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For a payday loan, the borrower writes a postdated check to a lender, and the lender gives the borrower an amount equal to some fraction of the face value of the postdated check. Depending on state regulations, payday lenders will take somewhere between 15 and 25 percent of the face value of the check as a fee and will provide the borrower the rest of the face value in cash on the day the check is written. At the end of the usual 2-week period of such loans, the borrower can redeem his or her check with a cash payment equal to the face value of the original postdated check or can permit the lender to present the check for deposit on the day the check matures. For these reasons, the payday loan is also known as a deferred presentment loan. The industry has grown dramatically over the past three decades and has become a central feature of the alternative financial services industry. With changing economic conditions and regulations, the products have continued to evolve. The users of these financial products tend to be lower-income people; therefore, there has been a growing debate between industry proponents and consumer advocates about the appropriateness of these financial products. In that context, the regulatory environment for these products has shifted rapidly over the past decade.
An early financial product with similar traits to the payday loan was the “salary buying” product of the early 20th century. Though illegal, it operated in a very similar manner as a payday loan. Modern payday loans are financial products that were developed as an extension of the traditional check-cashing business as alternative financial service providers were seeking to sustain and expand their businesses. Given the apparently high profits of this business, the number of physical storefronts offering these products grew from about 1,200 in the mid-1980s to more than 20,000 by the mid-2000s. With the growing availability of such loans on the Internet, these numbers likely understate the total availability of such products in the United States.
Development And Characteristics Of The Payday Loan
The payday loan is a relatively simple product. With a relatively minimal credit check, evidence of address, and an active checking account, an individual can write a postdated check to a payday lender and receive a cash payment the same day; the individual simply needs to ensure that the amount necessary to honor the check is available on the date for which the check is written. The limits on fees and interest, as well as availability of such products, vary widely by state. Fees and interest for payday loans are embedded in the difference between the amount for which the check is written and the amount that is actually paid to the borrower on the date the check is written. For example, to receive a 2-week payday loan in Mississippi, under statutes existing in 2014, the check writer could write a check on the first day of the month but postdate the check to the 14th of that month. If the check writer wished to receive $100 on the date of the writing of the check, he or she would need to write the check for $122. Consequently, the writer of the check would be paying $22 in interest and fees on the short-term credit, with an implied annual percentage rate (APR) of 572 percent. While each lender sets its own limits within the bounds of regulation, this would be a common fee in Mississippi, and one finds that statutory maximum limits on fees and interest rates are often equal to what payday lenders charge.
One common, although not universally legal, component of payday loans is the “rollover.” At the end of the 2-week term of the loan, many lenders will contact the borrower to ensure that there will be sufficient funds to honor the check if it is presented at a bank for deposit. If a borrower indicates that there are insufficient funds, then the lender will permit the borrower to roll over the loan through a variety of mechanisms, depending on the legal restrictions in a given state. These rollovers may be dubbed extensions, renewals, or new loans, but they all have the same effect of continuing the borrowing arrangement and the payment of an additional fee by the borrower. Given growing concern about the high longer-term cost of repeated rollovers, rules and initiatives to reduce rollovers have resulted in what is known as an “extended payment plan,” whereby individuals may, if they are unable to pay the original loan on the date it is due, repay the loan in equal installments over the subsequent four pay periods of the borrower. There have been other efforts to extend the standard length of payday loans beyond 2 weeks.
Interest Costs, Information, And Regulation
Wherever these products are allowed, fees in APR terms in this industry tend to be quite high, frequently above 200 percent. There is some debate over whether this rate represents a competitive cost for such credit, and some groups have argued that costs of credit in APR terms should not exceed 36 percent to avoid burdening low-income households with excess debt. For the standard brick-and-mortar–type payday lender, there are fixed costs of rental or facility maintenance, and there are labor and transaction costs per loan. Given these costs and the relatively high rate of default for such loans, others have argued that the interest charged must be much higher than standard loan products and that an APR of 120 percent would be somewhat close to break-even point for such products, if these products are offered at all.
A number of researchers have provided evidence that elimination of payday loan products appears to detrimentally affect household finances, at least in the short run, and that the existence of these products has some positive effect on a household’s ability to handle some unforeseen financial shock brought about by some financial or natural disaster. These findings are consistent with what industry advocates have explained in their claims that the number of alternatives to payday loans are few and that without access to such credit, consumers would end up bearing other costs from utility reconnection fees, bounced check fees, or other late payment penalties. All these concerns address the short-term financial position of low-income families.
While many payday lenders adhere to the legal requirements of providing information on their loan products to borrowers, there is some evidence to suggest that irregularities exist in their explanations. For longer-term planning, when complete and detailed information on the costs of these products is fully explained to borrowers, some choose not to use these products. Notwithstanding what appears to be a short-term value to payday loans, some consumer advocates argue that the existence and promotion of these loans may be detrimental to the longer-term financial health of low-income families.
In a political and policy climate with sharply diverging views about the appropriateness of these products, a great deal of regulatory and legislative action has occurred. By 2005, Georgia and North Carolina allowed legislation that permitted such payday loans to lapse, and either through legislation or the courts, both Ohio and Arkansas eliminated the traditional payday loan products. Other states, such as Oregon and New Hampshire, have enacted legislation that increases restrictions on the behavior of and interest rates charged by payday lenders. In many other states, regulations have only focused on regularizing the industry and placing minimal constraints on the operations of such businesses. At the federal level, the Dodd-Frank Wall Street Reform and Consumer Financial Protection Act established the Consumer Financial Protection Bureau with a view to better educating consumers, enforcing federal consumer finance laws, and continuing research on consumer financial products and markets. At this point, the Consumer Financial Protection Bureau has had limited ability to engage in any action to affect the payday loan industry.
- Caskey, John. “Fringe Banking and the Rise of Payday Lending.” In Credit Markets for the Poor, Patrick Bolton and Howard Rosenthal, eds. New York: Russell Sage Foundation, 2005.
- Graves, Steve and Chris Peterson. “Usury Law and the Christian Right: Faith Based Political Power and the Geography of the American Payday Loan.” Catholic University Law Review, 57 (2008).
- Stegman, Michael. “Payday ” Journal of Economic Perspectives, v.21/1 (2007).
- Stegman, Michael and Robert “Payday Lending: A Business Model That Encourages Chronic Borrowing.” Economic Development Quarterly, v.17/1 (2003).