Expert Commentary

Do payday loans exploit poor people? Research review

This 2016 research roundup looks at high-cost credit and the arguments over whether payday loans help or hurt the working poor.

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Half of Americans have almost no savings, according to a May 2016 survey by the Federal Reserve. For such people, car trouble or a toothache can trigger financial ruin.

Payday loans are instant, short-term cash advances against someone’s next paycheck. They can help in emergencies, but can also leave borrowers indebted for years. They target people without credit cards — often those with the worst credit — and charge these riskiest borrowers much higher interest rates. Annualized rates are about 390 percent, according to the Consumer Financial Protection Bureau (CFPB), a federal consumer watchdog. (At that rate, a $1,000 loan would cost over $4,000 to repay after one year.) By contrast, credit card interest rate averages tend to hover between 12 and 20 percent.

The market for payday loans grew quickly in the 1990s and 2000s. According to a Federal Reserve estimate, almost 11 million Americans use payday loans each year, spending, on average, over $500 in fees.

States’ attempts to regulate the sector have had limited success. “Confusion reigns as to legal jurisdiction,” note Keith Lowe and Cassandra Ward of Jacksonville State University in a 2016 paper.

In June 2016, the CFPB proposed a new federal rule that would require lenders such as, CashNetUSA, OneClickLoan and MyPaydayLoan to determine customers’ ability to pay back high-cost loans while forbidding them from offering new loans to pay off the old ones.

According to the CFPB, more than 80 percent of such loans are rolled over within a month — that is, borrowers borrow more money to pay off the principle, circling deeper into debt. For every five borrowers who offer their cars as collateral, one loses the vehicle, the CFPB says.

Critics argue that the fees are exorbitant and amount to predatory lending. “It’s much like getting into a taxi just to ride across town and finding yourself stuck in a ruinously expensive cross-country journey,” said Richard Cordray, the CFPB’s director, in a June 2016 statement. “Consumers are being set up to fail with loan payments that they are unable to repay.”

The proposed regulation is still under review and could be challenged in the courts. Groups like the Community Financial Services Association of America are lobbying against the rule with their Credit Strengthens Communities campaign. The Center for Responsible Lending is lobbying for more regulation over the industry. Whatever the ethical concerns, proponents say payday loans fill a much-needed gap in services.

What the research says

Researchers are generally split on the impact of payday loans. A 2016 study by Christine Dobridge of the Federal Reserve illustrates the paradox: She finds that payday loans support families during times of extreme misfortune, such as after a natural disaster, “helping households keep food on the table and pay the mortgage.” But in general, “access to payday credit reduces well-being” by encouraging borrowers to over-consume and spend less on such vitals as rent and food.

Writing in the Review of Financial Studies in 2014, Jonathan Zinman of Dartmouth College and Scott Carrell of the University of California at Davis find payday loans negatively impact job performance and retention in the U.S. Air Force. (Under the 2006 Military Lending Act, active-duty service members and their dependents cannot be charged more than 36 percent; the Obama administration has tried to close some outstanding loopholes.)

James Barth of Auburn University and colleagues observe that payday lenders congregate in neighborhoods with higher rates of poverty, lower education and minority populations — sustaining concerns that payday lenders target the vulnerable.

However, Chintal Desai at Virginia Commonwealth University and Gregory Elliehausen of the Federal Reserve find that a Georgia ban on payday loans hurts locals’ ability to pay other debts. They conclude that payday loans “do not appear, on net, to exacerbate consumers’ debt problems” and call for more research before new regulations are imposed.

Mehrsa Baradaran, a law professor at the University of Georgia, wrote in the Washington Post in June 2016 that the loans can be ruinous, but they fill a “void created by banks,” which don’t make small loans to the poor because they are not profitable. She suggests the Post Office take on public banking with federally subsidized interest rates, much the way Washington already subsidizes or guarantees loans for two things primarily geared toward the middle class: houses and college.

Other resources:

Journalist’s Resource has reviewed research on helping disadvantaged consumers access traditional banking.

Some useful studies:

“Do State Regulations Affect Payday Lender Concentration?”
Bartha, James R; et al. Journal of Economics and Business, 2016. doi: 10.1016/j.jeconbus.2015.08.001.

Abstract: “Ten states and the District of Columbia prohibit payday loan stores, and 31 other states have imposed regulatory restraints on their operations, ranging from limits on fees and loan amounts to the number of rollovers and renewals allowed a borrower. Given the importance of payday lenders to significant segments of the population and the wide variation among state regulatory regimes, our paper examines the extent to which the concentration of payday lenders in counties throughout the country is related to the regulatory environment as well as to various financial and demographic factors. The analysis is based on a unique dataset that has been obtained directly from each state’s appropriate regulatory authority.”

“Payday Lending, Bankruptcy, and Insolvency.”
Hynes, Richard. Washington and Lee Law Review, 2012.

Abstract: “Economic theory suggests that payday lending can either increase or decrease consumer welfare. Consumers can use payday loans to cushion the effects of financial shocks, but payday loans may also increase the chance that consumers will succumb to temptation or cognitive errors and seek instant gratification. Both supporters and critics of payday lending have alleged that the welfare effects of the industry can be substantial and that the legalization of payday lending can even have measurable effects on proxies for financial distress, such as bankruptcy, foreclosure, and property crime. Critics further allege that payday lenders target minority and military communities, making these groups especially vulnerable. If the critics of payday lending are correct, we should see an increase (decrease) in signs of financial distress after the legalization (prohibition) of payday lending, and these changes should be more pronounced in areas with large military or minority populations. This article uses county-level data to test this theory. The results, like those of the existing literature, are mixed. Bankruptcy filings do not increase after states legalize payday lending, and filings tend to fall in counties with large military communities. This result supports the beneficial view of payday lending, but it may be due to states’ incentives in enacting laws. This article tests the effect of a change in federal law that should have had a disparate impact according to the prior choice of state law. This second test does not offer clear support for either the beneficial or detrimental view of payday lending.”

“For Better and for Worse? Effects of Access to High-Cost Consumer Credit.”
Dobridge, Christine L. Finance and Economics Discussion Series: Board of Governors of the Federal Reserve System, 2016.

Abstract: “I provide empirical evidence that the effect of high-cost credit access on household material well-being depends on if a household is experiencing temporary financial distress. Using detailed data on household consumption and location, as well as geographic variation in access to high-cost payday loans over time, I find that payday credit access improves well- being for households in distress by helping them smooth consumption. In periods of temporary financial distress — after extreme weather events like hurricanes and blizzards — I find that payday loan access mitigates declines in spending on food, mortgage payments, and home repairs. In an average period, however, I find that access to payday credit reduces well-being. Loan access reduces spending on nondurable goods overall and reduces housing- and food-related spending particularly. These results highlight the state-dependent nature of the effects of high-cost credit as well as the consumption-smoothing role that it plays for households with limited access to other forms of credit.”

“The Effect of State Bans of Payday Lending on Consumer Credit Delinquencies.”
Desai, Chintal A.; Elliehausen, Gregory. The Quarterly Review of Economics and Finance, 2016. doi: 10.1016/j.qref.2016.07.004.

Abstract: “The debt trap hypothesis implicates payday loans as a factor exacerbating consumers’ financial distress. Accordingly, restricting access to payday loans would be expected to reduce delinquencies on mainstream credit products. We test this implication of the hypothesis by analyzing delinquencies on revolving, retail, and installment credit in Georgia, North Carolina, and Oregon. These states reduced availability of payday loans by either banning them outright or capping the fees charged by payday lenders at a low level. We find small, mostly positive, but often insignificant changes in delinquencies after the payday loan bans. In Georgia, however, we find mixed evidence: an increase in revolving credit delinquencies but a decrease in installment credit delinquencies. These findings suggest that payday loans may cause little harm while providing benefits, albeit small ones, to some consumers. With more states and the federal Consumer Financial Protection Bureau considering payday regulations that may limit availability of a product that appears to benefit some consumers, further study and caution are warranted.”

“An Examination of Payday Lenders: Issues Surrounding State and Federal Regulations.”
Lowe, S. Keith; Ward, Cassandra L. Proceedings of the American Society of Business and Behavioral Sciences, 2016.

Abstract: “Payday lenders as a source of small dollar, short-term loans has expanded exponentially over the past two decades. Starting out as simple storefront outlets in approximately 200 locations in the early 1990s, the industry grew more than twelve-fold by the end of 2014. While the growth of this payday loan industry is obvious, there is no general consensus on whether the product offered is beneficial to those who borrow through this medium and the industry’s long-term effect upon society. The majority of policies, legislation, and restrictions within the payday loan industry is administered at the state level. Presently, 13 states prohibit payday lenders to operate within their respective state boundaries through various legislation and statutes. Of the 33 states that allow payday loan operations, most restrict them in some manner through maximum interest rates, loan amounts, and payback periods. Beyond state-based legislations, some Federal oversight does exist in governing the payday loan industry. Most of the federal oversight was created through past Congressional action such as the Truth in Lending Act and through governmental agencies such as the Federal Trade Commission. However, federal reach is growing through newly created groups such as the Consumer Financial Protection Bureau. Payday lending continues to evolve beyond traditional geographical boundaries and into areas such as internet-based lenders. This creates an environment in which confusion reigns as to legal jurisdiction. Because of the uncertainty of existing laws and how they apply to the payday lending, evolving legislation will continue into the foreseeable future.”

“Banks and Payday Lenders: Friends or Foes?”
Barth, James R.; Hilliard, Jitka; Jahera, John S. International Advances in Economic Research, 2015. doi: 10.1007/s11294-015-9518-z.

Abstract: “This paper investigates the geographic distribution of payday lenders and banks that operate throughout the United States. State-level data are used to indicate differences in the regulatory environment across the states. Given the different constraints on interest rates and other aspects of the payday loan products, we empirically examine the relationship between the number of payday lender stores and various demographic and economic characteristics. Our results indicate that number of stores is positively related to the percentage of African-American population, the percentage of population that is aged 15 and under and the poverty rate. The number of stores is also negatively related to income per capita and educational levels.”

“Payday Loan Choices and Consequences.”

Bhutta, Neil; Skiba, Paige Marta; Tobacman, Jeremy. Journal of Money, Credit and Banking, 2015. doi: 10.1111/jmcb.12175.

Abstract: “High-cost consumer credit has proliferated in the past two decades, raising regulatory scrutiny. We match administrative data from a payday lender with nationally representative credit bureau files to examine the choices of payday loan applicants and assess whether payday loans help or harm borrowers. We find consumers apply for payday loans when they have limited access to mainstream credit. In addition, the weakness of payday applicants’ credit histories is severe and longstanding. Based on regression discontinuity estimates, we show that the effects of payday borrowing on credit scores and other measures of financial well-being are close to zero. We test the robustness of these null effects to many factors, including features of the local market structure.”

“The Effect of Payday Lending Restrictions on Liquor Sales.”
Cuffe, Harold E; Gibbs, Christopher G. Victoria University of Wellington Working Paper, 2015.

Abstract: “We exploit a change in lending laws to estimate the causal effect of restricting access to payday loans on liquor sales. Leveraging lender- and liquor store-level data, we find that the changes reduce sales, with the largest decreases at stores located nearest to lenders. By focusing on states with state-run liquor monopolies, we account for supply-side variables that are typically unobserved. Our results are the first to quantify how credit constraints affect spending on liquor, and suggest mechanisms underlying some loan usage. These results illustrate that the benefits of lending restrictions extend beyond personal finance and may be large.”

“‘In a Perfect World It Would Be Great if They Didn’t Exist’: How Australians Experience Payday Loans.”

Banks, M.; et al. International Journal of Social Welfare, 2014. doi: 10.1111/ijsw.12083.

Abstract: “In the last few decades, payday lending has mushroomed in many developed countries. The arguments for and against an industry which provides small, short-term loans at very high interest rates have also blossomed. This article presents findings from an Australian study to contribute to the international policy and practice debate about a sector which orients to those on a low income. At the heart of this debate lies a conundrum: Borrowing from payday lenders exacerbates poverty, yet many low-income households rely on these loans. We argue that the key problem is the restricted framework within which the debate currently oscillates.”

“In Harm’s Way? Payday Loan Access and Military Personnel Performance.”

Zinman, Jonathan; Carrell, Scott. Review of Financial Studies, 2014. doi: 10.1093/rfs/hhu034.

Abstract: “Does borrowing at 400% APR do more harm than good? The U.S. Department of Defense thinks so and successfully lobbied for a 36% APR cap on loans to servicemen. But existing evidence on how access to high-interest debt affects borrowers is inconclusive. We estimate effects of payday loan access on enlisted personnel using exogenous variation in Air Force rules assigning personnel to bases across the United States, and within-state variation in lending laws over time. Airmen job performance and retention declines with payday loan access, and severely poor readiness increases. These effects are strongest among relatively inexperienced and financially unsophisticated airmen.”

“Payday Loans and Consumer Financial Health.”
Bhutta, Neil. Journal of Banking & Finance, 2014. doi: 10.1016/j.jbankfin.2014.04.024.

Abstract: “The annualized interest rate for a payday loan often exceeds 10 times that of a typical credit card, yet this market grew immensely in the 1990s and 2000s, elevating concerns about the risk payday loans pose to consumers and whether payday lenders target minority neighborhoods. This paper employs individual credit record data, and census data on payday lender store locations, to assess these concerns. Taking advantage of several state law changes since 2006 and, following previous work, within-state-year differences in access arising from proximity to states that allow payday loans, I find little to no effect of payday loans on credit scores, new delinquencies, or the likelihood of overdrawing credit lines. The analysis also indicates that neighborhood racial composition has little influence on payday lender store locations conditional on income, wealth and demographic characteristics.”

“Can Voluntary Price Disclosures Fix the Payday Lending Market?”
Hawkins, Jim. Harvard Business Law Review, 2016.

Abstract: “This response discusses Eric J. Chang’s article, ‘ A Solution for Restoring Price-Competition to Short-Term Credit Loans.’ It offers some evidence from recent empirical research to suggest that the federally operated online exchange that Chang proposes for payday lending markets is unlikely to succeed in facilitating price competition. It argues that lenders are unlikely to voluntarily participate in the exchange and that, even if they did, many borrowers are unlikely to use the exchange.”


Tags: finance, borrowing, loans, poverty, usury, predatory lending, alternative banking

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