Limiting access to payday loans can do more harm than good

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One of the few loan options available to the poor could soon evaporate if a new rule proposed on June 2 takes effect.

The Consumer Financial Protection Bureau (CFPB) announced the rule with the aim of eliminating what he called the “debt traps” caused by the US $ 38.5 billion payday loan market.

But will he do it?

What is a payday loan?

The payday loan market, which emerged in the 1990s, involves in-store lenders offering small loans of a few hundred dollars for one to two weeks for a “fee” of 15-20%. For example, a loan of $ 100 for two weeks can cost $ 20. On an annualized basis, this equates to an interest rate of 520%.

In exchange for cash, 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 an additional $ 20.

Thanks to their great interest, their short duration and the fact that One out of five eventually default, payday loans have long been ridiculed as ‘predatory’ and ‘abusive’, making them a prime target of the CFPB since the office was created by the Dodd-Frank Act in 2011.

States have already been quick to regulate the industry, with 16 and Washington, DC, ban them outright or impose caps on fees that essentially eliminate the industry. Since the CFPB does not have the authority to cap the fees charged by payday lenders, the regulations they propose focus on other aspects of the lending model.

Under the proposed changes announced last week, lenders would have to assess a borrower’s repayment capacity, and it would be more difficult to “roll over” loans into new ones when they mature – a process that drives up interest charges. .

There is no doubt that these new regulations will significantly affect the industry. But is it a good thing? People who currently rely on payday loans actually better thanks to the new rules?

In short, no: the resulting Wild West of high-interest credit products is not beneficial to low-income consumers, who are in desperate need of 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 rate loans? What are the consequences of borrowing on these markets? And what should proper regulation look like?

One thing is clear: the demand for quick liquidity by households considered to be high risk for lenders is strong. Stable demand for alternative sources of credit means that when regulators target and limit a product, other, poorly regulated and often abusive options emerge in its place. Demand does not simply evaporate when there are shocks on the supply side of credit markets.

This slow-moving lagging regulatory approach means lenders can experiment with credit products for years to the detriment of consumers.

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Who gets a payday loan

About 12 million mostly low-income people use payday loans every year. For people with low income and low FICO credit, payday loans are often the only (albeit very expensive) way to get a loan.

My research lays bare the typical profile of a consumer who comes forward to borrow on a payday loan: months or years of financial distress from max credit cards, demand and denial of secured and unsecured credit , and non-payment of debts on time.

What their credit scores look like is perhaps more striking: The average credit scores of payday applicants were below 520 when they applied for the loan, compared to a american average of just under 700.

Given these characteristics, it is easy to see that the typical payday borrower simply does not have access to cheaper and better credit.

Borrowers can make their first trip to the payday lender out of rational need for a few dollars. But since these borrowers typically owe up to half of their take home pay plus interest on their next payday, it’s easy to see how difficult it will be to pay in full. Defering full repayment to a future pay date is far too tempting, especially considering that a payday borrower’s median checking account balance was only $ 66.

The consequences of payday loans

The empirical literature measuring the welfare consequences of borrowing on a personal loan, including mine, is deeply divided.

On the one hand, I have seen that payday loans are increasing personal bankruptcy rate. But I have also documented that the use larger payday loans actually helped consumers avoid default, perhaps because they had more leeway to manage their budget that month.

In a 2015 item, with two coauthors, I analyzed payday lender data and credit bureau files to determine how loans affect borrowers, who had little or no access to regular credit with very poor credit histories . 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 weren’t better or worse off with the loan. on salary.

Other researchers have found that payday loans help borrowers avoid foreclosures and help limit some economic difficulties.

So it’s possible that even in cases where interest rates reach as high as 600%, payday loans help consumers do what economists call “Smoothing” on consumption helping them manage their cash flow between pay periods.

In 2012, I examined the growing body of microeconomic evidence on the use of payday loans by borrowers and examining how they might respond to a variety of regulatory regimes, such as outright bans, rate caps, and restrictions on size, duration or renewal renewals.

I concluded that of all the regulatory strategies implemented by states, the one with potential benefit to consumers limited the ease with which loans are renewed. Consumers’ inability to predict or prepare for the escalating interest payment cycle leads to welfare-damaging behavior, unlike other characteristics of payday loans targeted by lawmakers.

In sum, there is no doubt that payday loans have devastating consequences for some. consumers. But when used appropriately and moderately – and when they are repaid quickly – payday loans allow low-income people who lack other resources to manage their finances in ways that are difficult to achieve. using other forms of credit.

End of the industry?

Changes made by the Consumer Financial Protection Bureau to underwriting standards – such as requiring lenders to verify borrower income and confirm borrowers’ ability to repay – coupled with new restrictions on loan renewals will certainly reduce the supply of payday credit, perhaps zero.

The business model relies on the flow of interest payments from borrowers unable to repay within the original loan term, thus offering the lender a new commission with each payment cycle. If and when regulators ban lenders from using this business model, there will be nothing left of the industry.

The alternatives are worse

So if the personal loan market disappears, what will happen to the people who use it?

As households today face stagnant wages as the cost of living increases, the demand for small loans is increasing. 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 that person, a surprisingly high utility bill, a medical emergency, or the consequences of a bad financial decision (which we all make every now and then) can prompt a perfectly rational trip to a local payday lender to resolve a problem. miss to win.

We all procrastinate, fight to save for a rainy day, try to continue with the Joneses, fail to predict unexpected bills and bury our head in the sand when the going gets tough.

These entrenched behavioral biases and systematic fiscal imbalances will not end with the entry into force of the new regulations. So where will consumers turn after payday loans dry up?

Alternatives available to the typical payday client include installment loans and flexible loans (which are a source of high interest revolving 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 result in higher costs than payday loans.

Payday loan oversight is necessary, but enacting rules that will decimate the payday lending industry will not solve any problems. The demand for small, fast cash is going nowhere. And because the default rates are so high, lenders are unwilling to provide short term credit to this population without great benefits (i.e. high interest rates).

Consumers will always find themselves strapped for cash on occasion. Low-income borrowers are resourceful, and as regulators play mole and cut a credit option, consumers will turn to the best solution, which is likely to be a worse and more expensive alternative.

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