Rollover, Rollover: A Behavioral Law and Economics Analysis of the Payday-Loan Industry*

Article excerpt

On February 26, 2009, two different, but financially related, deals commenced. Somewhere in America, Jamie Johnson, a young married mother of two, walked into a payday-loan store in her neighborhood to get a cash advance on next week's paycheck, thinking that $300 cash in her purse now was worth the onetime fee of $45.' Meanwhile, in Washington, D.C., a Congressman, thinking of consumers just like Jamie, introduced a new legislative bill. Representative Luis V. Gutierrez (D.-Ill.) and his cosponsors introduced the Payday Loan Reform Act of 2009 (House Bill 1214),2 which was referred to the House Financial Services Committee.3 The purpose of the bill is to "amend the Truth in Lending Act to establish additional payday loan disclosure requirements and other protections for consumers."4

The contractual deal that Jamie initiated when she entered the paydayloan store has become a commonplace credit transaction that often results in a Scylla-and-Charybdis conundrum of high costs now or higher costs later. Payday loans are generally short-term loans of small amounts offered at extremely high effective interest rates to consumers who have impaired credit histories.5 Most transactions begin when a customer enters a payday lender's retail store.6 To qualify for these types of loans, a borrower only needs a bank account and proof of an income.7 "[T]he lender extends a loan on one date, in return for a promise (usually evidenced by a postdated check or by automated clearinghouse (ACH) authorization) to repay the amount of the loan plus a standard fee, typically in the range of $15 to $20 per $100 borrowed."8 A common loan is for $300 with a fee of $45;9 if this loan had a term of two weeks, the annual percentage rate (APR) would be about 400%.10 The APR for these loans can vary greatly between states depending on how strict, and strictly enforced, the usury laws may be.11 Another notable (and oft-criticized) feature of these loans is that the terms mature with a balloon payment, under which the borrower must pay either the entire balance of principal and interest or "rollover" the loan for another term and pay an additional fixed fee.12 This decision increases the costs of these loans for two types of borrowers - those who are not capable of paying off the entire lump sum and those who may be capable of doing so but choose to pay more later so they can pay nothing now.13 Thus, like Jamie, real-life borrowers who have considered the cost to be merely a onetime nominal fee often get caught in the "debt trap" of extending the loan for multiple terms, ultimately paying more in interest than the amount of the original loan.14

The bill that Gutierrez introduced has been met with criticism from both sides of the spectrum with consumer advocates at one end and industry supporters at the other. Consumer advocates point out that the bill legalizes loans with APRs of nearly 400% by allowing interest and fees up to fifteen cents on the dollar (which sounds like 15%, but with only a two- week term the effective annualized interest rate is around 400%). 15 Advocates also remark that the bill contains loopholes that payday lenders can easily wriggle out of by altering the form of the payday loan.16 In fact, some consumer groups are supporting another bill that would cap the APR at 36%,17 like the specialized bill that passed in 2006 and effectively prohibited payday loans from being offered to military servicemen.18 In a riposte from the other side, some critics say that the government-imposed price control on payday loans is too strong and will only have negative effects - reducing the supply of short-term credit options and making borrowing more expensive.19

The current debate surrounding House Bill 1214 is only the most recent episode of a long-running controversy about the payday-lending industry. The remarkably high effective interest rates charged by payday lenders since the industry emerged in the early 1990s have generated a flurry of critical proposals. …