Payday loans appear to be growing in importance. The spam folder in my email register now seems to have as many solicitations for payday loans as for home mortgages. The Internet is a more cost-effective way of marketing payday loans than the traditional storefront. In addition, a number of banks have entered the market in recent years with “deposit advances,” which are essentially the same as payday loans.
Payday loans, including deposit advances, are small loans generally in the $150-$400 range, repayable in a few weeks when the borrower is due to receive a paycheck or some other scheduled payment. The loan is designed to tide the borrower over until the payment is received. The cost of a loan is usually $15 to $20 for each $100 borrowed, regardless of whether repayment is due in one, two or four weeks.
Payday loans are convenient, quick and readily available without a credit assessment. To assure repayment, borrowers provide lenders with direct access to their deposit account; in effect, borrowers authorize lenders to repay themselves from the borrower’s account.
Payday loans have been much criticized for their interest rates, which on an annual basis can run 400 percent or higher. But high interest rates are not really the problem. Since the cost to lenders of making a small loan is much the same as the cost of making a large loan, high rates on small loans are unavoidable. The real problem is not that payday loans are costly but that they are potentially addictive.
Payday loans remind me of an episode I had some years ago with morphine. I had a neck ailment that required that I lay motionless on my back for two days. To make the process as painless as possible, my physician prescribed morphine, which worked like a charm. I enjoyed my two days in a euphoric stupor.
When the two days were over, my neck was better but my euphoria was gone, and I missed it. I didn’t bother asking for a refill, however, because I knew the physician would say no, and in any case I had no desire to become addicted. My life proceeded without any more morphine.
Payday loans can be useful, just like morphine, if used occasionally to meet unexpected contingencies. But if the need for the loan arises from a persistent gap between the borrower’s income and expenditures, the loan will not eliminate the gap. Indeed, the ease with which the cash is obtained may discourage the borrower from making the changes in spending practices that are needed. The borrower becomes addicted to payday loans.
This evidently is more the rule than the exception. The newly created Consumer Financial Protection Bureau now administers the array of consumer protection laws that apply to payday loans. A recent study by the agency showed that among a sample of payday borrowers, only 13 percent had one or two transactions during the 12-month period covered by the study. Thirty-nine percent of the borrowers had three to 10 transactions, and 48 percent had 11 or more transactions. The median number of transactions during the year was 10.
The frequent borrowers account for a disproportionate share of loan fees paid to lenders. The 48 percent of borrowers who had 11 or more transactions produced 75 percent of the fees. The frequent borrowers accounted for an even larger part of lender profits because the marketing expenses of payday lenders is focused on getting new clients. For the most part, repeat borrowers require no salesmanship.
There is no one connected to the payday loan market who has an interest in helping the borrower deal with an occasional fund shortfall while preventing him from becoming a payday loan junkie — the role played by the physician who treated me for a bad neck. Payday lenders certainly can’t play that role because they make most of their money from payday junkies. The CFPB is on the borrower’s side, but the focus of the various statutes it enforces is protecting borrowers against abuses by lenders and others. To my knowledge, it has no authority to help borrowers avoid abusing themselves, which is the core problem.
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Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania. Comments and questions can be left at http://www.mtgprofessor.com.
©2013 Jack Guttentag
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