Warning: Payday Loans May Cause Excessive Money Loss, But Don’t Throw the Baby Out With the Bathwater

Brenda Proctor - University of Missouri

Brenda Procter has been fighting the good fight against payday lenders for 20 years, and boy does she have some stories to tell.

For starters, Procter — a Missouri state extension specialist and professor of personal financial planning at the University of Missouri — can recount how a local payday lender actually propositioned an obviously cognitively impaired member of her financial counseling group while he was in the drive-through line at Taco Bell, only to be rebuffed by the caseworker sitting in the driver’s seat beside him. 

“One of the lenders that he had borrowed from spotted him,” she said, describing how the lender pulled a U-turn into the Taco Bell parking lot, slammed on the brakes and proclaimed – , “Hey, buddy, I’ve got $400 just waiting; all you gotta do is come down and sign for it today.”

The caseworker leaned over to speak for her bewildered client and told him to back off.  “And he did go away,” Procter recalls, “but I think the moral of that story is no matter what, they’re still going to come after you.”

She’ll also tell you about how the shadiness of the industry drove a former payday lending company employee into the University of Missouri’s doctoral program so that he could work to help correct the injustices he once helped facilitate. His name is Graham McCaulley, and his stance on the value and purpose of payday loans is clear.

In my experience, these loans are not designed as a short-term, one-time solution – as the companies like to say they are – but are instead intended to keep people trapped in a cycle of debt and to prey upon the elderly, disabled, poor and minority populations,” he told CardHub.

“We were trained to push people toward bigger loans and encourage them to pay them back as slowly as possible. That way the company could make the most money. It did not matter if customers had loans out at other payday lending stores or were living off small fixed incomes. Credit worthiness was not really important.”

While they’re certainly interesting, those of you who are unfamiliar with payday loans might fail to grasp the significance of these tales. So, let’s take a closer look.

Taking Stock of the Payday Loan Market

A payday loan, in case you don’t know, is essentially a high-interest advance on one’s paycheck.  Payday loans are billed as a short-term solution for temporary cash-flow issues, but they’re not necessarily marketed or used for that purpose.

Part of the problem that contributes to a borrower’s ultimate inability to repay the loan within a short period is that lenders typically do not check their customers’ credit or ask about a borrower’s financial position. Often, borrowers can only afford the minimum payment, which typically is enough to cover only interest and mandatory fees, come their next payday. This leads to a perpetual cycle of debt.

Just consider the following statistics from a recent Pew Charitable Trusts study:

  • Twelve million people take out payday loans each year, spending $7.4 billion in the process.
  • While the average payday loan requires repayment of more than $400 within two weeks, the average borrower can only afford to repay $50.
  • Only 14 percent of borrowers are able to repay the average $400 payday loan.
  • The average payday loan is for $375, yet leaves the borrower indebted for five months and on the hook for $520 in interest.

Seven out of 10 payday loan borrowers use the loans to pay for things like rent and utilities and other recurring expenses,” adds Nick Bourke, the director of Pew’s Safe Small-Dollar Loans Research Project. “Only 1 in 6 use the loans for emergencies like unexpected car repairs or unexpected medical expenses. … Ninety-seven percent of payday loan volume goes to people who are repeat users — they use three or more loans per year.”

In other words, we have a product that’s ostensibly meant to provide a short-term financial bridge, yet whose marketing by lenders and ultimate use by consumers are often directly at odds with that intention. The result is a questionable landscape in which actors on both sides are pointing fingers about who is to blame for high costs and financial distress. Many on the consumer side of things are also calling for increased regulation.

The Current Regulatory Environment

To date, 15 states have banned payday loans while others have passed legislation to significantly limit their impact. But why stop there?

Procter believes payday lenders simply have too much at stake and are too effective at both lobbying and skirting the spirit of laws while at the same time adhering to their letter for additional regulations to move forward.

The payday lending industry has deep pockets, you see, and is able to make key contributions to political campaigns as well as media blitzes in opposition to ballot initiatives in order to ensure that business continues to thrive. They’re also notorious for a practice known as “license jumping,” which essentially involves tweaking their products just enough to keep them both legal and just as predatorily profitable as before.

Payday lenders are also increasingly moving operations online in order to avoid local restrictions. Plenty of physical stores remain, nonetheless, and they’re typically clumped together in low-income urban areas, essentially hunting in packs.

They’ll be very close to one another so they can refer clients back and forth,” Procter said.  “In Missouri, you can only renew one payday loan six times. So, if you’re in a store and you’ve kind of worked that consumer for all you can get out of them and they still can’t pay — because that typically is what happens — then they’ll probably say something like, ‘Well, maybe you could take out another loan.’”

And so, Procter says, “they’ll go to the store across the street, next door, or whatever” to take out yet another in a growing line of payday loans used to pay off obligations related to those that preceded it.  “Then the costs tend to snowball. It’s not unusual to see people with several thousand dollars in payday loan debt, and all they’ve done is pay interest up to that point.

Most recently, payday lenders have begun affiliating their businesses with Native American tribes, which are immune to certain federal and state regulations, as another tactic to circumvent their states’ usury laws. As a result, payday loan stores are appearing again in New York, where the practice is illegal.

In March 2014, a U.S. District Court judge reestablished the Federal Trade Commission’s power over lenders with Native American tribal affiliations. Part of its efforts included an investigation on lenders’ coercive collection efforts, some of which are illegal. Citing civil “bad check” laws in many cases, payday lenders have threatened their customers with lawsuits and arrests to collect on loans, but the FTC barred at least one lender from doing so in 2013.

Payday lenders, however, appear to have limitless creativity. Just as New York State’s financial regulators are cracking down on the resurrected payday loan industry in their state, lenders simultaneously are devising methods that work around the new rules. Loans obtained at brick-and-mortar stores historically have been tied to borrowers’ paychecks. For those issued online, the lender draws money out of the borrower’s bank account. Now lenders are using their customers’ debit card information as “backup” in case payment processors reject payments to lenders. Authorities have been working with credit card companies to do the same.

The Value of Payday Loans

Nevertheless, we can’t ignore the fact that payday loans occupy an important niche in the finance world. They’re available — albeit at a hefty price — when there’s no other credit to be had.

“There are people who know what they’re doing, and they [take out payday loans] because that’s the best option they have,” says Dr. Sugato Chakravarty, a professor of consumer economics at Purdue University. “It’s conditional rationality. But it might seem like irrational behavior to us watching from the outside.”

Sure, payday lenders can be both predatory and deceptive, but the products they’re hawking aren’t inherently evil. And blowing up the entire market could end up doing more harm than good.

“Restricting payday lending may also bring unintended consequences,” wrote Dr. Kelly Edmiston, a senior economist for the Federal Reserve Bank of Kansas City, in a 2010 report. “It is important for policymakers to understand both the potential benefits of restricting payday lending as well as the potential costs.”

What kinds of costs are we talking here? Well, without the availability of payday loans, it figures that desperate borrowers could conceivably turn to loan sharks and other criminal elements to get the funds they need. We obviously don’t want that. The downfall of the payday lending market could also put a damper on economic growth via increased bankruptcy and default rates as well as higher social services costs for the poor and people in need of medical care.

So, where does that leave us? Well, it seems we must strike some sort of regulatory balance that makes predatory lending more difficult without restricting consumer access to needed loans.

“I think there’s a place for [payday loans] simply because there are a number of people who have no other access to short-term credit,” Edmiston told CardHub. “Instead of banning them altogether — it’s not my view that we should ban them altogether until there are sufficient alternatives for people to get small-dollar loans who have no other access to credit — I think we can put some regulations in place.”

Edmiston recommends improved disclosures highlighting the true costs and expectations related to payday loans as well as education campaigns regarding the dangers of misuse.

Dr. Brian Melzer, an assistant professor of finance at Northwestern University who has done considerable research on payday loans, agrees, saying, “It does seem sensible to try to find that balance between prohibiting payday lending completely and allowing it, particularly for the cases where people are using the loans to their benefit — smoothing through short-term income or consumption” problems. He in turn recommends capping the number of payday loans a given consumer can take out and, if the consumer happens to reach that limit, transitioning them into an extended payment plan.

Alternatives to Payday Loans

Although various types of legislation aimed at payday loan regulation are currently in play, including Pew’s recommendations, countless consumers will find the need for a payday loan. And because such loans are typically an option of last resort, it’s fair to wonder what alternatives, if any, they’ll have. There are indeed some preferable options, including:

  • Small traditional loans: If you have decent credit, you might qualify for a traditional loan, which would certainly come with a much lower interest rate than a payday loan and offer a more reasonable repayment period.
  • Employer paycheck advances: If you have a good relationship with your employer, it might not hurt to at least ask for an advance on your paycheck. If you decide to go this route, make sure to have a good reason for needing the money now, and be very careful to budget so that you won’t need another advance next pay period.
  • Credit counseling: If you’re considering a payday loan to deal with unmanageable debt, try to work out a payment plan with your creditor first. If that doesn’t work, speak to a credit counselor about your debt repayment options.
  • Emergency assistance programs: Certain community and faith-based organizations offer financial assistance to people in need.
  • Credit card cash advances: We certainly don’t recommend doing a cash advance if you can help it, as credit card issuers typically charge high fees and interest rates in excess of 20%. But even that is better than the 400-plus percent rate you might get with a payday loan.
  • Military assistance: If you are or were a service member, you can seek help from a military charity or relief program associated with your branch of service.
  • Friends or family: Ask your loved ones to lend you money. Some may let you borrow at no interest. If you do this, you should draft a written agreement, or promissory note, before any money switches hands. The document will assure them of your promise to pay and prevent any strife in the future.

You can also take the following proactive steps to ensure that you won’t need an emergency loan in the future:

  • Budget: Rank your monthly expenses in order of importance, and eliminate those that would lead your expenses to exceed your after-tax income.
  • Feed an emergency fund: You won’t have to seek an emergency loan if you already have some reserve funds earmarked for that purpose. We recommend a fund with about a year’s worth of after-tax income.
  • Use the Island Approach: You can lower the cost of existing debt and give yourself a built-in warning system for overspending by implementing the Island Approach.

Ask the Experts

To continue the discussion, we’ve asked several experts in the fields of business, economics and law to share their opinions about the current payday loan landscape. You can check out their thoughts below.

  1. Payday lenders appear to be the lender of last resort for many low-income consumers, trapping them in a series of high-debt loans. Are these companies adequately regulated?
  2. What alternatives, if any, are there for low-income, or poor-credit, consumers in need of a small loan?
  3. Payday lenders say they can’t be profitable operating under a rate cap of 36 percent APR. Is this a valid claim?

Payday lenders appear to be the lender of last resort for many low-income consumers, trapping them in a series of high-debt loans. Are these companies adequately regulated?

Not at all. Historically, they have not been very well regulated. Things are getting a bit better in New York State, with our Attorney General suing those charging interest rates that violates the state legal cap of 25 percent. Many are escaping local jurisdiction, however, by going online or linking up with Native American tribes. This should be an area examined by the new Consumer Financial Protection Bureau, and it recently did send civil subpoenas to dozens of such companies. So there’s hope after all.

Paul Miesing, University at Albany


My personal feeling is no. But there is a big gap between ‘no’ and what and how to regulate. The core issues, it seems to me, are a clear understanding and agreement as to the outcome of regulation; a serious attempt to understand the cost of regulation relative to the benefits; and a regulatory framework that does not inadvertently construct incentives for an even more abusive situation.

Payday lending and related loan types are a large and growing business. There are many providers, large and small, providing a wide diversity of products, and there is evidence that the distribution system is growing — for example, the growth in online providers. If demand is growing and if supply is growing with a more innervated distribution system, appropriate regulation is extremely difficult.

Further, this is not a problem unique to the U.S. For example, it is a central focus of debate today in the UK and has been a concern in Canada. This provides opportunities to learn both ‘what works’ and what doesn’t.

Canada in particular appears to have constructed a regulatory approach with both a policy and philosophy that may provide useful insight for the U.S. situation. Central to this are a strong and apparently enforceable industry code of conduct coupled with such things as federal regulations regarding effective interest caps and ‘no-roll-over’ loans that individual provinces can tighten based on regional or local conditions — the latter is akin to the U.S. policy regarding minimum wage. While we also see industry codes of conduct in the U.S., there are multiple such codes and they may not have effective enforcement. Clearly, we have also seen state level actions in the U.S. that may provide regulatory guidance and perspective.

Bob Atkin, University of Pittsburgh


I do not know the regulatory structure enough to know just how regulated these lenders are compared to other lenders. However, more often than not, regulation that one would think would benefit the consumer actually works against the consumer by making it more difficult for competing businesses to entry and industry. In this case, if payday lenders are earning exceptional profits, others would enter the industry and drive down either the interest rates paid by borrowers or in some other way benefit the customers, in order to get a portion of the lucrative market.

The only way there can be an exception to this rule is if there is some barrier to entry. Significant regulation often is a barrier to entry that allows those already in the business to keep earning profits beyond the norm. I have no knowledge that payday lending is a particularly profitable industry, so my conclusion must be — unless someone else can show me otherwise — that the existing business practices are what must be in place in order to make the business profitable enough to be worthwhile.

Mark Pingle, University of Nevada at Reno


‘Trapping’ is a loaded term. Yes, there are people who get caught in a cycle of debt, but unseen are the people who judiciously use payday loans to get themselves out of a short-term financial setback. Regulating payday lenders only treats the symptoms of the problem. The problem to solve is how to find the people who are caught in a cycle of debt, or susceptible to one, and help them find a way out. Teaching financial literacy to the unbanked is the core problem.

Bart Wilson, Chapman University


What alternatives, if any, are there for low-income, or poor-credit, consumers in need of a small loan?

It’s unfortunate that an industry has thrived by taking advantage of the vulnerable. The first source should be family and friends. Even a cash advance from a credit card offers better rates. Another approach would be to ask the employer for an advance, even if at a slight discount. Given the needs and large profits to be made, this seems an opportunity for community loan and development organizations as well as local credit unions, and perhaps getting a line of credit on a bank account. There’s also an online service: credit.com.

Paul Miesing, University at Albany


Several ideas have been proposed — for example, greater participation of credit unions and better financial education. We have also observed extensive experimentation with ‘micro-loans’ — mostly in developing countries — and a growing development of the concept of ‘hybrid’ organizations, in which the normal price mechanism is conjoined with other objectives.

Having said that, do I have an easy answer? No. However, I do think that some combination of these, probably coupled with certain regulations on the current industry, may provide an alternative.

Bob Atkin, University of Pittsburgh


The primary alternative I know of are pawn loans. But, of course, the terms on those loans are also very unattractive.

Mark Pingle, University of Nevada at Reno 


There aren’t many options beyond pawn brokers. Credit unions have been proposed as an alternative but getting the unbanked access to a credit union is a difficult problem without an obvious solution.

Bart Wilson, Chapman University  


Sorry, don’t really have much insight here…the only aspect of this ecosystem I know even a little about is the problem of the unbanked. Many of the individuals who end up with the payday lenders are unbanked. If we could solve the unbanked problem and get them bank accounts through a combination of creative programs and education, we could better address this problem. I do agree that the extreme rates the payday lenders charge are unfortunate, but I am not convinced that regulating them more closely is the answer. Other parts of the ecosystem need to be addressed.

Todd Saxton, Indiana University


Payday lenders say they can’t be profitable operating under a rate cap of 36 percent APR. Is this a valid claim?

I don’t understand why they think it’s so risky. After all, the loans are almost certain to be repaid — it’s more of an advance, actually, than a loan. If that claim were true, the loan sharks wouldn’t be in most of the USA. [This] website shows the rate cap in each state, and many are far below 36 percent. While the default rate is high and collection is difficult, the industry continues to thrive even where there are caps. But the larger policy issue is whether these companies should be permitted to continue given the large harm they commit. For instance, studies have pointed out the tremendous loss in purchasing power and jobs.

Paul Miesing, University at Albany


I don’t have access to the data necessary to evaluate this. However, as a gut feeling, it seems excessive.

The true test, obviously, is whether some provider can demonstrate a means of providing comparable services at a much lower APR in a sustainable way. Like most other things, price tends to drop when vendors provide a viable ‘discount’ model. Indeed, given the volume of these types of loans and modern technology, I suspect there is a business opportunity for such vendors. Perhaps, regulation could also provide incentives for the start-up of such vendors.

Bob Atkin, University of Pittsburgh


That claim is likely valid if there are few barriers to entry into the payday lending industry, and payday lenders are actually charging 36 percent when facing the regulation. If a business can be profitable with better terms for consumers, then competition will provide the better terms. If there are barriers to entry, then the claim is probably not valid, and the solution is not a lower rate cap but rather removing barriers to entry.

The problem with simply lowering the rate cap as a means of trying to help those wanting the loans is that the market will naturally respond by screening the applicants more carefully, meaning those with weaker credit, or less trustworthy in some sense, will not be able to get a loan at any rate. So, what lowering a rate cap does is help those with better credit or those who are more trustworthy, by preventing the market from pooling them with those who are less trustworthy.

Mark Pingle, University of Nevada at Reno


Customers of payday loans are high-risk clientele, but only payday lenders know what the costs of their business are. Are payday lenders being truthful that they can’t be profitable at such an APR? No one who is not in the business can verify that they are or are not. But by the same token, it is speculation for anyone who is not a payday lender to assert that they know that payday lenders can operate profitably at any cap. Financial literacy is the core problem.

Bart Wilson, Chapman University

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