Borrowing While Poor

Upcoming regulation won't fix the underlying problem of payday loans: a lack of access to credit.

Lenny Ignelzi / AP

The market for quick, small loans has long been inadequate. Because banks would rather lend $50,000 than $500, and tend to require strong credit histories to borrow at all, the options for families that are down and out, or a bit behind on their bills, are limited. That’s where payday lenders come in. While they might seem like a quick fix, the high interest rates coupled with the low incomes common among their clients can create a cycle of indebtedness far worse than the financial troubles that force families to seek out such loans in the first place.

A story my colleague Derek Thompson shared last year captures this perfectly. Alex and Melissa were young parents living in Rhode Island who found themselves stuck in a cycle of debt after taking out a loan from a payday lender. It happened quickly: Alex was diagnosed with multiple sclerosis and had to quit his job. Shortly after, their son was diagnosed with severe autism. They were making much less than they were before and medical bills started piling up. Short on cash and without a strong enough credit history to get a bank loan to tide them over, Melissa went to a payday lender, taking out a meager $450.

When they weren’t able to pay the debt back in a matter of weeks, the amount ballooned to $1,700 thanks to the high interest rates, fees, and rollover loans (loans that get folded into new, larger loans when a borrower is unable to repay their initial loan).

There are plenty of stories like Alex and Melissa’s, and they are troubling. The potential harm that such debt cycles can do is clear and widely agreed upon. But what is not yet agreed upon is what’s to be done about the payday-loan industry.

One of the strongest criticisms is that the loans unfairly target and take advantage of economically weak Americans. Payday storefronts are frequently found in poor neighborhoods, almost never in rich ones. To address this concern, there are loud voices calling for swift and severe regulation—if not eradication—of payday lenders, including the Consumer Financial Protection Bureau. The Bureau has proposed regulations for the industry that would force lenders to do better due diligence about borrower’s ability to repay, and to cap interest rates and rollover loans to ensure that customers don’t get trapped in a cycle of debt. But detractors argue that the loans—while perhaps not optimally structured—play an important role in helping the most vulnerable families. They say that by capping rates, and decreasing the returns to lenders, no one will be around to offer a family with a low credit score a $300 loan to help pay rent, or a $500 loan to cover a sudden medical expense.

That perspective was recently advanced in an essay on the New York Federal Reserve’s Liberty Street blog. Researchers Robert DeYoung, Ronald J. Mann, Donald P. Morgan, and Michael R. Strain suggest that there’s a large disconnect between what academic research on payday loans finds and and the public narrative about the products. The paper starts with what it deems “the big question” of payday loans, which is whether they net help or hurt consumers. A part of that question, they say, is determining whether or not borrowers are unwittingly fleeced into a cycle of debt, or whether they are rational actors making the best choice available to them. The paper finds that borrowers may be more aware and rational than they’re given credit for, and that based on academic data, there’s no definitive answer to whether the products are all good or all bad. To that end, the paper concludes that perhaps the villainization and calls for aggressive regulation are a bit premature.

Is that the right conclusion to draw? Paige Skiba, a professor of behavioral law and economics at Vanderbilt University, agrees that the academic literature is mixed, but says that the question they are asking—whether the products are all good or all bad—is largely pointless, “For some people payday loans are fine, for some people borrowing on a payday loan turns out to be a very bad thing.” Instead, she says it’s important to examine the motivation and behavior of borrowers, as well as the actual outcomes.

When people apply for payday loans they’re already in somewhat dire financial straits. Skiba says that her research finds that the mean credit score for payday-loan applicants is 520. The mean for the overall population is 680. That means that the likelihood of being approved for any other type of loan is small at best. “They've been searching for and denied credit, maxed out on their credit cards, delinquent on secured and unsecured credit, so at the time that they show up at the payday place, it is their best hope for getting credit,” she says. The decision, at that point, is completely rational, just as the Liberty Street essay’s authors suggest. But what happens after borrowers have secured the loan is where things go awry, and whether they were rational to get the loan in the first place seems a bit beside the point. “I kind of disagree with the idea that people are very foresighted about their predicting their behavior,” Skiba says.

As the name indicates, a payday loan is meant to help bridge the time between paydays. The terms are supposed to be short, the equivalent of a pay period or a couple of weeks at most. But borrowers are typically indebted for around three months Skiba says. With fees and incredibly high interest rates, which can range between 300 and 600 percent when annualized, failure to repay within that short time span can make the debt mount quickly.

Skiba’s research shows that the default rate on payday loans is around 30 percent, and a study from the Center for Responsible Lending puts the default range between about 30 and 50 percent as the number of rollovers increase. (The Liberty Street authors don’t mention default rates in their essay.) But these defaults only occur after several interest payments and several efforts to stay current on the debt, evidence, Skiba says, that these borrowers are likely overly optimistic (and thus not particularly rational) about their ability to pay back the loans. (If borrowers knew they were going to default they wouldn’t waste time or money making any payments.) “They don’t know how hard it’s going to be to pay back half of their paycheck plus 15 to 20 percent interest in a matter of days.”

John Caskey, an economics professor at Swarthmore College, is likewise in agreement that the literature about whether these products are ultimately helpful or harmful is mixed. But he doesn’t think that that should stand in the way of improving them. “Unfortunately, it’s a very hard thing to test and get solid answers on, so you have to make your best judgement in terms of regulation,” he says. Caskey argues that part of the problem with the anti-federal-regulation sentiment is that a plan to leave regulation up to individual states leaves too many loopholes for borrowers, lenders, and lobbyists who would try to chip away at any constraints. With a state-by-state approach, an applicant who is denied in their own state because the loan might be too burdensome could simply head to a bordering state where regulations are much more lax, or head online. They’d nevertheless be running the risk of getting stuck in a cycle of bad debt.

Furthering the argument that these mixed academic findings aren’t reason enough to try to halt changes to the industry, a recent investigation by the Huffington Post calls into question the validity of some of the more favorable studies. In emails obtained by the news organization, it’s clear that the payday industry exerted both financial and editorial influence on the reported findings of at least one academic study from Arkansas Tech, with a lawyer from the Payday Loan Bar Association providing line edits and suggestions directly to researchers. That paper has been cited in filings to federal regulators, the reporters noted.

While payday loans are a potentially destructive solution to a person’s immediate financial crisis, they still represent a temporary solution. They allow families to borrow a few hundred dollars that can help them put food on the table or keep the lights and heat on. Some fear that regulation will mean the end of payday lenders, Skiba says, and other options—like pawn shops and installment loans—will see increased use. That too will have its costs.

That’s because payday loans are ultimately a symptom of a greater problem—the lack of access to the financial system or some other form of emergency financial insurance. While a rough month of unexpected expenses or earnings loss might take a toll on most households, for the millions of Americans without savings or access to credit, it can mean bankruptcy, eviction, or hunger. Most experts agree that it’s only a matter of time before regulations on payday loans are approved. While that will protect some consumers from bad lenders and themselves, it still won’t guarantee them access to the kinds of credit and resources they need to achieve security.