Robert DeYoung on payday loans

I thought this was an interesting editorial in Tuesday’s WSJ.

Robert DeYoung writes:

For those who depend on taking out a loan in advance of a paycheck, life may soon get harder if Congress passes the Payday Loan Reform Act.

The bill’s sponsors, which include Rep. Luis Gutierrez (D., Ill.), say they want to clean up abuse in credit markets by clamping down on the prices lenders charge for payday loans. In reality, the legislation will reduce the supply of these loans and make borrowing more expensive.

The reform is based on the false premise that consumers take out these loans without realizing how much they are paying. True enough, these loans are expensive. A two-week payday advance of $300 typically comes with a $45 finance charge– an implied annual percentage rate (APR) of 391%. Critics say borrowers could not possibly intend to pay that much for an advance on their paychecks, and that the cost alone is evidence of exploitation of the working poor.

But new research suggests that most payday borrowers are more rational and informed than critics believe. A January 2009 study by Gregory Elliehausen at George Washington University found that payday borrowers make informed choices. About half of the 1,173 payday borrowers he surveyed considered other credit alternatives– such as bank, credit card, or personal loans– before taking out a payday loan. Over 80% lacked sufficient funds in their bank accounts to meet their expenses, so by taking out a payday loan they avoided expensive checking account overdraft fees. Nearly 90% said they were either very or somewhat satisfied with the transaction.

A November 2008 FDIC report on overdraft protection provides the context. According to this exhaustive study, the average APR on a two-week checking account overdraft is 1,067%, more than double the rate on the typical payday loan. Worse, a large percentage of banks studied by the FDIC take deliberate measures to increase the frequency of customer overdrafts– such as displaying account balances on ATM screens only after the overdraft has occurred, and increasing the number of insufficient funds checks by clearing large customer checks before small ones. Compared to these overdraft practices, payday loans are transparent.

Nonetheless, the legislation pending before the House would cap payday-loan finance charges, even though government price limits almost always have negative effects. Price controls are especially harmful when competition is robust, as in payday-loan markets.

Ron Phillips of Colorado State University and I examined seven years of payday-loan prices in 117 Colorado neighborhoods. We found that local markets with more payday stores tend to enjoy lower prices, but that the benefits of competition were largely been washed away when Colorado imposed a cap on finance charges. Over time, the longer a price cap remains in place the more borrowers get charges the legal maximum price. Price caps make these loans more expensive and less available.

Details of the proposed legislation can be found here, and the DeYoung Phillips paper is available here.



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32 thoughts on “Robert DeYoung on payday loans

  1. Reg Gilbert

    Dear sir,
    Are you honestly supporting an analysis that justifies payday loan abuses because they are less abusive than bank overdraft and other abuses?
    Selling oneself into servitude or even slavery was also almost always a rational decision.
    This is abstract thinking crossing over into evil. This is the land of heartless laissez-faire freakdom.

  2. JDH

    Reg Gilbert: Why is it evil and heartless to offer people a choice, and good and loving to deny them a choice? Are there specific claims in the quoted text that you believe to be in factual error?

  3. ThomasL

    My parents once used a bank with the nasty habit that it would process all the withdrawals for a given day before the deposits in a deliberate attempt to create overdraft charges. It created scenarios where you might not immediately notice, because the overdraft charges were deducted straight from your deposits, leaving an net positive balance but of less than you expected, increasing the chance of yet more overdrafts. After the bank had done that a couple of times they simply switched banks.

  4. Michael Krause

    I have a better idea.. Why not do with payday loans with what the Fed is doing with all of this mortgage stimulus — create a new government operated non-profit payday loan agency that offers payday loans with fees that merely cover operating costs. It should put all of these payday shops out of business. This way the poor aren’t screwed over and payday shop owners will have to go find some other way to exploit the poor, likely involving some scheme with hubcabs and car stereos.

  5. Joseph

    Here is a link to Elliehausen’s research report:
    The Payday Reform Act is not particularly onerous to payday lenders. It still allows an annual interest rate of up to 391%. It merely requires more transparent disclosure to borrowers and also provides an extended payment plan that allows a way to break out the abusive rollover death spiral that most people object to.
    What is necessary is more research into the actual competitiveness of the payday loan market. Just saying that there are dozens of payday loan offices in a neighborhood does not tell you whether they are all controlled by a few owners under different names. Is there collusion between owners?
    Another approach would be to inspect the books of the lenders to see their profit margins. Excessive profits would indicate a lack of real competition. A more reasonable profit margin would indicate that interest rates really do reflect default rates and that the lenders are providing a genuine service.

  6. biofuel

    Obviously the question should not be about choices versus no choices, even the proverbial mafia boss gave you choices. The issue is with the quality of choices: good or bad. Seems like pay-day lending is sucking the populace dry. By eliminating the bad we will be left with 0, no bad choices, and 0 is always larger than any negative number. In a short term even with a complete ban on this kind of activity, pay-day borrowers will adjust, just like they have adjusted to stagnant wages, banishment of unions, etc; they may face some short term pain, but will be better off in the middle and long term ranges.
    Now, where’s the outrage over parasitic practices of the lenders???

  7. Michael Krause

    I have a gut feeling these lenders have outsized profit margins and as the above poster suggests, heavy collusion between nearby owners. A perfectly competitive market it is likely not. That is why the non-profit approach as a govt program could be an interesting solution. It would considerably weaken the market power of the likely colluded businesses.

  8. jm

    I’ve never been able to understand why some public-spirited non-profit organizations don’t get into the payday loan business. If the default rate is really so low that the amazing annual interest rates really do yield obscene profits, then the non-profits should be able to break even (as required by their non-profit status) while charging much lower rates.
    Is the failure of non-profits to enter this business simply a failure of imagination or ambition among the people who run them? Or does it just reflect a default rate among payday loan borrowers so high that only exorbitantly high rates charged to those who do repay make the business worth the risk?

  9. Fat Man

    They did this in Ohio last year. It strikes me as worrying about the arrangement of the deck chairs when the ship has hit an iceberg.
    The real question is not what unbankable people who want small loans will do when the small loan companies are putout of business. They won’t be borrowing at LIBOR + 1.5%. So they will have to go to Vinnie the Fish.
    Will they really be better off dealing with Vinnie?

  10. pak1835

    Drive by any military base and you’ll see payday loan shops as far as the eye can see. It’s sad that an industry takes advantage of these brave men and women.
    I’m not saying they’re without fault. They knowingly enter these contracts, but still….

  11. DickF

    Do-gooders never learn. What business is it of yours to run my life? Why do you know better how to spend my money than I do? This is the height of arrogance and hubris.
    How about you let me look at your pantry and throw out all the bad foods you shouldn’t eat? What about all your other bad habits, should I be the one to tell you what to do?
    Geesh, the world has changed into nothing but busy-bodies.

  12. Marie

    I had to use a PayDay loan once after I had a car accident. It was the only way that I could get a new vehicle. I paid it off one week after borrowing the loan.
    Believe me if you can ever avoid using them; then I would definitely do it. They are a rip off.

  13. Mike

    Good thing Marie’s accident happened before this legislation was passed. Otherwise, she’d have been walking instead of being “ripped off”.

  14. Gaston

    Marie, are you saying that in retrospect you regret using the payday loan service at that time, and should have simply waited to get a new vehicle? Was that an option? Since using the payday service was the only way you could get a car, it sounds like without them you would have been forced to take the bus.
    So the lesson here is, payday loan services are bad for the environment! Just because you regret your decision to use them, doesn’t mean others shouldn’t have that choice too.

  15. Steve

    The financial game is a risk reward game, RIGHT? Well then, how many of these payday loans lead to default? These are not securitized loans and if a person is late on a credit card it is $39.95 and then they explode the interest rate to default plus try and ruin your credit. I have no pity on the Banks, they are getting a free ride. We the American people are having to pay three times because of the mess created by the Gov. and the banks. 1) Credit Squeeze 2) Taxes we will pay for these bailouts 3) Inflation caused by the printing of money
    So…as you can see we are paying down debt, saving money. Many of my friends are now DEAD SERIOUS about never trusting the banks or wall street again.
    Hello local credit union, goodbye banker! I hope you choke on the spread!

  16. Rich Berger

    It is sad to see how indignant some people get when they disagree with someone’s “unwise” choice. Their first impulse is to eliminate the choice, their second impulse is to get someone else to underwrite the cost.
    I’ll bet they feel noble and broad-minded. Unfortunately, these feelings motivate many bad policies (like minimum wage laws and rent control).

  17. Brian

    JDH: Are you all for drug legalization? Is it better for people to have a choice on which narcotics to ingest in their body? Isn’t having a choice better than no choice?
    Just for the record, i’m playing devils advocate here. I think it is a shame for people to become addicted to debt, drugs, and anything else that seems pleasurable in the short run but will ruin them long-term. I think it is generally detestable to be a dealer in any of those services. However, it is not the government’s job to protect individuals from themselves, or even from disreputable dealers. A country of individuals that require constant babysitting and big-brother to look out for them is a weak country indeed.

  18. Mike Laird

    Brian: take a look at the Cato Institute’s recent report on how Portugal has succeeded in changing people’s choices about drugs. Since 2001, drugs are illegal in Portugal, but users get an administrative offense. There is no criminal record, no probation, no jail. Users must go through a rehabilitation program (length and intensity depends on the drug, repeat offense, addiction, etc.) and must get a fine (amount depends on the drug, repeat offense, etc.) After 8 years, drug use of all sorts is down significantly, and importantly it is down among the segment most at risk – males 16 to 25 low income, etc. Selling drugs is still a criminal offense, but it too is down because demand is down. Portugal seems to have found a formula that changes the decision people make. Rather than risk jail or not, the decision seems to be – get educated before, or get educated and fined afterwards. With education, people make better choices.

    Sorry, this is a long way off of payday loans, but it is still about choices.

  19. Reg Gilbert

    Finally responding to second commenter JDH. The issue here is one of overall social benefit vs. individual rights. We tolerate and even celebrate the greed and amorality of capitalist economic actors not primarily out of a theory of the individual’s absolute right to do whatever they want (although some do prioritize this) , but out of the belief that the resulting competition is a net positive good for all. When it is a net negative, as in the banking actions of the 1920s and today, we contemplate restraint of the previously unregulated or little-regulated activity. The posted article for the Wall St. Journal addresses a straw man — the supposed stupidity of the payday loan customer. Of course most of these people are acting rationally given the options available to them. But the fact is that the availability of this option for the group of customers as a whole leads to a net negative outcome, what another poster on this thread has powerfully called the payday loan death spiral. The drug policy subthread that has emerged in these comments is apt — the question of whether or not people have the right to choose to take drugs is relevant only if abstract rights are one’s sole point of reference. But if public health — the health of the nation’s citizenry — is the primary point of reference, then the argument turns on health outcomes. Equally the argument could turn on clean government outcomes, as restrictive drug policy has inevitable corruption follow-ons. The Cato study referenced in the comments points to unexpectedly positive health outcomes of the Portuguese legalization approach, contradicting the assumed health downside of legalization, which was based at least in part on the Prohibition experience, which, leaving aside its corruption and public violence attributes, managed to cut alcoholism and related diseases and death in half by some analyses. Getting back to payday loan operations, other commenters rightly point to a possible follow-on in people resorting to even more harmful loan sharks. I would like to see evidence of this as a likely significant result. I have not read of massive decline in organized crime loan-sharking operations due to the rise of payday loan businesses. To close, JDH, I challenge the implied accusation of nanny-statism. The market economy we live in has proven dozens of times since the first depression in 1819 that its unregulated cyclical nature causes unacceptable social damage. Thus there is now universal agreement that the raw principle of individual choice — that it be be limited only when that choice limits others’ choices — is not justifiably governing. We are rightly ruled now by the principle of the greatest good for the greatest number for the longest time. The argument must be over the nature of those “goods” and the validity of their maximization under any given policy proposal, in this case, the restriction of clearly predatory lending practices.

  20. JDH

    Reg Gilbert: The issue in my mind is not individual rights as an abstract point of reference, but rather whether, if individual X perceives an exchange with Y to be in X’s own best interests, such exchange indeed is. What you call a straw man– whether individual X’s perceptions are indeed accurate– is to me the core issue.

    The drug analogy is an interesting one, though it is clouded by the biochemical reality that the drug itself is altering the individual’s ability to make these perceptions. I suppose one might argue that some individuals are borrowing these funds because of a perceived drug need, in which case the issues are perhaps closely joined. Even in that perspective, there remains the objective question of what would be the impact on the individuals of the proposed legislation. It is curious to me that you perceived the moral dimensions of this issue with such clarity and yet seemed to say nothing of this question, as if the moral issues were settled without needing to analyze the practical outcomes.

    Do you believe it is necessary to have the same position, one size fits all, on regulation of drugs, bank risks, and payday loans? I personally do not.

  21. MDueker

    There have been some interesting studies of the ways in which household spending patterns change with the way who gets the household’s resources and when. Payday loans might also be a factor that change some households’ spending patterns (such as alcohol versus children’s shoes).

  22. Brian

    Let’s do some math. You work at McDonald’s for 7/hr and work 35 hrs a week. That is 490 every two weeks before taxes. Throw in food, rent, some other basics and you’re likely living on the edge check to check. Throw in one payday loan the person will never get off of the loan because as soon as the paycheck comes in they pay off the loan but need to pay rent. So they need to take out another loan. The person only needs one bad shock to completely leave them in the hole leaving them likely to pay that incredible annual interest rate if they can before they default. Payday Loans should be banned b/c the term is too short (two weeks to a month). Credit cards are a much better option if the available balance is low enough to fit the borrower’s monthly income. How many people would be in dire straits if they had to pay off their credit card balance in 10 days?

  23. Reg Gilbert

    JDH: Agreed that there should not be the same position, one size fits all, on regulation of drugs, bank risks, and payday loans. The point I was attempting to make — responding to what I took to be the fundamental thrust of the original post that payday loan regulation is ipso facto valueless or destructive nannyism violating the natural right of free choice — is that in none of these cases is it feasible to apply only the moral absolute of right of individual choice, whether in the issue of using drugs potentially detrimental to health, taking on loans under ultra-high-cost terms, or extending bank credit potentially recklessly. It is not feasible to solely apply the moral absolute because in these cases and potentially in any others, there is the aspect of potentially vastly greater harm for the group than any potential benefit for the individual. Making some payday loan terms illegal eliminates a credit option for some that may in fact in the end be useful for them. But such a policy may also result in improved financial health for many, many more people than the benefit for those some. If the ratio were 1000:1 could we not agree that the loss of the right of free choice in the case takes a back seat to the social benefit? Likewise, to simplify something much more complex than the payday loan example, making drugs illegal takes away the option of some to experience expanded consciousness, or simple recreation, but potentially also reduces or removes the danger to some of personal and family destruction. This example is in one sense the opposite of the payday example — drug policy like Prohibition restricts the options of the vast majority because the cost to the minority is so high, while restriction on payday loan terms probably restricts the truly beneficial outcomes of only a few while improving the long-term outcome for the majority. But the principle remains the same: social outcomes trumping moral principle. There are, of course, many cases where the reverse is true, that generally the moral principle outweighs any likely social benefit — free speech rights, the right to decide to open a small business despite the notorious failure rate — but not because those moral principles are written inviolate on golden tablets buried under Mount Vernon, rather because we value free speech above most harms of free speech and entrepreneurship for its protection against economic stagnation. Really all I am challenging in the original post and in our interchange, JDH, is what I perceive as a moral haughtiness that deigns with a mention of economic freedom to obviate all discussion of the social costs and benefits to any particular expression of that freedom.

  24. Ari

    This is an interesting discussion. I believe at the core of the issue is how we model human behavior in a dynamic setting. It is somewhat well known that if decision makers have preferences that are consistent with hyperbolic discounting, then it is individually optimal to eliminate the option of short term consumption at the expense of long term payoffs. If (as it seems to be the case here) an individual cannot eliminate the choice it may be best for the government eliminate the choice.

    Revealed preference in this case says nothing about efficiency, so saying that we should or should not have a policy based on such an argument is misleading at best.

    Unfortunately we do not know for sure if the people affected by such a policy are hyperbolic discounters or not (although we have some idea that they probably are). Regardless, the proposed policy seems ad-hoc in the sense that if payday loans are bad, why allow them at all? The policy seems to just hamper competition at best and creates a focal point for collusion at worst.

    I think there are many ways to model decision making such that payday loans are “bad”, but policy should be based on such models if it is to exist at all.

  25. Van

    I know someone who used to work at one of these places and she would try and do it right and actually work with the customer but the bosses from above told her she should not worry about this and just continue to make loans and get the maximum she could from them. and to let them know, almost encourage them to keep renewing if if they fall short.
    Van

  26. Vangel

    This is abstract thinking crossing over into evil. This is the land of heartless laissez-faire freakdom.
    This issue is about voluntary transactions versus serfdom. I have no idea how you can come to the conclusion that serfdom is virtuous or preferable to liberty.

  27. Reg Gilbert

    Vangel: Perhaps you misunderstood my point. I do hope you are not comparing restriction or banning of payday loans to serfdom. Here is my point: full adherence to the principle of allowing all voluntary transactions would permit people to sell themselves into slavery (or serfdom, if you wish a milder example). Those who do not object to that option elevate principle over morality and any conception of utility as a guide to permissible social transactions. Remember that Adam Smith did not approve of individual greed — he demonstrated that it had social utility. Presumably he would have objected to the full flowering of greed if it was clear that it delivered net negative results. Objection to the option of selling oneself into slavery concedes the validity of using social utility to judge the permissibility of any given transactional right. My claim is that payday loans deliver a social utility of x and a social harm of 10x (or whatever), thus should be restricted. I welcome any argument that claims a ratio of 1:1, or 2:1 (that is, more utility / benefit than harm). Given likely margins of error in these judgments, I would admit arguments that payday loan 1:2 or more utility / harm ratios might justify their continued practice, as I support a prejudice against interference in voluntary transactions. But an argument against interfering in payday loan transactions on principle alone must follow that principle (that social utility is irrelevant) to its logical conclusion, and support the right to sell oneself into slavery. Vangel, are you willing to make that leap?

  28. Assaf Oron

    Robert hi,
    A friend forwarded this post to me and I was very surprised to see your opinion. I read the excellent Colorado report which you co-authored, and reached the opposite conclusion from what you put forward here.
    In fact, your own report says that the convergence of loans to the price cap (over 95% of loans towards the end of the study period, I think) is indirect evidence for price collusion.
    In lay terms, there are two possible conclusions from this apparent price-fixing:
    - The market should be freed until a demand/supply balance point is found. I think that’s what you are arguing here, even though the report’s findings do not suggest this at all.
    - OR: this is not a free market, but a captive one. People with no access to cash sources cannot make free-market choices or form a bargaining base. They need to get cash quick, or they will be kicked out of modern society.
    I agree that payday-loan are a phenomenon, not the root problem. The root problem is the mainstream financial market shutting out everyone with a small blemish on their record. It makes no sense that overnight one may find oneself having to switch from 20% APR to 400% with nothing offered in the middle (and yes, APR is still the relevant measure here).
    As an aside, I think that anyone arguing for the deregulation of a financial market, especially an experimental, subprime one which the payday-loan market certainly is – has quite an uphill battle against reality nowadays.
    Time to revisit those free, deregulated market dogmas.
    Cheers, Assaf

  29. rmark

    “Let’s do some math. You work at McDonald’s for 7/hr and work 35 hrs a week. That is 490 every two weeks before taxes. Throw in food, rent, some other basics and you’re likely living on the edge check to check.”
    Only true assuming they work at McD’s forever. However,if they finish school and get a masters in Economics, then they’ll own the McD’s franchise and repay the loan with no trouble at all.

  30. rmark

    As an aside, I seem to recall a non-profit group entering into the microcredit business in Africa after complaining about high cost loans to the poor. They discovered a high default rate made that high cost necessary.

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