Payday loan

A shop window in Falls Church, Virginia advertises payday loans.

A payday loan (also called a payday advance) is a small, short-term unsecured loan "regardless of whether repayment of loans is linked to a borrower's payday". The loans are also sometimes referred to as "cash advances", though that term can also refer to cash provided against a prearranged line of credit such as a credit card. Payday advance loans rely on the consumer having previous payroll and employment records. Legislation regarding payday loans varies widely between different countries and, within the USA, between different states.

To prevent usury (unreasonable and excessive rates of interest), some jurisdictions limit the annual percentage rate (APR) that any lender, including payday lenders, can charge. Some jurisdictions outlaw payday lending entirely, and some have very few restrictions on payday lenders. Due to the extremely short-term nature of payday loans, the difference between nominal APR and effective APR (EAR) can be substantial, because EAR takes compounding into account. For a $15 charge on a $100 2-week payday loan, the annual percentage rate is 26 × 15% = 390%; the usefulness of an annual rate (such as an APR) has been debated because APRs are designed to enable consumers to compare the cost of long-term credit and may not be meaningful in cases where the loan will be outstanding for only a few weeks. Likewise, an "effective" rate (such as an EAR — $(1.15^{26}-1)\times 100\%=3,685\%$) may have even more limited value because payday loans do not permit interest compounding; the principal amount remains the same, regardless of how long the loan is outstanding. Nevertheless, careful scrutiny of the particular measure of loan cost quoted is necessary to make meaningful comparisons.

Payday loans carry substantial risk to the lender; they have a default rate of 10-20%, and according to one study, defaults cost payday lenders around a quarter of their annual revenue.

The loan process

The basic loan process involves a lender providing a short-term unsecured loan to be repaid at the borrower's next payday. Typically, some verification of employment or income is involved (via pay stubs and bank statements), but some lenders may omit this. Individual companies and franchises have their own underwriting criteria.

In the traditional retail model, borrowers visit a payday lending store and secure a small cash loan, with payment due in full at the borrower's next paycheck. The borrower writes a postdated cheque to the lender in the full amount of the loan plus fees. On the maturity date, the borrower is expected to return to the store to repay the loan in person. If the borrower does not repay the loan in person, the lender may redeem the check. If the account is short on funds to cover the check, the borrower may now face a bounced check fee from their bank in addition to the costs of the loan, and the loan may incur additional fees and/or an increased interest rate as a result of the failure to pay.

In the more recent innovation of online payday loans, consumers complete the loan application online (or in some instances via fax, especially where documentation is required). The loan is then transferred by direct deposit to the borrower's account, and the loan repayment and/or the finance charge is electronically withdrawn on the borrower's next payday. According to one source, many payday lenders operating on the internet do not verify income.

User demographics and reasons for borrowing

According to a recent study by the Pew Charitable Trusts, "Most payday loan borrowers are white, female, and are 25 to 44 years old. However, after controlling for other characteristics, there are five groups that have higher odds of having used a payday loan: those without a four-year college degree; home renters; African Americans; those earning below $40,000 annually; and those who are separated or divorced." Most borrowers use payday loans to cover ordinary living expenses over the course of months, not unexpected emergencies over the course of weeks. The average borrower is indebted about five months of the year.

Criticism

Payday lending is a controversial practice and faces both legal battles and social challenges in nearly every place where it is practiced.

Draining money from low-income communities

Many people who use it are low-income people with few assets because these people are least able to secure normal, lower-interest-rate forms of credit. Since payday lending operations charge higher interest-rates than traditional banks and less commonly encourage savings or asset accumulation, they have the effect of depleting the assets of low-income communities.

Exploiting financial hardship for profit

Critics such as the Consumers Union blame payday lenders for exploiting people's financial hardship for profit. They say lenders target the young and the poor, particularly those near military bases and in low-income communities. They also say that borrowers may not understand that the high interest rates are likely to trap them in a "debt-cycle," in which they have to repeatedly renew the loan and pay associated fees every two weeks until they can finally save enough to pay off the principal and get out of debt. Critics also say that payday lending unfairly disadvantages the poor, compared to members of the middle class, who pay at most a rate of about 25% on their credit card purchases.

Aggressive advertising practices

In May 2008 the debt charity Credit Action made a complaint to the UK Office of Fair Trading (OFT) that payday lenders were placing advertising on the social network website Facebook, which violates advertising regulations. The main complaint was that the APR was either not displayed at all or not displayed prominently enough, which is clearly required by UK advertising standards.

Aggressive collection practices

In US law, a payday lender can use only the same industry standard collection practices used to collect other debts.

In many cases, borrowers write a post-dated check (check with a future date) to the lender; if the borrowers don't have enough money in their account, their check will bounce. Some payday lenders have therefore threatened delinquent borrowers with criminal prosecution for check fraud. This practice is illegal in many jurisdictions.

Ignoring legal restrictions

Payday lenders have been known to ignore usury limits and charge higher amounts than they are entitled to by law. On May 30, 2008, the Illinois Department of Financial and Professional Regulation fined Global Payday Loan $234,000—the largest fine in Illinois history against a payday lender—for exceeding the $15.50 per $100 limit on charges for payday loans. A customer, known only as J.M., had borrowed $300 and repaid $360 ($13.50 more than the company was legally entitled to collect under the Illinois Payday Loan Reform Act), but the company kept sending her warnings that her account was 'seriously delinquent' and that her unpaid balance was $630.

Pricing structure of payday loans

Issuers of payday loans defend their higher interest rates by saying processing costs for payday loans are significantly higher than other loans, including home mortgages. They argue that conventional interest rates for lower dollar amounts and shorter terms would not be profitable. For example, a $100 one-week loan, at a 20% APR (compounded weekly) would generate only 38 cents of interest, which would fail to match loan processing costs. Research shows that on average, payday loan prices moved upward toward the legislated price ceiling over time, consistent with implicit collusion facilitated by price focal points.

Critics say payday lenders' processing costs are significantly lower than costs for mortgages and other traditional loans. Payday lenders usually look at recent pay stubs, whereas larger-loan lenders do full credit checks and make a detailed analysis of the borrower's ability to pay back the loan.

Proponents' stance

Charges are in line with costs

A study by the FDIC Center for Financial Research found that “operating costs are not that out of line with the size of advance fees” collected and that, after subtracting fixed operating costs and “unusually high rate of default losses,” payday loans “may not necessarily yield extraordinary profits.” Based on the annual reports of publicly traded payday loan companies, loan losses can average 15% or more of loan revenue. Underwriters of payday loans must also deal with people presenting fraudulent checks as security, ordering a check stopped, or closing their account.

Critics concede that some borrowers may default on the loans, but point to the industry's pace of growth as an indication of its profitability. Consumer advocates condemn the practice as a whole, regardless of its profitability, because it "takes advantage of consumers who are already hard-pressed to pay their debts".

According to the Dallas Morning News, in 2008 the U.S.'s largest payday lender, Advance America, "made $4.2 billion in payday loans and charged $676 million in interest and fees." And "Cash America, a pawnshop operator and payday lender based in Fort Worth, recorded net income of $81 million last year – a 132 percent increase in just four years – on total revenue of $1.03 billion."

Markets provide services otherwise unavailable

Opponents of government regulation of payday loan businesses argue that some individuals that require the use of payday loans have already exhausted or ruined any other alternatives. Such consumers could potentially be forced to illegal sources if not for payday loans. Tom Lehman, an advocate of unfettered payday lending, said,

"[P]ayday lending services extend small amounts of uncollateralized credit to high-risk borrowers, and provide loans to poor households when other financial institutions will not. Throughout the past decade, this "democratization of credit" has made small loans available to mass sectors of the population, and particularly the poor, that would not have had access to credit of any kind in the past...."

Lehman attacked proponents of increased regulation of the lending industry, arguing that,

"These allegations against the payday-lending industry are largely without merit, and generally reflect the views of "do-gooder" anticapitalist elites who abhor the "messy" and unplanned outcomes in low-income consumer finance markets. Rather than seeing payday lending practices as a creative extension of credit to poor households who may otherwise be without loans, these critics see it as yet another opportunity for government intervention in the name of "helping" the poor."

Lehman has in turn been criticized for presenting himself as an independent voice while taking money from the payday loan industry.

Household welfare increased

A staff report released by the Federal Reserve Bank of New York concluded that payday loans should not be categorized as "predatory" since they may improve household welfare. "Defining and Detecting Predatory Lending" reports "if payday lenders raise household welfare by relaxing credit constraints, anti-predatory legislation may lower it." The author of the report, Donald P. Morgan, defined predatory lending as "a welfare reducing provision of credit." However, he also noted that loans are very expensive, and that they are likely to be made to under-educated households or households of uncertain income.

Other studies have questioned this claim. Petru Stelian Stoianovici, a researcher from The Brattle Group, and Michael T. Maloney, an economics professor from Clemson University, found "no empirical evidence that payday lending leads to more bankruptcy filings, which casts doubt on the debt trap argument against payday lending."

Aid in disaster areas

A 2009 study by University of Chicago Booth School of Business Professor Adair Morse found that in natural disaster areas where payday loans were readily available, consumers fared better than those in disaster zones where payday lending was not present. Not only were fewer foreclosures recorded, but such categories as birth rate were not affected adversely by comparison. Moreover, Morse's study found that fewer people in areas served by payday lenders were treated for drug and alcohol addiction.

Payday loans around the world

Australia

Main article: Payday loans in Australia

The Australian states of New South Wales and Queensland have imposed a 48%-APR maximum loan rate, including fees and brokerage.

Canada

Main article: Payday loans in Canada

Payday loans in Canada are limited by usury laws, with any rate of interest charged above 60% per annum considered criminal according to the Criminal Code of Canada. In addition, the provinces of British Columbia and Saskatchewan have imposed specific regulations on payday loans, including lower interest rate caps.

UK

Main article: Payday loans in the United Kingdom

Payday loans in the United Kingdom are a rapidly growing industry, with four times as many people using such loans in 2009 compared to 2006 - in 2009 1.2 million people took out 4.1 million loans, with total lending amounting to £1.2 billion. The average loan size is around £300, and two-thirds of borrowers have annual incomes below £25,000. There are no restrictions on the interest rates payday loan companies can charge, although they are required by law to state the effective annual percentage rate (APR).

United States

Main article: Payday loans in the United States

Payday lending is legal and regulated in 37 states. In 13 states it is either illegal or not feasible, given state law. When not explicitly banned, laws that prohibit payday lending are usually in the form of usury limits: hard interest rate caps calculated strictly by annual percentage rate (APR). Since Oct. 1, 2007 a federal law has capped lending to military personnel at a maximum of 36% APR as defined by the Secretary of Defense.

Variations and alternatives

Alternatives to payday loans

Other options are available to most payday loan customers. These include pawnbrokers, credit union loans with lower interest and more stringent terms, employee access to earned but unpaid wages, credit payment plans, paycheck cash advances from employers, auto pawn loans, bank overdraft protection, cash advances from credit cards, emergency community assistance plans, small consumer loans and direct loans from family or friends.

If the consumer owns their own vehicle, an auto title loan would be an alternative for a payday loan, as auto title loans use the equity of the vehicle as the credit instead of payment history and employment history.

Payday lenders do not compare their interest rates to those of mainstream lenders. Instead, they compare their fees to the overdraft, late payment, and penalty fees that will be incurred if the customer is unable to secure any credit whatsoever.

The lenders therefore list a different set of alternatives (costs expressed here as APRs for two-week terms):

• $100 payday advance with $15 fee = 391% APR;
• $100 bounced check with $48 NSF/merchant fees = 1,251% APR;
• $100 credit card balance with $26 late fee = 678% APR;
• $100 utility bill with $50 late/reconnect fees = 1,304% APR.

Other alternatives include the Pentagon Federal Credit Union Foundation (PenFed Foundation) Asset Recovery Kit (ARK) program. Through the ARK program, the foundation has helped nearly 4,000 military families with over $1.6 million worth of emergency loans and financial counseling from the highly regarded Consumer Credit Counseling Service.

Variations on payday lending

A minority of mainstream banks and TxtLoan companies lending short-term credit over mobile phone text messaging offer virtual credit advances for customers whose paychecks or other funds are deposited electronically into their accounts. The terms are similar to those of a payday loan; a customer receives a predetermined cash credit available for immediate withdrawal. The amount is deducted, along with a fee, usually about 10 percent of the amount borrowed, when the next direct deposit is posted to the customer's account. After the programs attracted regulatory attention, Wells Fargo called its fee "voluntary" and offered to waive it for any reason. It later scaled back the program in several states. Wells Fargo currently offers its version of a payday loan, called "Direct Deposit Advance," which charges 120% APR. Similarly, the BBC reported in 2010 that controversial TxtLoan charges 10% for 7-days advance which is available for approved customers instantly over a text message.

Income tax refund anticipation loans are not technically payday loans (because they are repayable upon receipt of the borrower's income tax refund, not at his next payday), but they have similar credit and cost characteristics. A car title loan is secured by the borrower's car, but are available only to borrowers who hold clear title (i.e., no other loans) to a vehicle. The maximum amount of the loan is some fraction of the resale value of the car. A similar credit facility seen in the UK is a logbook loan secured against a car's logbook, which the lender retains. These loans may be available on slightly better terms than an unsecured payday loan, since they are less risky to the lender. If the borrower defaults, then the lender can attempt to recover costs by repossessing and reselling the car.

See also

• Alternative financial services
• Community Financial Services Association of America
• Loan shark
• Predatory lending
• Poverty industry
• Wage slavery
• Overdraft protection loans
• Refund anticipation loan
• Settlement (finance)
• Title loan
• Logbook loan
• Usury
• Mortgage discrimination
• Securitization
• Debt bondage
• Debt of developing countries

External links

• Payday Loans- All about Payday Loans.
• FDIC Guidelines on Payday Lending

Media related to Payday loans at Wikimedia Commons