The Outrageous and Usurious Interest Rates on Payday Loans
Executive Summary
- Outrageous levels of interest are now the norm in payday lending.
Introduction
The interest rates charged by payday loans are beyond belief. This is covered in the following quotation.
“Worse yet are these payday loans resorted to by the unbanked and underbanked, which average 400% interest annually or more.” – Banking on the People
Source: Banking on the People
https://www.amazon.com/Banking-People-Democratizing-Money-Digital-ebook/dp/B07R3F6ZX7/
The cost of this money is close to zero for the lenders.
The Interest Rates on Payday Loans
A payday loan is so-called because the borrower must have a regular paycheck against which she borrows, usually up to $500, with a typical term of anywhere from a week to a month. The borrower gives the lender access to her bank account in the form of either a postdated check or permission for direct withdrawal. The lender then deducts the outstanding payment when it becomes due, typically, the next payday. Consider these staggering statistics about the payday lending sector:The average payday lending customer is indebted for 199 days, “or roughly 55% of the year. A quarter of consumers were indebted for 92 days or less over the 12-month study period, while another quarter was indebted for more than 300 days.” Over 80 percent of payday loans are rolled over or followed by another loan within fourteen days (i.e., renewed). Of the loans that are rolled over, half are made in a sequence of at least ten loans, and the majority, 62 percent, are in sequences of seven or more loans. The payday industry relies on the constant renewal of these loans. One large payday lender even instructs its employees on how to perpetuate the loans with a circle diagram that reflects the need for constant renewal.A staggering 90 percent of payday lending business is generated by borrowers with five or more loans per year, and over 60 percent of business is generated by borrowers with twelve or more loans per year. Fees on these loans quickly add up. If a typical payday loan of $325 is flipped eight times—this usually takes just four months—the borrower will have paid $468 in interest. In order to fully repay the loan and principal, the borrower will need to pay $793 for the original $325. Most borrowers pay even more than that.
Source: How the Other Half Banks
https://www.amazon.com/How-Other-Half-Banks-Exploitation/dp/0674286065
Almost 100 percent of Four Oaks Bank’s customers were Internet payday lenders, and the company was granting them access to the payment system only to be used by banks. Not only were these lenders charging between 400 percent and 1800 percent interest, in excess of state usury laws, but they were gaining unauthorized access to their borrower’s accounts. According to the consent order, the lenders offered borrowers loans with an agreement that customers would pay their loan via a debit on a particular date, at which point their obligation would be discharged. However, the lenders did not deduct the amount on that date and instead manipulated customers into extending the loans and racking up multiple finance charges. In some cases, the lenders manipulated the amount and frequency of debits to obtain greater profits by keeping consumers constantly in debt. No other banks have been prosecuted under Operation Choke Point and no others likely will.The reason is that the payday lending industry immediately sued the DOJ over unfairly targeting them, and Congress stepped in to stop the project. The initiative faced significant political blowback right away, with many arguing that payday lending is a legitimate business being unjustly accused. Chairman Darrell Issa of the House Committee on Oversight and Government Reform found: “Contrary to the Department’s political statements, Operation Choke Point was primarily focused on the payday lending industry,” which is made up of “entirely lawful and legitimate merchants.” There was nothing “fraudulent” about the industry, Issa argued. Chairman Issa also released a staff report in 2014 highlighting key failures of the initiative, including (1) the operation was “choking out” companies the administration considered a “high risk” or otherwise objectionable, despite the fact that they were legal businesses, (2) the operation forced banks to terminate relationships with a wide variety of entirely lawful and legitimate merchants, and (3) the project primarily focused on the payday lending industry. Indeed, according to some state laws, it is legal for payday lenders to operate and charge the rates they do. However, roughly 40 percent of the industry’s volume consists of organizations that do not have the legal right to originate loans. Nearly all of the online-only payday lenders are lending in states that prohibit lending outright or that prohibit loans by lenders without a state-issued license. Even though these loans are void or voidable as a matter of law, these companies collect on their loans while failing to disclose this crucial legal fact—an omission that is likely actionable under mail and wire fraud statutes. The argument is that banks can lend to any legitimate business that they deem creditworthy, and payday lending is not illegal. Lissa’s report was factually incorrect, as up to 40 percent of payday lenders’ rates and activities are illegal. However, even if all payday lending operations were perfectly legal, one would have to be willfully deaf to the imbalance of services in the financial industry to bless the relationship between payday lenders and banks.
Source: How the Other Half Banks
How the costs to lend to the poor do not explain the extraordinary interest rates.
Although it is certainly true that it costs more to lend to the poor, it is by no means the case that payday lenders price their loans based on the borrower or even the “market.” In fact, across the board, these lenders are charging the maximum interest rates allowable by law.The first comprehensive study of payday lending pricing, released in 2009, revealed a “strong relationship between actual payday loan prices and the payday loan price ceiling imposed by [the state legislature].” Even if some price competition existed between lenders when they first opened, “with the passage of time, the average finance charge on payday loans … gravitated upwards toward this ceiling.” This pattern, suggest the researchers, is consistent with Nobel Prize winner Thomas Schelling’s theory of implicit collusion around pricing focal points. Although there is no smoking gun, the study reveals that there is not only little market competition among lenders, but possible price controls.
Source: How the Other Half Banks
Almost 40 percent of borrowers admit that when they need these loans, they are not “price-sensitive”; they would agree to the loan under any terms offered. As a result, there is no competition between lenders to lower prices.
Source: How the Other Half Banks
Alternatively, a presentation prepared by potential investors in a payday lending company found that “a store set up for $30,000 will generate more than $258,000 in operating cash flow over its first five years of operation, which implies an extraordinary average annual pretax rate of return—around 170 percent—on the initial investment.”
Source: How the Other Half Banks
Why it is
And yet, the banking industry has determined that because it can make much higher margins on larger loans, it is not worthwhile for it to spend resources to differentiate borrowers for small loans. The result is that the poor are generally determined to be “bad borrowers.” However, there is a difference between the poor who are creditworthy and those who are not. This is one of the reasons that credit unions, savings and loans, and Morris banks were able to lend to the poor. By differentiating a good credit risk from a bad one, a lender can effectively lend to the poor at low costs. An important distinction that must be understood first is the difference between illiquidity and insolvency.
Source: How the Other Half Banks
If the two types of borrowers could be adequately sorted, those who are illiquid could get lower cost loans that would help them stay solvent. But here’s the irony: the only loans available to the merely illiquid are high-cost loans that make it much more likely they will become insolvent.This is where the contrast between the credit markets for the average people-as-borrowers and the credit markets for the banks-as-borrowers becomes stark. The government provides banks low-cost loans when they are illiquid and also when they are insolvent.
Source: How the Other Half Banks