Payday loan arrangements are awful for the borrower, in case you didn't know. But if they're legislated out of existence, who will pick it up?
Payday loans (also called check loans) are extremely high-interest loans for people who have few other options. Just about anything else is better than a payday loan.
Ironically, the people they devastate the most are those people who take paying back the loan seriously.
Elliott Clark of Kansas City, Missouri, paid a staggering $50,000 in interest or five and a half years on just $2,500 in payday loans.
The harsh numbers on payday loans
Clark took out five $500 payday loans as a last effort to cover his wife's medical bills. Each loan carried an interest charge of $95 every two weeks. So, every two weeks, he had to shell out $475 and he'd still owe exactly what he owed before.
There are 143 biweekly periods in five and a half years. Multiplying this out gives just under $68,000 in interest, so presumably he paid some of the loans off before the 5 1/2 year mark.
But … wow. Paying a loan back twenty times over is unbelievable. But he did.
The fact that Clark paid back his loans almost puts him in the minority. (And gets a huge amount of respect from me, for what it's worth.) Forty-six percent of payday loan borrowers default on their loans within two years. A third default within six months.
Payday loan companies: High reward but also high risk
Default rates of 33% and 46% are extremely high. If you roll a die, there's a 33% chance you'll get a one or a two. Forty-six percent is slightly less than the chance of getting a one, two, or three.
Payday loan establishments see similar odds. There's a one-in-three chance that a borrower will default on their loans within the first six months. This, in part, is why the loan is covered by the interest charges in ten to twelve weeks. They want to break even before the (likely!) event that the borrower defaults.
High risk, high reward.
Take the reward away?
Following the payback of his payday loans, Clark has argued for a rate cap of 36% APR on these types of loans. This rate is comparable to the penalty rate on credit cards, which weighed in on average at 28% and change in 2014 and is the rate that kicks in once a credit card holder starts making late payments.
As great an idea as this might sound, it won't be business as usual, minus obscene profits for payday loan establishments. Limiting the income (interest rate) takes away the reward but leaves all of the risk. The payday loan places have a few options:
- Lose money. Six months' worth of interest at 36% APR on a $500 loan is $90. All other things being equal, a 33% default rate is $167 per loan just on defaulted principal. As they say: You can't make up on volume what you're losing on each unit.
- Make lending much tighter. Lenders can tighten up the criteria for qualifying for a loan. This will reduce the default rate, but it will also greatly reduce the volume. The very people that were coming to get the payday loans won't qualify. Lenders avoid a lot of the bad this way, but they're also missing out on a lot of the good (from their perspective).
- Close their doors. This is the most likely outcome. Payday lenders will just cease doing business and search for greener pastures.
Now, before everyone yells “mission accomplished” let's realize that the need for payday loans won't go away. These places sprang up because there was a need for “a lender of last resort.” Who is going to be willing to take on extraordinary risk for mediocre reward? Who is going to be as accessible as these places to people who, for whatever reason, legitimately need money like Mr. Clark and who don't want to go on the dole so easily? Without this kind of option (obviously not an optimal option) the consequence is that the person defaults and has their credit slammed much faster, which makes it even more difficult to get financial help.
To make payday loans friendlier, look to Redbox
(No, Redbox hasn't gotten into payday lending! It's just an analogy.)
You know the Redbox movie and game rental kiosks all over the place, right? Well, if you rent a movie or a game and don't return it within a reasonable maximum time (two to three weeks) they don't send your account to collections. They don't even get mad at you. They just charge a high-ish but not onerous fee for what you rented ($25, $34, and $69 plus tax for DVDs, Blu-Rays, and games, respectively) and they let you keep it!
Now, $25 plus tax for a DVD without the commercial box isn't really a bargain, but it's not a complete ripoff, either. If something actually happened to the disc (like the dog chewed it up), I bet you'd be ecstatic that Redbox let you off the hook this easily. It's, dare I say, merciful?
Let's apply this to payday lending.
Keep everything the same about the lending (including the $95 interest charge every two weeks) but after, say, a year's worth of payments, the lender says, “OK, you're done paying on this thing. Thank you for your business. Please come back again if you need another loan.” And then the borrower and the lender part ways, on good terms.
The borrower still would have paid back nearly $2,500 for every $500 borrowed, and done so over only a year. It's a lot. But after that, they'd be done. There's no more debt trap, and it's a workable business model that properly rewards the risk the lender is shouldering. In doing this, they can continue to provide the service.
What do you think? What other alternatives are there for short-term lending needs, if not payday loan places?
