Payday Lending and the Regulation of Consumer Finance I

The payday loan industry has come under increasing scrutiny in recent years. Proponents of the industry claim that payday loans supply an important niche in the market for consumer credit. Critics denounce this credit product as predatory and inherently dangerous to consumers. In a series of four posts, I plan to explain what payday loans are, explore the harshest criticisms of this form of credit, evaluate those criticisms in light of recent empirical studies, and argue that the case for substantial federal government intervention in this market has not been met.

The analysis is presented as follows. In this post, I offer some historical background on payday lending, provide a basic description of this type of credit transaction, and a brief statement of industry claims about the nature of the business. In my second post, I will explore the main criticisms of payday loans as well as the main reform proposals. In the third post, I intend to provide a review of the empirical literature on the effects of payday lending and evaluate the case of the critics as well as popular reform proposals. In the fourth and final post in this series, I intend to step back and discuss the most common justifications for restrictive regulation of private exchanges and ask whether these justification are available in the case of payday lending. I conclude that the case for regulation is mixed and that the states are best situated to experiment with alternative solutions for problems identified in this area of consumer finance.

What are payday loans?

Payday loans—also known as “cash advances” or “payday advances”—are small, short-term loans marketed to consumers as a means of bridging consumption gaps and coping with expenditure shocks. These loans require no credit check and no collateral. Lenders generally require proof of the borrower’s income (e.g., a pay stub), and many lenders require a check from the borrower’s personal checking account for the total amount to be repaid which can be deposited by the lender if the borrower does not return with payment.[1] Because a check cashed by the lender in the event the borrower fails to repay is likely to bounce, this check is not meant to serve as collateral, rather as a marginal deterrent to default.[2]

A typical payday loan term is two-weeks for an amount less than $300.[3] The finance fee ranges from about $15 to $20 per $100 borrowed and does not compound.[4] A typical customer may walk into a local storefront, provide basic personal information to the lender, and walk out a few moments later with cash in hand.[5] For a $200 loan with a finance of $18 per $100, the customer agrees to repay $236 in two weeks. For comparison with traditional forms of credit, the finance fee on a payday loan can be stated in terms of an annual percentage rate by multiplying the 18% interest charged for a two-week loan by 26 (the number of two-week periods in a year). Simply, 18% x 26 = 468%. For present purposes, I will define payday loans as short-term, unsecured loans made at an implied annual percentage rate in excess of 300%.

Payday loans, in one form or another, have a longer history than many realize. According to Paul Chessin:

Payday lending is not new. Rather, it is merely a recent incarnation of a form of credit transaction that has existed for over a hundred years. Its roots are directly traceable to the “wage assignment,” “salary buying,” or “salary lending” transactions of the late nineteenth and early twentieth centuries. In these types of transactions, a lender would “buy” at a discount the borrower’s next expected wage payment.[6]

By the mid-twentieth century, many of these types of transactions were classified as loans and restricted as “usurious.”[7] The payday loan in its most recent incarnation emerged in the 1990’s as check-cashing outlets—small stores which cash third-party checks for a fee—began offering their customers the option of borrowing against their next paycheck for a fee. Many states carved out legislative exceptions to usury laws which otherwise would have precluded these transactions.[8] As demand for this service grew, new firms entered the market specializing in this credit product. Today, there are more than 22,000 payday loan store fronts in 35 states with annual loan volume estimated to range from 27 billion to 50 billion.[9]

The payday loan market is best understood in context. On the supply side, banks and credit unions have largely receded from the market for small loans because of their high cost per dollar loaned. According to Lehman, payday lenders ascended during the same period in which conventional lenders “began to specialize in larger secured loans such as vehicle lending and home mortgages.”[10] Yet payday lenders face competition from several different sources. Pawn brokers, in addition to offering small collateralized loans, have also begun offering such loans without collateral, thus competing directly with stand-alone payday lenders. Payday lenders compete with informal sector lending from friends and family as well as illegal lending operations.[11] Recent studies have shown, however, that some banks and credit unions have increasingly begun to offer regular overdraft protection services which compete directly with payday loans at similar implied interest rates.[12]

On the demand side, the typical payday borrower is fairly typical. Due to the proof of income requirement, virtually all payday borrowers are employed. There is little to distinguish the average payday loan borrower from the general credit consuming population in terms of income, age, or marital status.[13] While some researchers have found that African Americans are more likely to be payday borrowers than their white counterparts,[14] this finding “is consistent with other research suggesting that African American households retain smaller balances in their checking accounts relative to whites,”[15] thus suggesting greater vulnerability to expenditure shocks for which payday loans are marketed. Overall, only about 5% of American households actually use payday loans,[16] compared to 77% of households which have credit cards.[17]

Members of the industry say their product fills an important niche in the market for consumer credit. They claim to make small, short-term loans available to individuals who lack access to conventional credit or who value the quick and convenient access to funds afforded by the payday lending process, store-front (and increasingly online) availability, and extended hours. These lenders claim that their products, when used as intended, provide consumers with more choice and flexibility than conventional lenders alone, especially where speed and discretion are concerned. Industry proponents argue that presenting the finance fee on such a short term loan as an annualized percentage rate can be misleading. Even so, say payday lenders, these rates compare favorably with annualized versions of alternative expenses such as bounced check fees and late payment penalties which consumers often resort to payday loans to avoid.[18]

But what do critics say about this form of consumer credit? That is the topic of my next post!


[1] In some jurisdictions, the lender may be authorized to electronically withdraw the principal and interest from the borrower’s checking account on the maturity date.  See Stoianovici, P.S. & Maloney, M.T. (2008) Restrictions on Credit: A Public Policy Analysis of Payday Lending. The Brattle Group and Clemson University.  p. 2, available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1291278.

[2] A bounced check is likely to result in bank fees for the account holder but not payment for the lender. A borrower who incurs this fee is not only penalized, but presumably less able to repay the lender. Thus, it is in the interest of borrower and lender to avoid this measure in most cases. See Stoianovici.

[3] Chessin (2005), in a Colorado-wide study, found that 72.93% of all loans were written for $300 or less. Chessin also reports the average loan term in Colorado as 16.63 days, with 60% of loans for 14 days or less. Borrowing From Peter to Pay Paul: A Statistical Analysis of Colorado’s Deferred Deposit Loan Act. Denver University Law Review, Vol. 83, 387-423.  pp. 391-92.

[4] Skiba, P. M., & Tobacman, J. (2009). Do Payday Loans Cause Bankruptcy. Vanderbilt University Law School Journal of Law & Economics.

[5] Stegman, M. (2007). Payday Lending. Journal of Economic Perspectives, 21 (1): 169-190. Wilson, et al (2010) report taking out loan in less than 25 minutes. Wilson, B.J., Findlay, D.W., Meehan, J.W., Wellford, C.P., Schurter, K. An Experimental Model of the Demand for Payday Loans (2010), available at http://ssrn.com/abstract=1083796.

[6] Chessin, P. (2005).

[7] See, e.g., Jackson v. Bloodworth, 152 S.E. 289, 291 (Ga. Ct. App. 1930).

[8] Fusaro, M.A. & Cirillo, P.J. (2011) Do Payday Loans Trap Consumers in a Cycle of Debt? http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1960776

[9] Parrish, L. & King, U. (2009). Phantom Demand. Washington, DC: Center for Responsible Lending. Also Stegman, M. (2007).

[10] Lehman, T. (2006). Payday Lending and Public Policy: What Elected Officials Should Know. P. 3-4, available at http://www.coalitionforfinancialchoice.org/pdf/Payday%20Lending%20Public%20Policy.PDF.

[11] See id. Also see a 2011 Government Accountability Office report which concluded that: “Recent statutory and regulatory changes and FDIC initiatives may encourage more institutions to offer small-dollar loan alternatives to payday loans or expand their availability, but many consumers may still choose to use payday loans for their wide availability and relative lack of eligibility restrictions.” GAO Report to Congressional Requesters (Jan. 2011), “Payday Lending: Federal Law Enforcement Uses a Multilayered Approach to Identify Employees in Financial Distress” available at: http://www.gao.gov/assets/320/315253.pdf.

[12] Melzer, B.T. & Morgan, D.P. (2012) Competition in a Consumer Loan Market: Payday Loans and Overdraft Credit, available at http://www.kellogg.northwestern.edu/faculty/melzer/Papers/Melzer_Morgan_7_12_2012.pdf.

[13] See Elliehausen, G. & Lawrence, E.C. (2001). Payday Advance Credit in America: An Analysis of Consumer Demand (Monograph No. 35). Washington, D.C.: Georgetown University, McDonough School of Business, Credit Research Center.

[14] See Stegman, M.A. & Faris, R. (2003). Payday Lending: A Business Model That Encourages Chronic Borrowing. Economic Development Quarterly, 17(1), 8-32.

[15] Lehman, T. (2006), p. 6.

[16] Stephens, Inc., Payday Loan Industry Annual Industry Update (2009)

[17] Federal Reserve System, Survey of Consumer Finances (2007)

[18] The Community Financial Services Association of America (CFSA), a payday lending trade organization representing over half of payday lending stores in America, offers a point-by-point defense of its members’ trade practices on its website: http://cfsaa.com/about-the-payday-industry/myth-vs.-reality.aspx.

5 thoughts on “Payday Lending and the Regulation of Consumer Finance I

  1. Pingback: Payday Lending and the Regulation of Consumer Finance II | Economics & Institutions
  2. Great post, but I have two comments and a question that maybe you could address. If the payday borrow is “typical”, such that there is no evidence to distinguish them from the general population by any metric, than what is the justification for a $27 billion+ market? Is it only speed that entices people to pay an exorbitantly higher interest rate or some other metric such as it is less regulated (which I suppose you will get to next time)? It would appear to me that people who have a relatively inelastic demand for funds need the money now, BUT the people in this situation would not be ‘typical’. I would imagine they would be low income users who are stripped for cash currently and need instant money infusion. A consumer with more more income, or savings perhaps, would not want to borrow money at that high of an interest rate.

    Second, if there is only 5% of Americans who use payday loans, yet the market is a $27 billion dollar one than obviously there are many repeat users for payday loans. It would seem then that check bouncing rarely occurs as consumers do pay back the loans within two weeks and they decide to continue taking out these loans. Is there an interest rate reduction based on frequent users to entice them to keep using? If not, again, it would seem that this is a niche market for an untypical user.

    Lastly, I understand that payday loans are loans that exist until you get the next paycheck, but can they not extend beyond 35 days?

    • Great questions, Danielle! “Typical” here is not meant to imply that there are no distinguishing characteristics of payday borrowers from credit consumers who do not use this form of credit. The question really becomes what policy-relevant distinctions there are between these two groups. I promise to address this in my third and fourth posts in this series.

      As for your question about extended loan periods, this is partly an issue of semantic definitions, partly an issue of variation among lenders, and partly and issue of variation in state policies which have attempted to reform these products by mandating an extension of the repayment period.

      Semantics: most scholars define a payday loan as a loan to be repaid within a few weeks and which is somehow tethered to the borrower’s bank account. These loans are generally marketed as consumption-bridging devices to aid the borrower till an upcoming paycheck.

      Variations: Of course lenders do vary, but the features described in the post are typical. Some states have mandated extended repayment periods as a way to make these loans less costly to consumers and less prone to rollover usage. I will address these in my review of the empirical literature–coming soon.

      Thanks for your questions. I hope to answer them all fully over the course of the series!

      A.K.

  3. Pingback: Payday Lending and the Regulation of Consumer Finance IV | Economics & Institutions
  4. Pingback: Payday Loans Direct Lenders UK Good Acceptance

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