Payday Loans

Payday loans are single-payment, short-term loans that are also called "payday advance or check loans." Essentially, a consumer writes a check on his or her bank account for the amount desired, plus a fee. Typically, the term is two weeks. At the end of that time, the borrower has three choices: pay cash to the lender for the amount of the check, allow the check to clear the bank, or pay an additional fee to renew the loan for another two weeks. Interest rates expressed as an annual percentage rate on the loans can be as high as 300 to 500 percent. Jean Ann Fox, Director of Consumer Protection, Consumer Federation of America, has published a lengthy and well-documented article on payday loans in the Spring/Summer issue of Advancing the Consumer Interest, a publication of the American Council on Consumer Interests. Appropriately, the author notes that she "helped to develop, and so naturally supports, the recommendations [concerning payday loans] made by the Consumer Federation of America."

There has been a protracted legal debate testing whether or not the charges on these loans are really "interest" and subject to disclosure requirements under Truth-in-Lending and to state usury laws. Payday lenders have variously described their services as leases or check-cashing transactions. The business is apparently profitable, given evidence concerning the expansion of payday lenders in states where they are licensed. Fox cites the growth in Colorado, where from 1997 to 1998 the number of payday lenders rose by 16 percent, the number of loans by 40 percent and the amount borrowed by 56 percent. She reports similar growth rates in several other states. At the end of November 1999, there were 24 states that permitted payday loans. Nineteen other states and two territories either (1) permit small loans by finance companies, but with low rate caps that do not allow payday loan firms to operate, or (2) specifically prohibit check cashers.

In those states where payday loans are permitted, the rate caps range "from $15 to $33.50 to borrow $100 for 14 days." These charges generate gross yields of 391 percent to 873 percent. In some states efforts to moderate the high rates have failed because of the wide gulf between the interested parties. In Indiana, for example, both the regulators and payday lenders attempted to lower the cap of $33 per $100, but could not reach a compromise.

According to Fox, "Payday lenders have recently partnered with banks to evade state laws that have limited the effective rate of interest they may charge." Essentially, the approach rests on the doctrine that national banks may export their rates to residents of other states, as in the case of rates on bank credit cards. Fox views this gambit as "extortion"—as a devious way "to export its home state's lack of regulation all across the country irrespective of whether their practices would be illegal for payday loans in the borrower's home state." Her recommendation is "legislation that prohibits banks from making loans based on personal checks or electronic withdrawals from checking accounts" or to set limits on the terms of payday loans made by banks and require them to abide by the laws of the states where borrowers reside.

The issue reflects a perennial problem in consumer credit. Small, short-term loans can be profitably made only at interest rates that offend those seeking to "protect" consumers. To illustrate the problem, assume that a store offers a consumer a hair drier for $10 cash or $1 down and $1 a week for ten weeks. Total finance charge = $1; annual percentage rate = 102 percent. In the case of sales credit, as in the hair drier example, the seller can always bury part of the finance charge in the cost of the merchandise. However, if this were a cash loan subject to a legislated rate ceiling of 36 percent in order to "protect" consumers, the loan would not be made.

Naturally, this outcome might cause the consumer to wonder "What good is the regulator's guarantee of a low interest rate if I can't get a loan?" Proponents of the payday loan industry are quick to point out that an alternative exercised by many consumers caught in an end-of-month cash shortage is to bounce checks. But, the typical $25-30 insufficient funds charge levied by banks (on top of the merchant's charge on returned checks) makes the payday advance fee look downright reasonable, especially if the shortfall would result in multiple bounced checks.