Payday lending

As the payday lending industry has grown quite immensely over the past decade, particularly in lower-income and minority communities, the usual critics of free-market commerce have found yet another capitalist whipping boy ripe for attack. These critics, often terming themselves as "consumer advocates," charge that payday lending exploits the poor and lower-income customers that comprise its target market, preys on their lack of financial sophistication, leads them into chronic borrowing habits at "excessively high" effective interest rates, and generally takes advantage of their weak bargaining position.

The "alternative" proposed by these critics is further government regulation of the financial institutions that provide payday lending services, usually in the form of caps on the fees that these business firms can charge. Of course, there is no doubt that further government intervention is not the answer. Indeed, it is worthwhile pointing that previous government regulation in the consumer finance industry that has, in part, led to the rapid growth of the very payday lending practices so reviled by critics. As is pretty much always, the law of unintended consequences prevails, leading to outcomes that are directly opposite those sought by government regulators.

Payday lending, sometimes termed to as a "payday advance" or a "deferred deposit" loan, is a short-term two- to four-week loan backed by a postdated personal check that a borrower agrees to cover with sufficient funds out of his or her next paycheck. As a matter of fact, the borrower issues a postdated check to the payday lender in exchange for immediate cash, usually in the amount of $100 or $200.

The normal fee for this service is $15 or $20 per $100 borrowed, so the postdated check is written for an amount equal to the sum of the desired loan plus the related fees. More often the payday lender holds the check until the agreed-upon date, at which point it is cashed and (hopefully) covered by the borrower?s payday deposit.

This is a straightforward enough business model, and would seem to be a legitimate means of extending credit to poor and low-income households who may not otherwise be able to obtain loans due to poor credit histories. Indeed, research has indicates that payday borrowers are more likely to have poor credit histories and to have worked with credit counselors in the past, and are more likely to have had one or more bounced checks in the previous five years.

Apart from that, customers who utilize payday lending services most frequently are also more likely to have been called by a collection agency for overdue bills. Therefore, payday 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 last five year or so, 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.

So, what's the issue Lot's according to the critics of the payday lending industry. First and foremost, the effective annualized interest rates charged on payday loans are relatively high when compared with the rates charged on more conventional consumer credit or on credit card purchases. In case if a typical payday loan fee is $15 per $100 borrowed, and the typical term of the loan is just 14 days, then the annualized compound interest rate is easily in the triple-digit range.

The critics of payday lending termed these relatively high interest rates with much alarm, arguing that the fees charged are exploitative of poor borrowers lacking in personal financial management skills. Furthermore in the eyes of these critics, payday lending establishments are scarcely better than the mob-related lending tactics of a street-corner "Guido" or "Vinny."

Secondly, critics argue that payday lending impoverishes poor households by encouraging chronic borrowing from paycheck to paycheck, putting them under the scanner of more debt. What?s more payday lenders are alleged to purposely keep their low-income customers dependent, forcing them to return month after month. Payday lenders may give to "roll over" the initial debt by asking the borrower to pay an additional fee to defer the loan or to write a second postdated check in place of the original. This sort of "predatory" lending is seen by critics as a way for the payday lending firms to increase profits and keep customers in chronic dependency on payday loans.

Moreover these allegations against the payday-lending industry are largely without merit, and generally reflect the views of "do-gooder" anti-capitalist elites who abhor the "messy" and unplanned outcomes in low-income consumer finance markets. Rather than seeing payday lending practices more or less 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.

First and foremost, because payday lending establishments are admittedly dealing with a high-risk clientele, the effective annual interest rates charged on these types of small loans are going to be considerably higher. On the other hand the entrepreneurs in this high-risk industry must find a way to recover their investment and earn a positive rate of return.

After all, there is no denying that they are drawing scarce financial resources out of some other line of investment, and committing these resources to a high-risk venture in making unsecured loans to borrowers, the large majority of whom have poor credit histories. Because the risk is relatively higher in nature, the risk premium on the loan will naturally be higher.

Keeping this aside, the fixed labor and capital costs associated with offering and underwriting a small loan are the same as offering and underwriting a larger loan. Most crucially with a larger loan principle, the lender can cover costs and earn a profit by charging a lower annual percentage rate over a lengthier period of time. Whereas small principle short-term loans, while costing roughly the same to supply, cannot charge equally low rates of interest and expect to cover costs. They must, that?s why, charge higher rates of interest over short payback periods in order to be profitably offered. Therefore, by their very nature and quite apart from the risk associated with them, small-balance short-term payday loans must charge a higher effective annual interest rate to induce profit-seeking entrepreneurs to provide them.