Wednesday, May 07, 2008

The Effects of Payday Loans

Below are the highlights of a literature review I wrote summing up several articles that have been published about the payday lending industry.

What is a Payday Loan?
A payday loan is a small cash advance, usually less than $300, for a short period of time, typically two weeks. The process uses a personal check as collateral. The borrower will write a postdated check to the lender for the amount of the loan plus the fee charged. For example, the customer will write a $300 check, dated two weeks from the current date, and receive $250 back, with the $50 fee taken out. When the loan has expired, the payday service will cash the check.

Michael Stegman
Payday Lending

Are they just urgent but useful types of short-term loans or are they predatory businesses that increase the government’s welfare problem?
A common explanation for mainstream banks’ lack of involvement in this industry has been a fear of reputation damage. Doubt is cast on this idea is when you recognize that in many ways large banks already do provide a type of short-term high interest loans. When regular checking accounts are overdrawn the customer pays a fee that is very comparable in size to a payday loan. Interpreted into an interest rate, these figures look more like cash advances than typical bank loans.

The demand for these short term loans is surprisingly widespread. According to Stegman’s article, 5 percent of the population has claimed to have taken out such a loan and 10 percent say they are likely to do it in the future.

payday loaners’ main market is consumers with poor or risky credit, but it is not the poorest of the poor that these loaners aim for. Borrowers must have a checking account and steady employment to be eligible for such loans.

Twenty states currently limit the number of payday loans a customer can have at one time and thirty-one states limit customer rollovers.

Mandatory breaks between loans and limiting lenders’ legal resources to reclaim unpaid debts have also been used.

Michael Stegman describes the regulation of the payday lending business as a legal chess game. A state will pass a law limiting their power and the payday lenders find ways around the law. More parameters many times mean more loopholes.

Michael Stegman showed that attempts to regulate the business have only led to structural changes in the industry and do not have the intended result. Another important point he makes is that we cannot seek to entangle the government in the cash advance industry without also dealing with mainstream banks and their bounced check fees.

Don Morgan and Michael Strain Payday Holiday: How Households Fare after Payday Credit Bans
In 2004 and 2005 Georgia, followed by North Carolina, made illegal and hence closed all payday loans stores in their two states. Donald Morgan uses the resulting data from these new laws to test the theory that payday loans are “debt traps”

Relative to other states, the people in Georgia substantially bounced more checks, complained more about lenders and collectors, and filed for Chapter 7 bankruptcy more after the ban on payday lending.

These results make a clear argument that consumer’s find cash advances from payday lenders a cheaper solution to financial constraints than the bounced check protection offered by banks. This makes sense when we realize that translated into APR, bank fees for covering a bounced check are equal to 2400 percent (this compared to average 390 percent charged by payday loans).

By taking the changes from other states and comparing them to the changes in the number of bounced checks in Georgia, we see a 13 percent increase in the amount of checks returned in Georgia. This comes to 300,800 more bounced checks per quarter, at $30 per check; Georgians paid $36 million more in returned checks fees.

Morgan shows that the amount of complaints increased by 64 percent increase against debt collectors. Georgia was higher than any other state after the ban.

We see an increase of 8.5 percent in Chapter 7 bankruptcies in Georgia relative to before the ban.

The final critique that Morgan confronts is the claim that these decreases in welfare after the ban are only due to the problems that are associated with the immediate withdrawal of the stores and that they only temporary. In 2003 Hawaii took a different route than that of Georgia and North Carolina and actually doubled the allowable limit of loans from $300 to $600. This larger “dose” of instant credit gives us a chance to look at the effects of loans from the increase in availability perspective. If these critics are correct and credit traps are real, then we should see an increase in financial problems as more payday debt is allowed. The results of the study proved just the opposite.

The difference in the number of complaints about lenders and debt collectors saw a 50 percent decline as compared to other states. Chapter 7 bankruptcies also fell by about 27 percent relative to the national average.

Mark Flannery and Katherine Samolyk Payday Lending: Do the Costs Justify the Price?
Flannery uses individual store data from two large cash advance lenders to investigate store costs and profitability. Using this store level data we can see whether the price of payday lending is predatory or just a reflection of business costs.

The costs of this type of business are very fixed. The rent for the building and the payment of the workers are a large cost to these lenders as compared to other parts of the financial market. For this reason, loan volume is a major contributor to store income. This helps explain the gap between new and mature store profits.

Another contributor to the high price of payday lending is the higher average default rate. This of course is correlated with common economic understanding of interest. The higher the risk of an investment, the higher the expected return should be.

Repeat customers, those claimed to be trapped by their cycle of debt, are the victims that consumer groups say are being extorted. But in fact, these chronic borrowers are not especially profitable to these individual stores, not per loan at least. They are of course more profitable in the sense that they visit the store more, but this is true for all businesses. Are graduate students a victim of university’s because they pay for several more years of education? The same is true for payday lending. Repeat customers are only more profitable in the sense that they contribute to a larger volume.

The two major costs are the fixed costs of employees, rent, local advertising and taxes and the variable cost of loan defaults. According to Flannery, fixed costs account for almost half of the total costs. That comes to about $19-27 per loan. Defaults on loans account from between 21-25 percent. This equals roughly $6-9 per loan. All of these statistics are greatly depending on the maturity of the store, with the mature store being generally lower cost.

For a loan of $100, these costs come to $11-14 per loan. The average loan is $250 for 20 days with typical fees of $15-20. We can see very little overcharging. In fact, pretax income for mature stores comes to about $11.26 per loan and -$3.01 for young stores. This all makes clear economic sense when realizing the huge boom in the industry over the last decade. Competition has kept down any possibility of exorbitant prices.

Adair Morse
Payday Lenders: Heroes or Villains?
Personal economic distress can be due to many things, one of them being natural disasters. The occurrences of natural disasters are inherently out of the control of individuals and governments, but the resulting harm of the disaster is not. By looking at the availability of payday loans in an area struck with a natural disaster, Morse measures whether these high interest loans are beneficial or harmful to borrowing communities.
He measures welfare by investigating the number of foreclosures, alcohol and drug treatments, deaths and births in a community, all organized by zip code and measured before and after disaster. Prior research has proven that birth and death rates decrease after a disaster and that building foreclosures increase. They have also shown that drug and alcohol treatment goes down after this rude awakening. Drug and alcohol abuse tend to rise in most stressful times, except for some reason in natural disasters.

To test the arguments of both sides Morse used natural disasters in communities in California from 1996-2005. By using information from only one state, he held constant any legal restrictions on the cash advance industry. To ensure accuracy, Morse measured the welfare determinants two years before and two years after the disaster. Another benefit of using the exogenous shock of natural disasters is that previous data has shown payday lending shops do not open up in response to natural disasters. This is probably because of the benefits of having a regular customer base in the payday loan industry. There is no long-term demand and hence no chance to collect regular customers in an area with short-term financial shortage.

The conclusion of the data collected is that payday lenders do in fact provide an important service to communities in unexpected short-run financial hardship. In fact, short-term high interest loans seem to be a valuable tool to communities trying to recover from unforeseen destruction of assets.

Natural disasters normally increase foreclosures, but areas containing payday lenders significantly counteract this increase. What's more, in most communities birth rates drop following a disaster, but those neighborhoods with easy access to instant credit are able to sustain their previous rate. The same proves true for the death rate after a disaster. The final measure used is the amount of drug and alcohol treatments. The decreases in these treatments are magnified when there is access to payday loans.

Further Study
Although the articles reviewed here are thorough, there are still some areas for further study. One would be to see how the payday lending industry affects crime. Does it cause the small minority who are hurt to commit more crimes? It may even have the effect of lowering crime by raising the financial stability of the working poor.

Click here for the full paper.

1 comment:

  1. Payday loans are the devil!


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