The payday loan has long been at the epicenter of an incendiary national debate.1 Payday lenders argue that they provide a necessary source of credit for borrowers with nowhere else to turn.2 Consumer advocates consider payday lending to be a form of legal loan sharking that traps borrowers into a downward spiral of debt.3 Who is right?,Convincing evidence supports the consumer advocates.4 An increasing number of states limit, expressly prohibit, or in effect prohibit payday lending.5 Federal financial regulators require underwriting and limit payday loans offered by national banks, which are not subject to state payday-lending laws.6 The U.S. Department of Justice, state banking commissioners, and state attorneys general are cracking down on illegal Internet payday lending.7 And the new federal regulatory cop on the beat—the Consumer Financial Protection Bureau—held its first hearing on the subject in 2012.8 The bureau conducted research that, according to a New York Times editorial, “discredits once and for all the industry’s portrayal of these loans as a convenient option for people who can easily repay the debt on the next payday.”9 Bloomberg News reports that the bureau is formulating new rules to bring needed reforms to this market.10,The payday-lending industry continues to fend off attacks by resorting to well-worn but fraying defenses such as:,The facts argue against these defenses. Consumer advocates have long argued that the debt trap is the business plan and that the payday-loan product is intentionally designed to ensnare borrowers in an endless cycle of debt.12 As a result, advocates assert, precious assets are drained from both borrowers and the economy, and this leads to more, not less, financial strain.13,After offering a brief historical perspective, I identify and refute the arguments advanced by payday-lending proponents. I conclude that, in the short term, policymakers should act to eliminate the debt cycle endemic to payday lending and, in the long term, foster—with the participation of all sectors—a systemic solution to provide access to credit without the predation inherent in and the financial adversity caused by the traditional payday-lending product. Fostering a systemic solution would strengthen the economy by strengthening family financial stability and security.,Today’s payday-lending industry can be traced to James Eaton, a former credit bureau employee, who reportedly offered the first modern payday loan when he opened Check Cashing Inc. on December 2, 1991, in Johnson City, Tennessee.14 Two years later W. Allan Jones, Eaton’s colleague, opened Check Into Cash, which is described as the first of the national payday-lending chains.15 These events gave rise to what is now a multibillion dollar industry.16,But small-amount, short-term lending at exorbitant rates is not a new phenomenon in America.
Eaton and Jones are merely links in a chain dating back to the late 1880s, when for-profit lenders began making such loans “at rates often well above the statutory limits.”17 Around the turn of the 20th century came the so-called salary lenders, who offered short-term loans against workers’ next paychecks at interest rates ranging from 270 percent to 955 percent.18 Then, as now, users of these loans sank into financial quicksand and were unable to satisfy the original debt and were thus forced to take out loans perpetually.19,Public outrage at these practices ultimately led to the adoption by many states of the Uniform Small Loan Law.20 The uniform law, which was drafted in 1916, was adopted only after the lending industry, with its formidable resources, blocked consumer protection legislation in state after state, year after year.21 The new law mandated manageable installment repayments and capped interest rates at between 36 percent and 42 percent APR.22 Soon after, however, unscrupulous competitors tweaked the loan product design or combed for loopholes to evade the law.23,The salary lenders of old would more than likely recognize the modern payday-lending model. Payday-loan transactions still require a lump-sum repayment of principal and interest on payday.24 Borrowers still cannot escape the financial trap that keeps them in continual debt.25 The industry still possesses seemingly unlimited financial and political resources to combat federal and state reform.26 And where strong consumer protection laws exist, lenders troll for loopholes and develop other circumvention schemes.27,However, more jurisdictions are enacting reform because accumulating evidence calls into question the industry’s rationale for the way it does business.28 Payday loans are not constructive credit options because they do not build or repair credit.29 Rather, they drain vital assets from borrowers and communities, impede progress toward family financial stability, prevent upward mobility, and hinder macroeconomic growth.30 In the following section I detail and rebut the industry arguments in defense of the payday loan.,In defense of its product, the payday-lending industry has typically relied on a series of arguments. Following are six assertions most often used to defend payday lending along with evidence that calls them into question.,a payday loan is a bridge loan For the vast majority of borrowers, a payday loan is a lure into a debt trap.31 The industry contends that payday loans serve as “financial taxis,” which are meant to handle emergencies and to get borrowers from one payday to another.32 The facts, however, do not bear out these assertions and, in fact, show the opposite is true. Borrowers often find themselves worse off after getting involved with payday lenders.33,Most payday borrowers do not use payday loans as they are advertised (i.e., for unexpected, temporary financial emergencies).34 In fact, the onetime use of a payday loan is the exception because profitability depends on repeat, long-term use.35 The average payday borrower is indebted to a payday lender for nearly seven months out of the year. Fully 25 percent of borrowers have loans outstanding for more than ten months of the year.36,That payday lending results in long-term indebtedness should come as no surprise.Borrowing a significant percentage of income against the next paycheck unavoidably creates a cash-flow problem for the next pay period—and the one after that, and the one after that.37 The resulting predicament leaves borrowers little alternative but to roll over the existing loan, take a new one, or borrow from one payday lender to pay off another.38 There is evidence that the debt cycle is fed by lenders who train and incent their employees to keep the customers borrowing indefinitely.39 It is this characteristic especially that led the Center for Responsible Lending to call the payday loan “a defective product.”40 Some suggest it is not the product itself but rather consumer misuse of the product that causes financial harm.41 However, advocates decry blaming the victim for falling deeper into debt, they argue that the product design forces borrowers to take out repeated loans because the repayment of prior loans leaves them with inadequate funds.42,you may not apply an APR to a two-week loan You most certainly may apply an APR to a two-week loan—and should—when the vast majority of payday borrowers are in debt for a substantial portion of the year, as conclusive evidence shows to be the case.43 The industry argues that use of the APR inappropriately inflates and unfairly creates a misperception of the true cost of the loan.44 The argument would have merit if borrowers were indebted to payday lenders for just a small portion of the year.
Because borrowers are indebted for a substantial portion of the year, the industry’s argument fails.,the risk justifies the rates No, in fact the risk does not justify the rates. The Consumer Financial Protection Bureau defines risk-based pricing as offering “different consumers different interest rates or other loan terms, based on the estimated risk that the consumers will fail to pay back their loans.”45 First, payday lenders do not differentiate among consumers because they do not alter rates based on a borrower’s ability to pay.46 Second, payday loans, though high-cost, are not high-risk.47 Even as some industry defenders continue to claim that the risk justifies the rate, other industry supporters concede that most payday loans do not end in default because repayment is virtually guaranteed through automatic debit agreements.48 Default rates on payday loans are low.49 In sum, there is simply no quantifiable, risk-based justification for the excessively high rates payday lenders charge.50,a payday loan is a product to help the unbanked In actuality the unbanked are typically ineligible for a payday loan. A bank account and an automatic debit authorization are prerequisites to obtaining payday loan credit.51 The payday lender, with such authorization, is often the first in line to drain the account when the employer directly deposits the paycheck.52 Payday lenders suggest that taking payday loans is a cheaper alternative to bouncing checks.53 However, evidence strongly suggests that payday loans cause borrowers to bounce checks and to incur overdraft and other bank fees.54 Payday loans do not serve the unbanked but are likely to cause banked borrowers to incur additional costs.,a payday loan is a straightforward transaction that borrowers clearly understandThe mechanical simplicity of the payday transaction masks its hidden complexities, while its casual nature belies its dangers. There is significant informational asymmetry between payday lenders and payday borrowers.
This asymmetry results in the inability of consumers to predict accurately the length of indebtedness they will experience or assess the financial jeopardy into which they are placed by using payday loans. Sociologists, economists, and financial analysts have all identified the “difficulty [consumers have] in accurately estimating the costs” of a payday loan.”55 Even industry supporters admit that payday-lending transactions tax the cognitive capabilities of the typical customer.56 In truth, the vast majority of payday borrowers are imperfectly informed and imperfectly rational.57,Consumers of course know the dollar amount of the fee charged on a payday loan.58 However, they suffer from a deep misunderstanding … of the true cost of the loans.59 Consumer confusion stems from, among other sources:,Further, payday lenders often intentionally withhold or manipulate disclosures to the detriment of full borrower awareness of the costs of the transaction.64 And borrowers often do not anticipate or factor in the costs of repeated rollovers, leading to a significant misbelief of what the loan will actually cost.65,In sum, many borrowers clearly are not acting in an informed and economically rational manner when taking payday loans.
As two of the most frequently cited defenders of the industry acknowledge, “[i]t is simply not plausible … that a person of ordinary capacity would sensibly decide to borrow money at a rate of 400 percent, using a loan that, in most cases, is likely to remain outstanding for months, if not years.”66,payday lending does not lead to further financial distress Payday lending does not relieve financial stress, it exacerbates financial problems.67 Payday borrowers are more likely to end up in bankruptcy.68 Borrowers also often find themselves buried under a cascade of defaults regarding other expenses, such as mortgage, rent, utility bills, medical bills, and credit card bills.69 Payday lending has been linked to the destruction of military families.70 Such lending is associated with negative effects on societal externalities that have an adverse impact on state and local economies.71,Even payday lending’s most strident critics would agree that, for a segment of financially struggling consumers, there is a significant demand for short-term, small-dollar loans. The industry continues to benefit from the perception that the provision of its product must be tolerated because there is no alternative for many borrowers to obtain this necessary credit.72,But there are alternatives. Credit unions and Community Development Financial Institutions (or CDFIs as they are often known) around the country have established models, providing small-amount loans at reasonable interest rates, payable within a brief term, often through an installment repayment plan.73 New ideas, such as lending circles, are emerging to deal with access-to-short-term-credit problems that build credit scores.74 The problem is that these alternatives, however successful, are typically isolated and serve limited numbers of borrowers.,In the meantime, policymakers should look to states that have achieved needed reform to correct the fundamental flaw in the payday-lending model: the debt trap. Delaware and Washington State, for example, have limited to five and eight, respectively, the number of loans a borrower may take per year.75 Evidence suggests these policies have been effective in reducing the debt cycle that is so destructive to borrowers.76,For most borrowers, payday loans do not, as the industry insists, provide a financial bridge over temporarily troubled financial waters.
On the contrary, because the norm is a long-term slide deeper and deeper into debt, more often than not, such loans push borrowers to the financial brink. Without question, there is a void in the financial markets for responsible short-term credit. But the payday-lending business model that emerged to fill the void exploits financially desperate consumers by charging unconscionable and unjustifiable interest rates, and, worst of all, trapping the most financially vulnerable in unending debt.,Policymakers often are paralyzed when the debate about payday lending ensues.
They are disturbed about the propensity of borrowers to fall into the debt trap, but they are reluctant to shut off access to payday credit, despite its high costs and questionable impact. However, the same characteristics that define the subprime payday loan—the willful absence of underwriting, unaffordable balloon payments, loan churning, excessive interest, unsustainable loan terms and conditions—defined the subprime mortgages whose proliferation precipitated the economic collapse in the mid-2000s and have now been thoroughly discredited.,Payday lending erodes assets and creates financial insecurity among borrowers. Financially healthy families undergird a financially stable economy.
The payday loan is symptomatic of the collective and systemic failure to provide access to reasonably priced, short-term, small-amount credit.,Policymakers must first reform laws to limit the likelihood that payday loan borrowers will fall into the debt trap. They should then facilitate the creation of a new system that offers the necessary credit to move families forward and not push them farther behind.
Success will by no means be easy, but the status quo is unacceptable. If the will is there, the way will inevitably follow.,2 Benjamin D. Faller, Payday Loan Solutions: Slaying the Hydra (and Keeping It Dead), 59 Case Western Reserve Law Review 125, 146 (2008) (“[p]ayday lenders and their supporters often argue that bans on payday lending will leave borrowers who cannot access mainstream credit with nowhere to turn”).,16 Mayer, supra note 12, at 837 (since its inception, “payday lending grew from nothing into a $50 billion business”).,31 Pew Charitable Trusts, supra note 4, at 6 (“Only 14 percent of borrowers can afford enough out of their monthly budgets to repay an average payday loan”).,49 Pew Charitable Trusts, supra note 4, at 18 (“Loss rates at the larger payday lenders are about 3 percent” of total funds loaned).,52 Johnson, supra note 12, at 389 (“[T]he majority of payday lenders now have consumers sign contracts that allow electronic debits to their bank accounts to facilitate payment of the entire loan”).,54 Alan M. White, Behavior and Contract, 27 Law and Inequality 135, 159 (2009) (activation of automatic withdrawal feature of loan leads to greater insufficient fund fees upon default).,58 Mann Hawkins, supra note 48, at 881 (customers “might well understand the specific fees” associated with first payday-loan transaction).,64 Ben-Ishai, supra note 62, at 326, 353 (“Many payday lenders hide basic information about their loans from consumers” and exploit consumers with “English-language difficulties”).,65 Karen E. Francis, Rollover, Rollover: A Behavioral Law and Economics Analysis of the Payday-Loan Industry, 88 Texas Law Review 611, 614 (2010) (“[B]orrowers systematically underestimate their future borrowing, leading to unexpected rollover loans and imposing substantial and unnecessary costs on these borrowers”).,75 See Del. Code Ann. tit. 5, § 2235A (2013), Wash.
Rev. Code Ann. § 31.45.073 (2013). At present, 15 states and the District of Columbia confront the debt-cycle problem by capping interest rates. Some states have never authorized payday lending, they subject any payday loan to the state’s usury cap.
Others have eliminated the high-interest payday loan, they subject—through legislation or ballot initiative—any such offering to an APR cap of not more than 36 percent (Montezemolo, supra note 5, at 33).,76 Montezemolo, supra note 5, at 14 (borrowing patterns before and after enactment of Washington State law show that law “appears to have been successful in greatly lowering the level of payday lending debt trap and associated fees”).
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