Regulating payday loans is a start, but it won’t solve the underlying problem
The market for small quick loans has long been inadequate. Because banks prefer to lend $ 50,000 to $ 500 and tend to require a strong credit history to borrow, the options for families who are broken down or slightly behind on their bills are limited. This is where payday lenders come in. While they may seem like a silver bullet, the high interest rates coupled with their clients’ low incomes can create a much worse debt cycle than the financial problems that force families to seek such loans in the first place. .
A story my colleague Derek Thompson shared last year captures this 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. Soon after, their son was diagnosed with severe autism. They were earning a lot less than before and the medical bills started to pile 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, withdrawing a paltry $ 450.
When they were unable to repay the debt in a matter of weeks, the amount shot up to $ 1,700 thanks to high interest rates, fees and revolving loans (loans that turn into new, larger loans). when a borrower is unable to repay their original loan).
There are plenty of stories like Alex and Melissa’s, and they are disturbing. The potential damage that such debt cycles can cause is clear and widely recognized. But what is not yet agreed is what needs to be done about the payday loan industry.
One of the harshest criticisms is that the loans unfairly target and benefit economically weak Americans. Payday storefronts are frequently found in poor neighborhoods, almost never in the rich. To address this concern, strong voices are calling for the swift and tough regulation, if not the eradication, of payday lenders, including the Consumer Financial Protection Bureau. The Bureau proposed regulations for the industry that would require lenders to exercise better due diligence on borrowers’ ability to repay and cap interest rates and revolving loans to ensure that customers do 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 there to offer a family with low credit a $ 300 loan to help pay the rent, or a $ 500 loan. to cover a sudden medical expense.
This perspective was recently put forward 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 payday loan research finds and public discourse about the products. The paper begins with what it sees as “the big question” about payday loans – whether they help or hurt consumers. Part of that question, they say, is whether borrowers are unwittingly plunged 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 one might think, and that based on academic data, there is no definitive answer as to whether products are all good or all bad. To that end, the paper concludes that the nastiness and calls for aggressive regulation may be a bit premature.
Is this the right conclusion to draw? Paige Skiba, professor of behavioral law and economics at Vanderbilt University, agrees the academic literature is mixed, but says the question they ask – whether the products are all good or all bad – is largely Useless: Loans are fine, for some people borrowing on a payday loan turns out to be a terrible thing. Instead, she says it’s important to look at the motivation and behavior of borrowers, as well as the actual results.
When people apply for payday loans, they already find themselves in quite a difficult financial situation. Skiba says his research reveals that the average credit score of payday loan applicants is 520. The average for the general population is 680. This means the probability of being approved for any other type of loan. is weak at best. “They have sought and refused credit, have exhausted their credit cards, are in default of secured and unsecured credit, so by the time they show up to the place of payday, this is their best hope of getting credit.” , she says. . The decision, at this point, is quite rational, as is 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 when predicting their behavior,” Skiba said.
As the name suggests, a payday loan is meant to help bridge the time between pay days. Terms are supposed to be short, the equivalent of a pay period or a few weeks at most. But borrowers are usually in debt for about three months, Skiba says. With unbelievably high fees and interest rates, which can range anywhere between 300% and 600% when annualized, failure to repay within this short period of time can lead to a rapid increase in debt.
Skiba research shows the default rate on payday loans to be around 30 percent, and a Center for Responsible Lending study places the default range between 30 and 50 percent as the number of renewals increases . (The Liberty Street the authors do not mention default rates in their essay.) But these defaults only occur after several interest payments and several efforts to stay up to date on debt, proof, Skiba says, that these borrowers are probably too optimistic (and therefore not particularly rational) about their ability to repay loans. (If borrowers knew they were going to default, they wouldn’t waste time or money making payments.) Days.
John Caskey, professor of economics at Swarthmore College, also agrees that the literature on the usefulness or harm of these products is mixed. But he doesn’t think that should stand in the way of their improvement. “Unfortunately, this is a very difficult thing to test and get solid answers to, so you have to make your best judgment in terms of regulation,” he says. Caskey argues that part of the problem with anti-federal regulatory sentiment is that a plan to leave regulation to individual states leaves too many loopholes for borrowers, lenders and lobbyists who would try to ease the constraints. With a state-by-state approach, an applicant who is turned down in their own state because the loan might be too large 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.
Supporting the argument that these mixed academic results are not sufficient reason to attempt to halt changes in the industry, a recent survey by the Huffington Post questions the validity of some of the more favorable studies. In emails obtained by the news agency, it is clear that the troubleshooting industry exerted both financial and editorial influence on the reported results of at least one Arkansas Tech academic study, with an attorney from the Payday Loan Bar Association providing line changes and suggestions directly to researchers. This document was cited in documents filed with federal regulators, 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 which can help them put food on the table or keep the lights and heat on. Some fear that regulation will mean the end of payday lenders, Skiba says, and that other options, such as pawn shops and installment loans, will be used more. That too will have a cost.
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 unforeseen spending or lost income can take its toll on most households, for the millions of Americans without savings or access to credit, it can mean bankruptcy, eviction or hunger. . Most experts agree that it is 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 keep them safe.