How to Fight Payday Loan Sharks
The concern that members of the U.S. military are getting sucked into debt traps by predatory lenders is revising calls for Congress to pass legislation to mandate nationwide limits on interest rates on all consumer loans.
Among the proposals is a cap on interest rates at 36 percent a year, as the New York Times recently recommended.
This remedy, however, might not work as intended. It might even make an unsavory practice harder to control, for the simple reason that it defies a basic rule of economics: Price controls -- in this case, caps on the cost of borrowing money -- tend to cause shortages of the goods involved, while encouraging behavior to evade the strictures.
The problem interest caps are supposed to resolve is very real and increasingly pressing: Payday lenders extend small loans, usually for seven days to one month to low-wage earners, who sometimes use them to make ends meet between pay periods. In the states where payday loans are allowed, the interest rates can be eye-popping. In Louisiana, for example, a lender can charge a fee of as much as $30 on a $100 14-day loan. This works out to an annual interest rate of 780 percent.
If such extortionate rates weren't bad enough, worse befalls a borrower who may have been misled and can't repay on time, then rolls over the old loan and finance charge into a new short-term credit. Once a borrower is on this refinancing treadmill -- and research suggests a majority of those who resort to payday lenders will be at some point -- getting off can be difficult. We have been treated to a seemingly unending flood of horror tales of consumers who borrowed a few hundred dollars and very quickly wound up with thousands of dollars of high-interest debt. Such stories often end in abusive dunning calls, default and bankruptcy.
Yes, payday lending is an ugly business with potentially horrible consequence for customers. Even so, here's why price controls aren't the answer.
Let's say a ceiling was placed on the interest these lenders can charge, say 36 percent a year, as the Center for Responsible Lending has proposed. That's still high, and yet it might not be enough to cover a lender's expenses. Payday lenders are the lenders of last resort and cater to people -- many with damaged credit -- who can't walk into JPMorgan or Wells Fargo and expect to be approved for a loan. They are, by definition, risky borrowers with high default rates, and lenders often don't get repaid.
If a business can't make a profit, odds are it isn't going to offer its goods or services for sale. This can be illustrated with a supply and demand chart, just like a freshman would find in Econ 101:
The chart shows that the ceiling, by forcing down the price, increases demand (qD). But the lower price, in turn, leads to curtailed supply (qS). The result is a shortage. In Venezuela, price controls are creating shortages in consumer goods such as toilet paper. Something similar happened in the U.S. in the 1970s, when the Nixon administration tried to limit increases in oil prices.
The U.S. has a long history of capping interest on loans, otherwise known as usury laws, and some states retain such rules in one form or another. But many states exempt payday lenders. (See the following map for state interest-rate limits.) Credit-card lenders also get around usury laws by being based in states such as South Dakota and Delaware, which either exempt credit cards from their interest ceilings or have very high limits.
Usury laws can have a perverse effect. To evade them, lenders to financially stressed borrowers tend to move underground, giving rise to loansharking and deceptive loan terms that conceal the true interest rate through hidden fees or charges. Lenders can also cross states lines when the payday-finance business is banned.
It's worth noting that the Consumer Finance Protection Bureau, set up after the financial crisis with the goal of preventing predatory lending, so far hasn't backed interest-rate caps except for a 36 percent ceiling on loans to military personnel. (Perhaps for that reason, some payday lenders such as Advance American, the nation's biggest, don't make loans to military personnel.) Instead, the CFPB favors more financial education for consumers.
Education is fine, but how many people understand the idea of an annual percentage rate that's extrapolated from a fee charged for the few weeks of a loan's term?
But there are some changes that might help prevent some of the worst abuses.
A good place to start is more rigorous enforcement of existing truth-in-lending laws and adoption of an industry-wide regimen of best practices. Too often, consumers get duped or the terms aren't explained clearly when they sign a payday loan. To avoid misunderstanding, loan agreements could come with a warning in bold letters -- such as the one found on a pack of cigarettes -- that says something like, "This Product Can Pose a Risk to Your Financial Health. Failure to Repay May Lead to Bankruptcy." Real annual interest rates must be clearly disclosed.
Lenders also should be required to make an assessment of a borrower's ability to repay. This was one of the central changes made to mortgage-lending rules after the subprime crisis. The U.K. made a similar change in order to limit payday lending abuses, as has the state of Utah.
There also should be limits on how many times an existing loan can be rolled over -- say three times. This might help prevent the cycle of debt being piled on top of debt that has trapped so many consumers. It also would be a step in the direction of disrupting a business model that profits most when customers get into a financial hole.
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James Greiff at email@example.com
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Max Berley at firstname.lastname@example.org