One of the few loan options available to the poor could soon evaporate if a new rule proposed on June 2 takes effect.
But will he?
What is a payday loan?
The payday loan market, which emerged in the 1990s, involves storefront lenders offering small loans of a few hundred dollars for one to two weeks for a “fee” of 15% to 20%. For example, a loan of $100 for two weeks may cost $20. On an annualized basis, this equates to an interest rate of 520%.
In exchange for the money, the borrower gives the lender a post-dated check or debit authorization. If a borrower is unable to pay at the end of the term, the lender can defer the loan to another payment date in exchange for another $20.
Thanks to their great interest, their short duration and the fact that One out of five end up in default, payday loans have long been branded “predatory” and “abusive,” making them a prime target of the CFPB since the bureau’s inception. established by the Dodd-Frank Act in 2011.
States have already been quick to regulate the industry, with 16 and Washington, DC, banish them outright or impose caps on fees that essentially eliminate the industry. Since the CFPB does not have the authority to cap fees charged by payday lenders, the regulations they are proposing address other aspects of the lending model.
Under the proposed changes announced last week, lenders would have to assess a borrower’s ability to repay, and it would be more difficult to “roll over” loans into new ones when they come due – a process that results in higher interest charges.
There is no doubt that these new regulations will have a significant impact on the industry. But is this a good thing? People who currently rely on payday loans will he be better off under the new rules?
In short, no: the resulting Wild West of high-interest credit products is not beneficial to low-income consumers, who desperately need access to credit.
I did some research payday loans and other alternative financial services for 15 years. My work has focused on three questions: Why do people turn to high interest loans? What are the consequences of borrowing in these markets? And what should proper regulation look like?
One thing is clear: the demand for quick cash by households considered high risk for lenders is strong. Steady demand for alternative sources of credit means that when regulators target and rein in a product, other lightly regulated and often abusive options emerge in its place. Demand does not just evaporate when there are shocks to the supply side of credit markets.
This fast-paced regulatory approach that is changing at a snail’s pace means that lenders can experiment with credit products for years at the expense of consumers.
Who gets a payday loan
About 12 million people, mostly low income use payday loans every year. For people with low incomes and low FICO credit scores, payday loans are often the only (albeit very expensive) way to get a loan.
My to research lays bare the typical profile of a consumer who comes forward to borrow on a payday loan: months or years of financial hardship due to the maximum use of their credit cards, the demand and refusal of secured and unsecured credit and failure to pay debts on time.
Perhaps more striking is what their credit scores look like: the average credit scores of payday applicants were below 520 when they applied for the loan, compared to a American average just under 700.
Given these characteristics, it is easy to see that the typical payday borrower simply does not have access to cheaper, better credit.
Borrowers may make their first trip to the payday lender due to a rational need for a few dollars. But since these borrowers typically owe up to half their take home pay plus interest on their next payday, it’s easy to see how difficult it will be to pay in full. It’s too tempting to defer full repayment to a future payment date, especially considering that a payday borrower’s median checking account balance was fair. $66.
The consequences of payday loans
The empirical literature measuring the welfare consequences of borrowing on a payday loan, including my own, is deeply divided.
On the one hand, I’ve seen payday loans increase personal bankruptcy rate. But I also documented that using larger payday loans actually helped consumers avoid defaults, perhaps because they had more leeway to manage their budget that month.
In a 2015 article, I, along with two co-authors, analyzed data from payday lenders and credit bureau records to determine how loans affect borrowers, who had limited or no access to traditional credit with very poor credit histories. weak. We found that the long-term effect on various measures of financial well-being, such as their credit scores, was close to zero, meaning that on average they were neither better nor worse because of the payday loan.
So it’s possible that even in cases where interest rates are as high as 600%, payday loans are helping consumers do what economists call “smoothing” on consumption helping them manage their cash flow between pay periods.
In 2012, I reviewed the growing body of microeconomic evidence on the use of payday loans by borrowers and examined how they might react to various regulatory regimes, such as outright bans, rate caps and restrictions on the size, term or renewal renewals.
I concluded that of all the regulatory strategies implemented by states, the one that had a potential benefit to consumers was limiting the ease with which loans are rolled over. Consumers’ inability to predict or prepare for the rising cycle of interest payments leads to welfare-damaging behavior in ways that other features of payday loans targeted by lawmakers do not.
In sum, there is no doubt that payday loans have devastating consequences for some consumers. But when used appropriately and sparingly — and when repaid quickly — payday loans allow low-income people who lack other resources to manage their finances in ways that are difficult to achieve using just a few. other forms of credit.
End of industry?
The Consumer Financial Protection Bureau’s changes to underwriting standards – such as requiring lenders to verify borrowers’ income and confirm borrowers’ repayment capacity – coupled with new restrictions on loan renewals will certainly reduce the payday loan offer, maybe zero.
The business model relies on the stream of interest payments from borrowers unable to repay during the original term of the loan, thereby offering the lender a new commission with each payment cycle. If and when regulators ban lenders from using this business model, nothing will be left of the industry.
The alternatives are worse
So if the payday loan market disappears, what will happen to the people who use it?
As households today face stagnant wages as the cost of living rises, the demand for small loan amounts is strong.
Consider an American consumer with a very common profile: a low-income, full-time worker with some credit problems and little or no savings. For this person, a surprisingly high utility bill, medical emergency, or the consequences of a poor financial decision (which we all make from time to time) may prompt a perfectly rational trip to a local payday lender to resolve a shortfall. to win.
These entrenched behavioral biases and systematic budget imbalances will not end with the entry into force of the new regulations. So where will consumers turn once payday loans dry up?
Alternatives available to the typical payday customer include installment loans and flexible loans (which are a high interest revolving source of credit similar to a credit card but without the associated regulations). These forms of credit can be worse for consumers than payday loans. A lack of regulation means their contracts are less transparent, with hidden or confusing fee structures that lead to higher costs than payday loans.
Oversight of payday loans is necessary, but passing rules that will decimate the payday loan industry won’t solve any problems. The demand for small quick cash is going nowhere. And because default rates are so high, lenders are unwilling to provide short-term credit to this population without great rewards (i.e. high interest rates).
Consumers will still find themselves short of money from time to time. Low-income borrowers are resourceful, and as regulators play tricks and remove one credit option, consumers will look to the next best option, which is likely to be a worse and more expensive alternative.