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Archive for October 2010

Payday lenders have often been accused of taking advantage of consumers by charging exorbitant interest rates to low-income consumers who borrow from them.  Some proposed legislation, including a referendum on the ballot in Montana, seeks to cap the annual interest rate payday lenders and certain other lenders may charge to 36%.

The argument for the legislation is that low-income consumers are taken advantage of by payday lenders, who charge interest rates as high as 400% per year.  This argument is somewhat persuasive in that low-income consumers going to payday lenders often lack financial savvy and fail to understand the ramifications of taking on a high-interest loan and then failing to pay it back promptly.

The contrary argument, which I find more persuasive, is that a cap on payday loan rates will drive payday lenders out of business, and thus eliminate the payday loan option for consumers who truly need payday loans.  John Koppisch at Forbes.com writes:

Payday and other non-bank consumer lenders take tremendous risks handing over money to customers they often don’t know and who have a very high default rate. These lenders don’t have the FDIC or TARP safety net enjoyed by banks. They need to look the borrower in the eye, size up their employment record, financial situation and sincerity, and then make an educated guess on whether they’ll see their $75 or $2,000 ever again.

In other words, payday lenders take massive risks on making loans to customers who walk into their office on short notice and with financial emergencies necessitating a payday loan.  Risk is costly, which is why loans always cost more money when they are for riskier borrowers.  Payday lenders don’t charge low interest rates because many of their borrowers default – far more than those who borrow through more traditional loans.  To make up for the loss, payday lenders must charge higher interest rates.  A payday lender may make a large profit on one payday loan, but much of that profit is likely to be used to offset the losses from defaulted loans.

If the amount of interest a payday lender can charge is capped, then to make the same amount of profits, a payday lender will have to hope that far fewer people default on their loans.  That won’t happen.   Instead, payday lenders’ profits will shrink, likely so far that they’ll be pushed out of business.  Koppisch again:

Laws like this usually end up putting dozens of mom-and-pop outfits out of business and sending hundreds of employees to the unemployment line. Expecting the measure to pass, nationwide chains such as Advance America have already closed outlets in [Montana]. The interest rates allowed are just too low to cover the losses from deadbeats. In 2008, a 24% interest-rate cap took effect in Washington, D.C. and soon every licensed payday lender had disappeared from the market and such loans were no longer legally available anywhere in the city. A 36% cap began July 1 in Arizona, forcing many payday loan companies to shut down.

The idea of capping payday lending rates is heavy-handed, misguided legislation.  A better proposal would be to require payday lenders to provide clear information on the costs of each payday loan to each consumer.  If consumers are fully aware of the costs of a payday loan, there is no good argument why they should not be allowed to obtain one.  Clear language in payday loan contracts, brochures, and interactions with consumers would be far more helpful than a cap on interest.

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