Every year, U.S. households pay $3.5 billion in interest for payday loans, with the annual percentage rates ranging from 200 percent to 500 percent. What starts as a short-term loan becomes a long-term debt cycle.
Payday lenders follow a specific business model, target repeat customers (often minorities), charge fees that build over time without offering feasible payment plans, borrow from big banks and function with few regulations.
Payday lenders follow a specific business model, target repeat customers (often minorities), charge fees that build over time without offering feasible payment plans, borrow from big banks and function with few regulations.
The ease of the process and the easy access to cash make payday lending appealing to many consumers.
Payday Lenders Prey on the Poor
Payday loans are offered at payday loan stores, check-cashing places, pawn shops and some banks. Payday loan stores are open longer than typical bank hours, allowing easy access to cash regardless of the time of day.
Payday lending requires a borrower to write a check to a lender for the amount of a loan, usually around $300, plus a fee, which will be kept by the lender. The lender agrees to wait to deposit the check until the borrower has received his or her next paycheck. Since most people receive paychecks on a biweekly basis, the typical loan period is two weeks or less.
Once the next paycheck comes in, the borrower may choose to let the check go through, return to the lender and pay in cash, or pay another fee to let the loan roll over to the next pay period. Payday lenders charge fees for bounced checks and can even sue borrowers for bad checks.
The process allows those who have little or no credit to quickly access cash. Lenders do not check borrowers’ credit scores, nor do they report borrowers’ activity to credit bureaus.
Lenders require borrowers to earn at least $1,000 a month and to provide the following :
- Home address.
- Valid checking account number.
- Driver’s license.
- Social Security number.
- A couple of pay stubs to verify employment, wages and pay dates.
Payday lenders often seek out locations in impoverished and minority neighborhoods.
A typical borrower has one or more of the following characteristics :
- Young.
- Has children.
- High school graduate.
- Does not own his or her home.
- Relies on Social Security checks.
- No access to any other type of credit.
Nearly everyone who visits a payday lender has been there before. It is unusual for a customer to go to a store, pay the two-week fee and then never return. Just 2 percent of payday loans are taken out by single-use customers.
It is estimated that 90 percent of business is generated by borrowers with five or more loans per year, with the average user taking out nine loans per year. Each of these loans charges a fee when it’s taken out and with each rollover.
The Credit Research Center at Georgetown University’s McDonough School of Business notes these common characteristics of payday customers: limited credit availability, history of borrowing from a pawn shop in the last five years, history of filing for bankruptcy in the past five years, or history of making late payments on mortgage or consumer debt in the last year.
Payday lenders also target military personnel. One in five active-duty military personnel were payday borrowers in 2005. But since 2007, the Department of Defense has prevented lenders from requiring a check from borrowers, and the annual percentage rate for military borrowers has been capped at 36 percent.
Some states require payday lenders to be at least a quarter of a mile from each other and 500 feet from homes — similar to the restrictions on sexually oriented businesses.
Payday Lenders Promise a Debt Cycle
Instead of advertising their three-digit interest rates, lenders focus on the price-per-$100 fee, leading customers to believe the equation works in their favor. Lenders typically charge around $15 or more for every $100 loaned. And since payday loans are not often paid off after two weeks, the annual percentage rate (APR) keeps growing and growing.
So an average $200 two-week loan, with $30 in fees, would amount to an APR of 391 percent.
Computing the annual percentage rate (APR) for payday loans can be done in a few simple steps.
- Divide the finance charge by the amount of the loan.
- Multiply that by 365 (number of days in a year).
- Divide that by the term of the loan (typically 14 days).
- Then move the decimal two places to the right and add the percent sign.
Research shows that many customers using payday loans are unaware of the high interest rates and focus more on the so-called fees. The Truth in Lending Act of 2000 required that the APR be released on payday loans. Focusing on the fee alone prevents customers from shopping around and comparing APRs that banks and credit unions may offer. For example, many credit cards charge a cash advance fee of 4 or 5 percent, with a 25 percent annual interest rate.
The problem is many customers have maxed out their credit cards or have had to close their credit card accounts.
Customers may utilize payday lenders for emergency services like doctors visits or car problems. If a paycheck does not stretch far enough to cover utilities, rent or other bills, consumers will use payday lenders. The difficulty occurs when the loan is due, because by then it is time to pay the next month’s cycle of bills. So, users are forced to take out another loan to keep up with their regular bills.
The majority of payday borrowers function in this way, either paying a fee to roll over a loan for two more weeks or taking out new loans, immersing them into a dangerous cycle of debt.
Banks and Regulation
This practice of payday lending is not limited to small payday shops, as banks both offer similar programs to accountholders and make loans to the payday lenders themselves. Wells Fargo, U.S. Bank and Fifth Third offer payday loan products with annual interest rates up to 102 percent. Wells Fargo, Bank of America and JPMorgan Chase all lend money to payday lenders. Together, big banks provide $1.5 billion in credit to publicly held payday loan companies.
These banks provide money to lenders at a low interest rate. The banks borrow money from the Federal Reserve at an even lower interest rate. Meanwhile, consumers are faced with three-digit interest rates to pay for food, medical care and car repairs.
Regulating payday lending poses many difficulties, as laws that apply to banks do not apply to payday lenders. The Consumer Federation of America reports that 17 states have laws preventing high-cost lending. States achieve this by prohibiting payday lending or setting interest rate caps.
The U.S. Consumer Financial Protection Bureau, which was created in 2011, oversees payday lenders and other consumer financial services. Consumers can register complaints with this group, as well.
The Center for Responsible Lending Organization recommends these regulations for payday lenders:
- Cap interest rates at 36 percent.
- Limit the amount of time each year a borrower could be indebted to a payday lender.
- Expand access to affordable small-loan products.
Despite recommendations and regulations, payday lenders continue to prosper by taking advantage of impoverished communities. Faced with an emergency situation — or regular monthly bills — many consumers feel like they have little choice but to engage payday lenders — and be trapped by an irrecoverable debt cycle.
Al Krulick