The Benefits of Payday Lending

At first blush, the situation appears exploitive. Here we have masses of lower income people transferring their meager wealth via outrageous interest rates to unscrupulous moneylenders. However, despite the sizeable APRs, the lenders may not making be out as well as one might suppose. As the outstanding growth rate of the payday lending industry suggests, potential borrowers aren't exactly running in terror. Indeed, it may be the Center for Responsible Lending that is to be feared most.

Consider first the outrageous APRs (240% compared to, say, 6% for a typical home loan). The high APR in part reflects the relative size of transaction costs to the small loan amount (<$300). The lending company must run credit checks, process paperwork, etc., regardless of whether the loan is $100,000 or $100. In this way, a reasonable $50 transaction fee translates into an APR that appears unreasonable. Even if transaction fees were removed from the picture, one would still expect large APRs for payday loans because of the relative credit risk of payday borrowers. A North Carolina government report (sited by the Center's study) reveals that over 25% of check assets held by payday lending companies in the state were in the form of bounced checks! Not surprisingly, high APR’s also reflect the high risk of borrower default. Now consider the situation from the borrower’s perspective. Most who turn to payday lending have poor or limited credit history. Although their situations may be dire, they naturally find few people stepping up to extend them a loan. Credit is a measure of the reliability of a borrower to live up to a loan contract. As economist Henry Hazlitt pointed out, credit is not "something a banker gives to a man. Credit, on the contrary is something a man already has."




For a borrower with bad credit, payday lenders offer an invaluable service few banks will offer. Not only do they provide liquidity when it is most needed, payday lenders provide the borrower an opportunity to establish a positive credit history. In short, payday lenders provide a means for the unbanked to join the financial mainstream.

Finally, consider the hazardous option of government regulation via loan-amount and frequency restrictions. Regulation creates market distortions that are often the source of more problems. First, limits on loan amount and frequency, no matter how sensible they may seem to an enlightened advocacy group, necessarily ignore the nuances of individual situations. Each side in the loan transaction considers its opportunity costs by weighing price, convenience, and urgency. Loans are taken for critical needs like paying an electric bill, and for less critical needs like buying Christmas presents. Who is to draw the line between necessary and frivolous? Ultimately, the decision to take a loan reflects the subjective value and time preferences of consumers (which is more valuable to me: $250 today or $300 in 30 days?). On the margin, it is the borrower and lender who are most fit to decide the appropriateness of any transaction—not the Center for Responsible Lending, or a congressman.

Payday lending was an innovation created to serve an underrepresented market segment. To the extent that this market result is undesirable (high costs to borrower), it leaves open the possibility for other market players to create better solutions. Government regulations stifle innovation by reducing the potential for profits or by outlawing such innovation. One example of a recent development that ameliorates the need for regulation is "payroll cards". These are plastic cards that act like debit cards, but do not require the holder to hold any bank account. Many companies now pay employees by crediting their payroll cards instead of issuing a paper check. As the market evolves, expect other innovations that seek to tap into the unbanked consumer segment.

Finally, the question of whether such a thing as a "debt trap" even exists is debatable. The Center for Responsible Lending sites the high frequency of repeat business (2/3 of borrowers incur 5 or more loans per year). But the transaction frequency may simply reflect the lack of credit alternatives. And to the extent that borrowers feel pinched by the high costs of borrowing, those costs may still be preferable to the alternate cost of resorting to the underground economy. Whereas a payday loan borrower always has the protection of declaring bankruptcy, he has no such option in the face of a surly loan shark.