The market for quick, small loans has long been inadequate. Many families take for granted that they can fix their water heater when it breaks, or take their child to a dentist if she has a toothache. But in reality, more than half of American households — not just poor people — have less than a month's worth of savings, according to Pew studies. And about 70 million Americans are unbanked, meaning that they don't have or don’t qualify for a traditional banking institution. So what happens when a crisis hits and there isn't enough savings to cover it?
Beginning in the 1980s and 1990s, storefront payday loan businesses began to spring up across the country and quickly became commonplace. Today, there are approximately 20,000 storefront lenders, an average of 6.3 payday stores for every 100,000 people. By comparison, in 2016, there were 14,157 McDonald’s restaurants in the United States. Additionally, payday loans are increasingly offered online. The growth and success of the industry has shown that payday loans are in demand and fulfill a need for many people.
As the name indicates, a payday loan is meant to help bridge the time between paydays. Therefore these loans are marketed as a convenient, short-term solution for quick cash, of an average amount of around $500. Unlike traditional loans however, borrowers do not need to have a given credit score to get a payday loan. A balloon payment—full payment of the loan plus fees—is generally due on the borrower’s next payday after the loan is made. The typical length of a payday loan is 14 days, but loan lengths vary based on the borrower’s pay schedule or how often income is received—so the length could be for one week, two weeks, or one month. Although these loans don’t sound very menacing, the annual interest percentage rates of these loans are almost laughably high. Most households who take out loans for a mere $200 or less, usually end up paying over $1000 at the end of it all with average interest rates totalling around 467 percent.
A story that was shared by NPR in 2015 perfectly captured the effects that this corporate price gouging has on typical American households and individuals. Alex and Melissa were young parents living in Rhode Island who found themselves 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 making much less than they were before and medical bills started piling up. Short on cash and without a strong enough credit history to get a bank loan to tide them over, Melissa went to a payday lender, taking out a meager $450.
When they weren’t able to pay the debt back in a matter of weeks, the amount ballooned to $1,700 thanks to the high interest rates, fees, and rollover loans (loans that get folded into new, larger loans when a borrower is unable to repay their initial loan).
There are plenty of stories like Alex and Melissa’s, and they are troubling. The potential harm that such debt cycles can do is clear and widely agreed upon. But what is not yet agreed upon is what’s to be done about the payday-loan industry.
One of the strongest criticisms is that the loans unfairly target and take advantage of economically weak Americans. Payday lenders, a type of alternative financial service providers, tend to be concentrated in locations with higher-than-average poverty rates, lower income levels, more single parents, and some minority groups (Mahon, 2008). For example, a 2013 study in California found more payday loan stores located in areas with higher percentages of blacks and Latinos and in areas with high poverty rates and lower levels of educational attainment (Barth, 2013). To address this concern, there are loud voices calling for swift and severe regulation—if not eradication—of payday lenders, including the Consumer Financial Protection Bureau. The Bureau has proposed regulations for the industry that would force lenders to do better due diligence about borrower’s ability to repay, and to cap interest rates and rollover loans to ensure that customers don’t get trapped in a cycle of debt. But detractors 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 decreasing the returns to lenders, no one will be around to offer a family with a low credit score a $300 loan to help pay rent, or a $500 loan to cover a sudden medical expense.
That perspective was recently advanced in in economics research paper published in 2010. Researchers Robert DeYoung and Ronald J. Mann suggest that there’s a large disconnect between what academic research on payday loans finds and and the public narrative about the products. The paper starts with what it deems “the big question” of payday loans, which is whether they net help or hurt consumers. A part of that question, they say, is determining whether or not borrowers are unwittingly fleeced 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 they’re given credit for, and that based on academic data, there’s no definitive answer to whether the products are all good or all bad. To that end, the paper concludes that perhaps the villainization and calls for aggressive regulation are a bit premature. The conclusion of the two researchers is synonymous with Mehrsa Baradaran, a law professor at the University of Georgia and author of How the Other Half Banks.
It is well understood that payday lenders can be exploitative, but for millions of Americans, there aren’t many alternatives, and solutions lie not just in regulating “predatory” lenders, but in providing better banking options, some experts say. "When people go to payday lenders, they have tried other credit sources, they are tapped out, and they need $500 to fix their car or surgery for their kid," says Baradaran. She mentions in her book, "It's a common misconception that people who use payday lenders are 'financially stupid,' but the truth is that they have no other credit options."
There are "two forms of personal banking" in America, according to Baradaran. For those who can afford it, there are checking accounts, ATMs, and traditional lenders. Everyone else — including 30 percent of Americans or more — is left with "fringe loans," which include payday lenders and title loans. Reliance on payday lenders shot up between 2008 and 2013 when traditional banks shut down 20,000 branches, over 90 percent of which were in low-income neighborhoods where the average household income is below the national medium. Throughout her book, she argues for the principles behind the payday loan industry, stating that their universal access and emergency debt relief they provide to low-income households outweighs its current high-interest rate disadvantages.
Even low-income individuals who do have local access to a bank are not necessarily being financially irresponsible by using a payday lender, according to Jeffery Joseph, a professor at the George Washington Business School. He points out that other financial products can also be expensive for low-income people because they require minimum balances, service charges, and punitive fees for bounced checks or overdrafts, as do credit cards with late fees and high interest rates. These opinions on the industry do bring light to the plight of many Americans who need extra money
Is that the right conclusion to draw however? According to Paige Skiba, a professor of behavioral law and economics at Vanderbilt University, borrowers are typically indebted for around three months. With fees and incredibly high interest rates, which can range between 300 and 600 percent when annualized, failure to repay within that short time span can make the debt mount quickly. Because banks would rather lend $50,000 than $500, and tend to require strong credit histories to borrow at all, the options for families that are down and out, or a bit behind on their bills, are limited. While payday loans might seem like a quick fix, the high interest rates coupled with the low incomes common among their clients can create a cycle of indebtedness far worse than the financial troubles that force families to seek out such loans in the first place.
Skiba agrees that the academic literature is mixed, but says that the question they are asking—whether the products are all good or all bad—is largely pointless, “For some people payday loans are fine, for some people borrowing on a payday loan turns out to be a very bad thing.” Instead, she says it’s important to examine the motivation and behavior of borrowers, as well as the actual outcomes.
When people apply for payday loans they’re already in somewhat dire financial straits. Skiba says that her research finds that the mean credit score for payday-loan applicants is 520. The mean for the overall population is 680. That means that the likelihood of being approved for any other type of loan is small at best. “They've been searching for and denied credit, maxed out on their credit cards, delinquent on secured and unsecured credit, so at the time that they show up at the payday place, it is their best hope for getting credit,” she says. The decision, at that point, is completely rational, just as the Liberty Street essay’s authors suggest. But what happens after borrowers have secured the loan is where things go awry, and whether they were rational to get the loan in the first place seems a bit beside the point. “I kind of disagree with the idea that people are very foresighted about their predicting their behavior,” Skiba says.
Skiba’s research shows that the default rate on payday loans is around 30 percent, and a study from the Center for Responsible Lending puts the default range between about 30 and 50 percent as the number of rollovers increase. (The Liberty Street authors don’t mention default rates in their essay.) But these defaults only occur after several interest payments and several efforts to stay current on the debt, evidence, Skiba says, that these borrowers are likely overly optimistic (and thus not particularly rational) about their ability to pay back the loans. (If borrowers knew they were going to default they wouldn’t waste time or money making any payments.) “They don’t know how hard it’s going to be to pay back half of their paycheck plus 15 to 20 percent interest in a matter of days.”
John Caskey, an economics professor at Swarthmore College, is likewise in agreement that the literature about whether these products are ultimately helpful or harmful is mixed. But he doesn’t think that that should stand in the way of improving them. “Unfortunately, it’s a very hard thing to test and get solid answers on, so you have to make your best judgement in terms of regulation,” he says. Caskey argues that part of the problem with the anti-federal-regulation sentiment is that a plan to leave regulation up to individual states leaves too many loopholes for borrowers, lenders, and lobbyists who would try to chip away at any constraints. With a state-by-state approach, an applicant who is denied in their own state because the loan might be too burdensome could simply head to a bordering state where regulations are much more lax, or head online. They’d nevertheless be running the risk of getting stuck in a cycle of bad debt.
Furthering the argument that these mixed academic findings aren’t reason enough to try to halt changes to the industry, a recent investigation by the Huffington Post calls into question the validity of some of the more favorable studies. In emails obtained by the news organization, it’s clear that the payday industry exerted both financial and editorial influence on the reported findings of at least one academic study from Arkansas Tech, with a lawyer from the Payday Loan Bar Association providing line edits and suggestions directly to researchers. That paper has been cited in filings to 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 fear that regulation will mean the end of payday lenders, Skiba says, and other options—like pawn shops and installment loans—will see increased use. That too will have its costs.
That’s because payday loans are ultimately a symptom of a greater problem—the lack of access to the financial system or some other form of emergency financial insurance. While a rough month of unexpected expenses or earnings loss might take a 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’s only a matter of time before regulations on payday loans are approved. While that will protect some consumers from bad lenders and themselves, it still won’t guarantee them access to the kinds of credit and resources they need to achieve security.
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