In Tennessee, they are euphemistically known as "deferred presentment services companies". Most of us know them as payday lenders, firms that live in the shadows of the banking system making short-term, high cost loans to financially vulnerable individuals. While these companies claim to provide a needed service to consumers without other options, recent data again confirms that the costs for borrowers from payday loans usually surpass their benefits.
Payday lenders claim to promote one-time loans intended to cover unexpected expenses. In fact, neither assertion is true in practice.
According to a new paper from the Consumer Financial Protection Bureau, 80 percent of loans are renewed (rolled over or reissued within 14 days), incurring new fees and interest charges each time at annualized rates exceeding 400 percent.. Half of all loans are part of a sequence at least 10 loans long, trapping borrowers in a destructive debt spiral.
Meanwhile, the Pew Charitable Trusts reports that these loans are typically not taken out to cover unexpected emergencies; fully 69 percent of new payday loans are used to meet routine expenses like rent, utilities and credit card payments.
Perhaps the most astounding result from the Pew study was the fact that the average customer borrowed $375, remained in debt for five months, and spent $520 in interest to re-borrow the same $375 a total of eight times during the year. It is virtually impossible to argue that this consumer is better off for having walked into the loan office.
In actuality, payday lenders' very existence depends upon borrowers falling into long cycles of renewing their loans. Industry analysts estimate that lenders lose money on one-time customers and only profit once a loan is rolled over four to five times.
Another justification offered by the industry is that high-cost loans are preferable to bounced check charges. Fair enough. But one might also say the same for betting on the lottery or shoplifting. All are true, but hardly useful comparisons. Besides, as it turns out, over half of borrowers also paid overdraft fees last year anyway, and half of those report that the lender triggered an overdraft by withdrawing payment.
Lenders defend usurious charges by noting high default rates. Industry statistics indicate that roughly 6 percent of loans default each year and make up about 20 percent of total costs. In reality, overhead to operate 20,000 omnipresent storefront locations is the biggest single expense. This is roughly the same as the number of credit union branches in the United States, which originate three times the loan volume and offer many other beneficial services.
While a free market recognizes the right to make bad decisions, the fact that payday lenders deliberately exploit low-information borrowers argues for greater regulatory oversight. These products more closely resemble loan sharking than traditional lending and warrant additional scrutiny for their propensity to victimize the less financially sophisticated.
And while federal regulation is usually inefficient and frequently intrusive, many states have failed to act. Tennessee, in fact, recently moved on behalf of payday lenders to relax the cap on fees. This is perhaps unsurprising, as our state is the reputed birthplace of this industry.
Now, however, the CFPB has entered the fray. Having catalogued over 1,000 complaints in its first two months of record keeping, the agency is preparing to announce reforms to rein in some of the more abusive practices. While one can easily debate the relevance of the agency and its mandate, in this case some good just might come of it.
Next week we look at alternatives to predatory loans and ways to break the debt cycle.
Christopher A. Hopkins, CFA, is vice president for Barnett & Co.