of such loans—as consumer advocates in effect propose by setting artificially low caps on interest rates. The answer may lie in greater education of the borrowing public and other correctives to user’s misapplication of the loans.