Could Restrictions on Payday Lending Hurt Consumers?
Edmiston, Kelly D., Economic Review - Federal Reserve Bank of Kansas City
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The payday loan, or more generally, the deferred deposit loan, is among the most contentious forms of credit. It typically signifies a small-dollar, short-term, unsecured loan to a high-risk borrower, often resulting in an effective annual percentage rate of 390 percent-a rate well in excess of usury limits set by many states.
Consumer advocates argue that payday loans take advantage of vulnerable, uninformed borrowers and often create "debt spirals." Debt spirals arise from repeated payday borrowing, using new loans to pay off old ones, and often paying many times the original loan amount in interest. In the wake of the 2008 financial crisis, many policymakers are considering strengthening consumer protections on payday lending.
A substantial volume of literature has examined the dangers of payday lending, yet few studies have focused on any unintended consequences of restricting such lending. Thus, the question arises: Could restrictions on payday lending have adverse effects?
This article examines payday lending and provides new empirical evidence on how restrictions could affect consumers. The first section discusses why many states restrict the practice of payday lending and describes the pattern of restrictions. The second section explores ways in which restrictions might adversely affect consumers. The third section reviews the limited existing evidence on such effects and provides new evidence.
The analysis shows that restrictions could deny some consumers access to credit, limit their ability to maintain formal credit standing, or force them to seek more costly credit alternatives. Thus, any policy decisions to restrict payday lending should weigh these potential costs against the potential benefits.
I. MOTIVATION FOR PAYDAY LENDING REGULATION
Payday lending came under fire almost as soon as it surfaced, and consumer advocates have kept pressure on lenders and policymakers ever since. Chief among the concerns are the high cost of payday loans, the tendency for payday loans to contribute to consumer debt spirals, and the targeting of payday lending to financially vulnerable populations. These concerns often justify calls for additional regulation of payday lending.
The costs of payday borrowing
Consumer advocates feel that payday loans are a menace to consumers for a number of reasons, but chief among these is their high cost. Most states have established legal limits on the rate of interest that can be charged on a loan, usually 6 to 12 percent (Glaeser and Scheinkman). In many cases, however, lenders are not subject to these laws. For example, the Depository Institutions Deregulation and Monetary Control Act of 1980 eliminated usury limits for most loans made by banks. Some payday lenders have partnered with banks to take advantage of looser usury laws (Chin). Other lenders or types of loans are subject to their own specific laws.
While payday lenders often charge fees rather than interest payments, in effect these charges are interest. Comparing the terms of varying types of loans requires computing an effective, or implied, annual interest rate. For payday loans, this computation is straightforward. A typical payday loan charges $15 per $100 borrowed. If the term of the loan is two weeks, then the effective annual interest rate is 390 percent. By comparison, in 2010 the average annual interest rate (APR) on credit cards, the traditional source for rapid short-term loans, was 14.7 percent (Simon). Thus, the fee on a typical payday loan is more than 25 times greater than the interest on a typical credit card.
Of course, a payday loan provides cash. Most credit card fees on cash advances, if considered short-term loans, are costly as well. The fee for cash advances on many credit cards has recently climbed to 4 or 5 percent (Blumenthal). In addition, higher interest rates, which average 25 percent, generally apply to cash advances (Blumenthal). …