Today on the Rules of Thumb blog from MoneyThumb we would like to clear up any misunderstanding about how payday loans work and why they are a good thing for millions of people.
Payday lending is simple. An individual has an urgent short-term need for cash and goes to a payday lender, many of who are now online. A person with a job, a checking account, and proper identification can borrow anywhere from $100 to $500 until his or her next payday. Such borrowers write post-dated checks or provide written authorizations to the payday lender for the amount of the loan plus a fee, which is typically 15%. On the next payday, the loan is either repaid in person by the borrower or the lender cashes the check or initiates an electronic funds transfer. That's it.
Millions of middle-income Americans live paycheck to paycheck. The average person is doing their best to manage their finances so that all their obligations are met. But when something unexpected crops up, such as a blown transmission, an unexpected doctor's bill, or a badly needed roof repair, their financial schedules are thrown off and the need for short-term credit may arise.
Some turn to relatives or friends for help in a crunch. But many may face the choice of deciding between having their electricity turned off, their car repossessed, their job lost, their rent or mortgage unpaid or their check bounced. Payday lenders offer a better way out.
Critics of payday lending cite the high interest rates they charge. A $15 fee on a $100 advance for two weeks amounts to a 391% annual percentage rate or APR. That's high when expressed as an annual rate, but keep in mind that the typical term of these loans is a couple of weeks. It's also notable that the annualized interest rate on the average payday loan is much lower than it would be for the fee on a bounced check or a late mortgage or credit card payment.
The $15 cost of a $100 payday loan also pales in comparison with the lost income when a car is out of commission and a job is lost. Good payday lenders clearly disclose their loan terms and conditions, including the dollar amount of any fees and the APR. Moreover, payday lenders are regulated and supervised by state agencies and also the new federal Consumer Financial Protection Bureau.
Some online lenders avoid regulation by setting up operations offshore or on an Indian reservation outside the reach of regulators. We applaud the regulators for attempting to shut down such operations by denying them access to the banking system.
But we also caution about the potential unintended consequences of driving all payday lenders away from banks. This is the last thing we need at a time when the economy is languishing, in significant part because only the most creditworthy can qualify for a bank loan.
At this point, banks would be well advised to conduct proper due diligence on their payday lending customers to determine whether they are following state and federal laws, have established written regulatory compliance and anti-money laundering programs, follow trade association best practices and obtain from valid customer authorizations for automatic funds transfers. If a payday lender cannot answer these questions affirmatively, the bank is likely to work with the wrong customer.
Some argue that payday loan portfolios have enormous losses embedded in them because the loans are never really repaid, just rolled over and over again. But most states limit the number of rollovers, and most payday lenders impose similar limits, even in the absence of state laws.
The risks of payday lending are ameliorated due to the enormous diversification in the portfolios, and risks are priced into the fees. It's feasible for a reputable and efficient payday lender to maintain high loan loss reserves and substantial capital against payday loans and still achieve decent returns.
The regulators would do well to examine the welfare of borrowers in a variety of regulatory settings before they act in a way that might endanger the very people they are trying to protect, the underbanked. The truth is that millions of customers have a very favorable experience with short-term lending products, and we should be careful not to disrupt this important lifeline.
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