Are Payday Loans as Addictive as Cocaine?

Frank Lopez: Lesson number one: Don't underestimate the other guy's greed![laughing]

Elvira Hancock: Lesson number two: Don't get high on your own supply.

-Scarface 1983

With all the noise around marketplace lending, I am digressing a bit on business credit to focus on payday loans and the recent discussions by the Consumer Financial Protection Bureau (CFPB) to protect users from the product.   In essence, the CFPB believes payday loan lenders must regulate who they lend to and how many times a borrower can renew a payday loan annually. Payday lenders of course believe these new rules would be game changers.

Who’s right, are payday loans really a savior for people needing quick cash where their only other option is Freddie the Loan Shark or do the loans put the customers in a cycle of debt?

Most consumers that access payday loans are what would be considered the worst of subprime borrowers – those that are living paycheck to paycheck. The original idea of payday loans was to fill a short term gap – your car needs engine work, you have a medical emergency, you have a tax bill, etc.

Just like in Scarface where using your own product is that start of your downfall, do payday loans trap consumers in a cycle of debt.

It is hard to take the research on this subject too seriously, as many are financed by the industry itself – see here

In another effort, the Consumer Credit Research Foundation provides industry credit data – and they showed people suffered from the disappearance of payday loan shops, but again CCRF is funded by payday lenders and editorial control is always an issue. The key in any research which draws specific conclusions can this study’s results be reproduced.  Can someone else can take the same protocols and procedures and get the same results?

The problem is payday loans are not always used as designed, ie, a quick solution for emergencies, but are used for everyday expenses – rent, utilities, groceries, etc. One study said the industry business model is structured as a debt trap by design.

A Look at the Economics

In the USA, payday loan fees are an estimated $3.4bn year. 75% of industry fees come from borrowers that take out 10 loans or more a year.  Because these loans are so small, for every $100 borrowed, the lender gets $15 fees.

Typical credit card rates are 20% or thereabouts, but the payday loan industry says it’s not reasonable – they operate on a thin margin. When you hear 400% on an annual basis, it’s not so bad in nominal terms for a loan for a few weeks, but if you do continuous roll-overs for 52 weeks, its crazy. Instead of paying 400% to borrow money, if you move to APRs to 36% will payday lenders have enough to be in business?

But where do people who need cash get it if don’t have payday lenders? Loan sharks? Family?  Would banks fill the gap?  There are an estimated 10m people that use them in a year – but how do you regulate the industry without shutting it down?  Having access to payday loans can help reduce financial stress.  I am sure there are studies that show the opposite.  The key is rollovers.  If you can actually predict who would not be addicted to roll-overs that would be great, this is where big data could come into play.  The expense to underwrite to figure this out could outweigh profit.

Bottom line if you need $300 fast and marketplace lenders are not an option given your credit score and have to pay $70 to get it, a payday loan may not be a bad trade-off.

What do you think? Should Congress limit roll-overs? Interest rates?  Is this a death knell for payday lenders?

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