Payday lending is a type of predatory lending that involves offering small, very short-term loans (generally up to two weeks) in exchange for a post-dated check for the loan amount plus an interest charge. On an annualized basis, the interest charged by payday loan businesses generally amounts to several hundred percent, but customers use them because in most cases they have little alternative, and payday loan places don't require good credit or collateral.
So this is how the system works. You head into a payday loan place like Check 'n Go or Advance America and show them a pay stub to prove employment (or evidence that you're receiving Social Security benefits). You write them a check, postdated until your next payday — say $345. You receive $300 — the amount of the loan less the extremely high interest charged by the business. On your payday, you may simply let them cash the check, or else you can roll over the loan for another two weeks (adding, of course, another set of fees on top of it). At this point, you're paying so much for the privilege of borrowing that your debt to the payday loan company pushes you further into whatever financial difficulties led to your borrowing in the first place. Typical fees are in the area of $15 to $30 per hundred dollars borrowed; at 15% for two weeks, even the low end works out to 390% interest annually. As a measure of the effectiveness of payday loan companies at targeting the poor, the average payday loan is for $325 — but costs the borrower $800 to repay.
So why do people use payday loans?
The reason payday advance businesses are so successful — and are they ever successful: around 22,000 of them existed in 2003 — is that they provide financial options to an underserved sector of the economy. Payday loans are popular amongst the young, the poor, and the uneducated. A sharp illustration of the way they prey upon the poor can be seen in the way they sprout up around military bases, helping soldiers (who don't get paid very well) keep afloat. In many cases, they're the best of a lot of bad options: charges for bounced checks or late fees on credit card payments have risen so much in recent years that in many cases, it's actually cheaper to suck it up and take a payday loan out, despite the fact that they cost hundreds of percent in interest.
So payday loans do indeed fill a niche in the market; some staunchly laissez faire economists indeed feel that they can be justified on that basis. But the claim that they're a type of predatory lending is hard to ignore: according to the Center for Responsible Lending, 91% of payday loans are made to customers who borrow five or more times a year. The fact that it's so easy to roll your loan over (even with the incredible cost of doing so) makes it easy for the poor to become trapped by ever-mounting debt. Credit card debt has nothing on these places for making it easy to get into deep financial trouble.
Payday loan outfits primarily serve the poor, as I've mentioned (just look for their presence in impoverished neighborhoods). Traditional banks are often reluctant to serve these customers — actual banks are often quite hard to find in poor areas, leaving them out of reach for potential customers who have limited access to transportation. And banks don't provide short-term loans, especially not to people who are judged to be poor credit risks. The only real alternative when someone is looking for a short-term loan is to turn to the informal economy; ironically enough, should you be fortunate enough to live in an area with a substantial mafia presence, you'll likely end up paying a lot less for loans. Mobsters get sent to jail for breaking usury laws when they offer loans at 150% interest, while large corporations (with high-priced lobbyists) charge two or three times that and the government doesn't bat an eye. (And the penalties for failure to repay are not necessarily all that different between the mob and a payday advance place — contrary to common belief, it's pretty rare for a loan shark to resort to violence, since that attracts unwanted police attention. On the other hand, payday loan businesses hold the threat of cashing a check they know to be bad over their customers heads, meaning that bounced check fees and even prosecution for writing bad checks is a risk faced by borrowers.)
How do these fuckers sleep at night?
There's a set of arguments usually couched in the terminology of laissez faire economics that is used to justify the existence of payday loan businesses. One is the simple truth that they are indeed filling an economic void: when you're living paycheck to paycheck, it's not hard for some crisis to pop up that needs money that you just don't have. If the car breaks down, if the kid gets sick — well, you need money. These minor financial crises don't exist for the middle class, since if you've got a savings account or just don't routinely drain your checking account, you can cover unexpected expenses. But the poor don't usually have those luxuries. And there's not a lot of other sources for quick money. Credit cards offer cash advances, of course, but those are fairly costly too, and if you're poor and have bad credit, you probably don't have a high credit limit on your Visa card. So in some circumstances, even a loan with abusively high interest can be a lifesaver.
Naturally, high interest rates are to be expected on short-term loans; if, say, someone loaned you $200 for two weeks even at 25% interest (which most of us would consider quite high on a credit card), they'd only earn $1.93 on the deal, which is hardly enough to cover the costs of the transaction. And places like Check 'n Go do indeed face a higher risk when lending money than a bank offering a long-term, low interest loan. Actually, though, the risk isn't as high as you might expect. Thanks to their practice of taking post-dated checks, the payday loan businesses have an easy way of going after you if you default, and you can expect collection agencies or worse should you be unable to repay.
Even if you accept the payday loan companies' rationale for charging substantially more than a normal bank loan, the outrageously high fees that payday loan outfits charge and the ease with which they permit you to roll over your loan and pay even more interest make it clear that they are anything but altruistic. It's a system designed to make money off of poverty. These are Old Testament-style moneylenders with slick TV commercials — they're exactly the creatures held in such contempt by the scriptures of most religions and countless works of literature.
Some economists have claimed that government regulation of the more conventional financial services industry has actually created the market for payday lending. Since many states have usury laws that limit the amount of interest that may be charged on a bank loan, borrowers who are (probably correctly) perceived as high risk can't obtain ordinary bank loans, since a fair market interest rate would be higher than usury laws permit. Thus, the claim goes, banks are regulated out of the short-term loan business, and payday loan businesses that charge a flat fee for borrowing in lieu of interest and thus exploit a loophole in lending laws step in and, in the absence of competition from the banks, are free to charge as much as they want.
Of course, this analysis conveniently ignores the fact that these are populations that are largely poorly served by banks. Most banks don't operate in poor areas and they certainly do nothing to attract poor customers, since they don't fit in with a normal bank's business plan. Thus, if banks were interested in the short-term loan business, they'd probably do it by establishing storefronts dedicated to that business — supplying auto loans and savings accounts to the very poor isn't really a workable business model. In fact, there's nothing stopping banks from doing that as it is, except that most banks don't wish to tarnish their image by entering into the always lucrative but ugly world of making money on human misery.
Why on God's green earth is this shit legal, then?
Well, that's an interesting question. In some cases, as I mentioned above, usury laws as read literally don't actually outlaw payday loans, since their fees are not treated as interest. But more important is that many states — thirty-six at present — specifically exempt payday loan businesses from the laws that apply to things like credit cards and home mortgages. The payday loan companies are not hard-up for cash; a law in California that would have dropped the cap on 14-day loans from 391% to a nice, low 312% was fought by these corporations, who spent over half a million dollars on lobbyists.
Interestingly, a 1978 Supreme Court decision, Marquette National Bank v. First of Omaha, actually makes it possible for these companies to operate in states that ban such high-interest loans. See, a company can offer financial products in a state that would otherwise be illegal as long as they're legal in the company's home state. So even if your state has strict usury laws, a business operating out of another state can charge in the hundreds or thousands of percent, and get away with it freely. Unfortunately, loan sharks, offering much more reasonable rates, can't take advantage of that decision.
References
"Payday Lending: Serving the Unbanked", Mike Foley, Ludwig von Mises Institute (http://www.mises.org/fullstory.aspx?control=1441&id=70)
"In Defense of Payday Lending", Tom Lehman, Ludwig von Mises Institute (http://www.mises.org/freemarket_detail.asp?control=454&sortorder=articledate)
"How the Other Half Banks", Michelle Leder, Slate (http://www.slate.com/id/2100276/)
"Free the Sharks", Brendan Koerner, Slate (http://www.slate.com/id/2059386/)
The Payday Lending section at the Center for Responsible Lending (http://www.responsiblelending.org/payday/)
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