Home > Personal Finance > Why the Feds Need to Step In on Payday Loans

Comments 0 Comments

The Pew Charitable Trusts recently released the fourth report in its series Payday Lending in America. The focus this time is on fraud and abuse in online lending.

The report calls out payday loan structures that are designed to prolong indebtedness by front-loading fees on loans that average 650% APR. It also describes incidents of unauthorized withdrawals after loans were paid off as well as other unfair, deceptive and predatory practices. The report says that some consumers were also threatened.

Regulating these companies has been difficult. Pew estimates that 70% of payday lenders are not licensed by the states in which they do business. Instead, these companies search for jurisdictions with laws that are most accommodating for the type of business they do and use them to govern the contracts they write.

Interest rates are a good example of how that can affect consumers. Usury limits vary among states. So does the manner in which they’re calculated. An unscrupulous lender’s goal, therefore, would be to select as its governing state the one that permits the highest rate or the most latitude for calculating it. Lately, however, several states—such as Arkansas, Colorado, Illinois, Maryland, Minnesota, New York, North Carolina, Vermont, Washington and West Virginia—are challenging the legality of this tactic with some success.

How Payday Loans Work

Consumers who are having trouble making ends meet—either because of an unexpected expense or because their household budgets are out of balance—are the most likely to pursue short-term financing to help bridge that gap. But because of their tenuous financial circumstances or limited ability to pledge valuable collateral to secure the loan, they’re unlikely to gain access to credit that’s reasonably priced—or any credit, for that matter. (Editor’s Note: Good credit means access to better interest rates. You can see where your credit scores stand for free on Credit.com.)

Payday loans were developed to address this need. The consumer-borrower pledges next week’s paycheck—which acts as the aforementioned valuable collateral—for the cash he needs today. Bill-pay loans are a variation on this theme, where consumers borrow to pay this month’s utility or cellphone bill with cash that’s advanced from next month’s paycheck. Also similar are so-called merchant advance loans that are marketed to small businesses, although in that case, today’s cash comes from next week’s or next month’s accounts receivable.

There are two fundamental problems with this mode of financing. The first is that it’s almost certain to inspire repetitive borrowing. That’s because loans of this type aren’t introducing new cash into a consumer’s household or small-business’s operation. Rather, it’s speeding up the cash these borrowers would otherwise have received in normal course. Consequently, the cash-flow hole that’s created when next week’s paycheck or next month’s accounts receivable is exchanged for a roll of hundreds today will need to be filled a week or month later, unless the borrower’s financial position improves by a factor of two.

The second problem has to do with cost. Aside from the obvious greed factor on the part of certain lenders, these loans are comparatively expensive because they’re outstanding for a relatively short period. But that seems counterintuitive given that brevity of tenure is a traditional hedge against risk.

The reason is, it costs money to approve, document, fund and service (collect payments for) a loan—costs that are typically spread over the life of the contract. So the longer the loan’s duration, the less of an impact the adding-on of these costs will have on the payment amount. The interest rate is also only moderately affected because of the effect that the time value of money has on the calculation.

The opposite, though, is true for short-term loans. And in the case of certain payday loans in particular, some lenders exacerbate that problem by structuring their contracts so that fees are credited before principal.

Setting Standards

With all that in mind, PCT suggests several policy considerations: Ensuring that borrowers can actually afford to repay their debts, requiring that loan costs are more evenly spread over the duration of the contract, and that consumers are protected against predatory practices.

But what’s needed most is regulatory oversight at the federal level that would be responsible for enforcing a set of standards that govern all short-term lending—for the benefit of consumers and small businesses alike. Usury limits, for example, should be annual APR-based, and practices that are intended to take advantage of unwitting borrowers should be outlawed.

The APR calculation combines interest rates and fees into a single metric that enables prospective borrowers to easily compare alternative-financing offers. No longer would unscrupulous lenders stand to gain from parsing the true charge into separate categories of interest rate and fee, or by shopping for jurisdictions that calculate usury by taking only one of these elements into account.

So, too, would borrowers be protected against lenders that, for example, change their so-called merchant identifiers, which they do to circumvent the automated clearing house (ACH) blocks that borrowers put into place to prevent post-repayment debits against their accounts. The same goes for borrowers whose loan agreements require them to share user names and PINs, even though these should also be changed as soon as the last payment is made.

Short-term lending plays a legitimate role in the realm of consumer and small business finance. What must be done, however, is to reform or remove those players whose business practices are harmful or corrupt. But given how much money is at stake (payday lending alone is a $27 billion a year business, according to the Center for Responsible Lending), the often fragile financial positions of the borrowers who seek these products and the cunning intractability of some of the companies involved, Pew is correct to call upon the regulators to pick up where the industry’s self-policing efforts have left off.

This story is an Op/Ed contribution to Credit.com and does not necessarily represent the views of the company or its partners.

More Money-Saving Reads:

Image: Domen Colja

Comments on articles and responses to those comments are not provided or commissioned by a bank advertiser. Responses have not been reviewed, approved or otherwise endorsed by a bank advertiser. It is not a bank advertiser's responsibility to ensure all posts and/or questions are answered.

Please note that our comments are moderated, so it may take a little time before you see them on the page. Thanks for your patience.

Certain credit cards and other financial products mentioned in this and other articles on Credit.com News & Advice may also be offered through Credit.com product pages, and Credit.com will be compensated if our users apply for and ultimately sign up for any of these cards or products. However, this relationship does not result in any preferential editorial treatment.

Hello, Reader!

Thanks for checking out Credit.com. We hope you find the site and the journalism we produce useful. We wanted to take some time to tell you a bit about ourselves.

Our People

The Credit.com editorial team is staffed by a team of editors and reporters, each with many years of financial reporting experience. We’ve worked for places like the New York Times, American Banker, Frontline, TheStreet.com, Business Insider, ABC News, NBC News, CNBC and many others. We also employ a few freelancers and more than 50 contributors (these are typically subject matter experts from the worlds of finance, academia, politics, business and elsewhere).

Our Reporting

We take great pains to ensure that the articles, video and graphics you see on Credit.com are thoroughly reported and fact-checked. Each story is read by two separate editors, and we adhere to the highest editorial standards. We’re not perfect, however, and if you see something that you think is wrong, please email us at editorial team [at] credit [dot] com,

The Credit.com editorial team is committed to providing our readers and viewers with sound, well-reported and understandable information designed to inform and empower. We won’t tell you what to do. We will, however, do our best to explain the consequences of various actions, thereby arming you with the information you need to make decisions that are in your best interests. We also write about things relating to money and finance we think are interesting and want to share.

In addition to appearing on Credit.com, our articles are syndicated to dozens of other news sites. We have more than 100 partners, including MSN, ABC News, CBS News, Yahoo, Marketwatch, Scripps, Money Magazine and many others. This network operates similarly to the Associated Press or Reuters, except we focus almost exclusively on issues relating to personal finance. These are not advertorial or paid placements, rather we provide these articles to our partners in most cases for free. These relationships create more awareness of Credit.com in general and they result in more traffic to us as well.

Our Business Model

Credit.com’s journalism is largely supported by an e-commerce business model. Rather than rely on revenue from display ad impressions, Credit.com maintains a financial marketplace separate from its editorial pages. When someone navigates to those pages, and applies for a credit card, for example, Credit.com will get paid what is essentially a finder’s fee if that person ends up getting the card. That doesn’t mean, however, that our editorial decisions are informed by the products available in our marketplace. The editorial team chooses what to write about and how to write about it independently of the decisions and priorities of the business side of the company. In fact, we maintain a strict and important firewall between the editorial and business departments. Our mission as journalists is to serve the reader, not the advertiser. In that sense, we are no different from any other news organization that is supported by ad revenue.

Visitors to Credit.com are also able to register for a free Credit.com account, which gives them access to a tool called The Credit Report Card. This tool provides users with two free credit scores and a breakdown of the information in their Experian credit report, updated twice monthly. Again, this tool is entirely free, and we mention that frequently in our articles, because we think that it’s a good thing for users to have access to data like this. Separate from its educational value, there is also a business angle to the Credit Report Card. Registered users can be matched with products and services for which they are most likely to qualify. In other words, if you register and you find that your credit is less than stellar, Credit.com won’t recommend a high-end platinum credit card that requires an excellent credit score You’d likely get rejected, and that’s no good for you or Credit.com. You’d be no closer to getting a product you need, there’d be a wasted inquiry on your credit report, and Credit.com wouldn’t get paid. These are essentially what are commonly referred to as "targeted ads" in the world of the Internet. Despite all of this, however, even if you never apply for any product, the Credit Report Card will remain free, and none of this will impact how the editorial team reports on credit and credit scores.

Our Owners

Credit.com is owned by Progrexion Holdings Inc. which is the owner and administrator of a number of business related to credit and credit repair, including CreditRepair.com, and eFolks. In addition, Progrexion also provides services to Lexington Law Firm as a third party provider. Despite being owned by Progrexion, it is not the role of the Credit.com editorial team to advocate the use of the company’s other services. In articles, reporters may mention credit repair as an option, for example, but we’ll also be sure to note the various alternatives to that service. Furthermore, you may see ads for credit repair services on Credit.com, but the editorial team isn’t responsible for the creation or implementation of those ads, anymore than reporters for the New York Times or Washington Post are responsible for the ads on their sites.

Your Stories

Lastly, much of what we do is informed by our own experiences as well as the experiences of our readers. We want to tell your stories if you’re interested in sharing them. Please email us at story ideas [at] credit [dot] com with ideas or visit us on Facebook or Twitter.

Thanks for stopping by.

- The Credit.com Editorial Team