Need Quick Cash?
By Charles Gerena of The Federal Reserve Bank of Richmond
Payday loans provide short-term relief for people in financial distress. But policymakers are grappling with the long-term headaches that these loans can cause.
Moderate-income consumers looking for a quick financial boost often have relied on the assistance of family and friends or have turned to credit officers at banks. Today, a new type of financial instrument is meeting the needs of this population – the Payday loan.
Large, colorful signs promote "Instant Cash Until Payday" at neighborhood check cashers, pawnshops, and stand-alone lenders throughout the Fifth District.
Nationwide, the number of storefronts providing Payday loans grew from just a few hundred at the start of the 1990s to an estimated 10,000 in 2001. But as this explosive growth continues, lawmakers debate whether lenders are taking advantage of their customers.
The main selling point of a Payday loan, also known as a Payday Advance or deferred deposit, is that it provides liquidity for people in financial distress. Typical borrowers have a household income between $25,000 and $50,000, but they live on a tight budget that leaves little room for financial missteps or emergencies. The Payday loan helps these people get through a cash crunch without paying late fees or bouncing checks.
Here’s how it works. The borrower writes a personal check for the loan amount plus a finance charge, which ranges from $10 to $35 per $100. The lender doles out the money but doesn’t deposit the check until a future date, typically within two to four weeks, when the borrower gets paid again.
The application process for Payday loans is fast and simple. It usually requires only a few supporting documents such as a driver’s license, a bank statement, and a recent pay stub. Also, the lender doesn’t obtain a standard credit report, which could reveal late payments and other financial red flags that can derail a bank loan or credit card application. Instead, it may use a third party like Tele-Track to evaluate the borrower’s check-writing history and future likelihood of posting a bad check.
"[The appeal of Payday loans] is the convenience," says Michael Stegman, a professor of public policy at the University of North Carolina at Chapel Hill
who has studied the demand for nonbank financial services. "Customers can get in and out quickly without extensive credit checks."
For example, a nurse at CJW Medical Center in Richmond, Va., had heard about how easy it was to get money from Advance America Inc., which operates 60 Payday
loan offices in Virginia and 269 throughout the Fifth District. She stopped by the company’s office in Brook Run Shopping Center one afternoon in April when
she fell behind on paying her bills. "I was thinking I sure could use some extra money to get me through the week," explained the nurse, who didn’t want to be
identified. It took her only 10 minutes to fill out the one-page application and get her loan approved.
Convenience is just one reason why people choose Payday loans over alternative financial services. First, financially strapped consumers are wary of dealing with banks and finance companies. According to an April 2001 report by Georgetown University’s Credit Research Center, 68 percent of Payday loan customers considered applying for credit, but changed their minds because they feared rejection.
Second, financial services like home equity loans and cash advances on credit cards have more stringent qualifications than a Payday loan. Almost three-quarters of Payday loan customers were turned down by a creditor or not given as much credit as they wanted in the last five years.
Last, financial industry observers say that many companies have moved away from making small, short-term consumer loans to pursue more profitable lines of
business in the last decade. Small loans require "the same work you would do with a $10,000 loan – run a credit report, check on employment, create the
paperwork, and add it to your system," notes Jeff Smith III, president of the Virginia Financial Services Association. Since most of these administrative costs are fixed, larger loans generate more income while longer-term loans enable expenses to be spread out over time.
There was another disincentive to making small loans. Some states continued to restrict interest charges, late fees, and application fees on such loans. This made it difficult to produce a profit while covering the expense and risk of lending small amounts of money to people with troubled finances.
Yet payday lenders made money doing small loans in the 1990s. How did they do it?
On the revenue side of their profit equation, lenders were allowed to charge a higher fee on an annual percentage rate (APR) basis in states like North Carolina and South Carolina. Or they circumvented fee limitations in places like Virginia by making arrangements with out-of-state banks to provide loans. As a result, the APR for an average Payday loan ranged from 182 percent to 910 percent in 2001. In contrast, World Acceptance Corporation, a Greenville, S.C.-based finance company, charged between 24 percent and 205 percent for its four- to 15-month loans.
On the expense side, the cost of defaulted loans has varied quite a bit. "Some payday lenders will try very hard to minimize defaults. They’ll have people calling borrowers to remind them that their loans are due," says John Caskey, an economics professor at Swarthmore College and an expert on consumer finance. quot;Others say it’s not worth it to them [and] they are willing to incur the cost of defaults." Billy Webster, chairman and CEO of Advance America, says his company charges off 8 to 14 percent of revenue to defaults.
To hold down administrative costs, payday lenders have kept both the application procedure and debt collection process as simple as possible. They also have depended on making lots of loans, which reduces the cost per transaction. Lenders have driven up volume by staying open after business hours and operating in high-traffic locations such as suburban shopping centers and busy urban neighborhoods.
Stegman and others believe that the structure of a Payday loan also encourages repeat business. Because the loan has a short duration, a borrower has less time to get the cash to pay it off. Therefore, another big hole threatens to open in the borrower’s budget after the initial debt is paid. Unless the lender is willing to accept repayment in installments or forgive the loan, another Payday loan may be necessary to cover the new deficit. Or, the outstanding loan may be extended for another two weeks or "rolled over" to give the borrower more time. In either case, the lender charges additional fees.
Several studies indicate payday lenders do a lot of repeat business. According to research conducted by Stegman and Robert Faris at UNC’s Center for Community Capitalism, the typical borrower in North Carolina took out about seven loans in 2000. In Indiana, 77 percent of Payday loans are rollovers, with the average customer taking out more than 10 loans per year. In California, the average borrower takes out 11 Payday loans annually.
But Webster argues that there is nothing intrinsic about Payday loans that encourages repeated use. He says that Advance America’s customers tend to need all forms of credit more frequently. "The people who bounce checks tend to bounce more than one. The people who are late with their credit card payment tend to be late multiple times of the year."
Regardless of why Payday loans are used frequently, critics believe that repeat customers can get trapped in a destructive cycle of debt, especially those who do rollovers. "When you borrow 15 times and pay $35 each time, you quickly spend more in finance charges than what you have borrowed," notes Caskey.
Given the potential pitfalls of Payday loans, legislators are under pressure to clamp down on "predatory lending" practices. But industry leaders argue that
it’s misleading to talk about APRs. Instead, the cost of taking a Payday loan should be viewed as a service charge. According to market research conducted by Advance America, banks and merchants charge an average nonsufficient funds fee of $24 per check. Credit card companies impose an average late fee of $26, while auto finance companies charge $23. In contrast, the average finance charge on a Payday loan is about $18 per $100 borrowed.
Consumer advocates counter that payday lending creates financial and emotional hardships in addition to the dangers of repeated borrowing. The borrower can get hit with penalties as high as $35 – plus the nonsufficient funds fees charged by banks and merchants – if the lender deposits the check and it bounces. Also, payday lenders have been known to hound borrowers and their family members by telephone for payment of bounced checks. Some unscrupulous lenders even threaten to have borrowers criminally prosecuted for writing a bad check.
To address these issues, the Community Financial Services Association of America, a payday-lending industry group, established a code of ethics for its members. It also has lobbied state governments to incorporate these standards into their consumer lending laws. Currently, the District of Columbia, South Carolina, and 33 other states directly regulate payday lenders.
Other Fifth District states have responded differently to the growth of payday lending. Virginia legislators considered banning the industry this year. Instead, they required lenders to obtain a license and adhere to various fee restrictions. The legislation that authorized payday lending in North Carolina lapsed a year ago, but several lenders stayed in business by partnering with out-of-state banks. North Carolina’s attorney general has challenged the legality of this strategy and the Office of the Comptroller of Currency said last November that it would closely scrutinize banks that engage in such partnerships. (See article for more on payday
lending laws in the Fifth District.)
If lawmakers are worried about lenders making too many profits from their customers, Caskey believes the industry "will take care of itself." The number
of Payday loan outlets is expected to more than double to 25,000 by the end of 2002. With so many new market entrants, the profitability of individual lenders will eventually suffer as they start taking business away from each other. "At some point, there will be a payday lender on every corner and there won’t be enough demand."