Payday lenders thrive where banks are scarce

At one point or another nearly everyone has to borrow cash, even if it’s just an amount for a brief period.It could be to cover the necessities such as buying milk or cereal for the kids or for fun, such as funding a weekend getaway at the beach.How are we all paying 460 percent of interest for that money?

It could be a surprise.There are 12 million American individuals who borrow more than $50 billion annually via “payday” loans – very short-term unsecure loans that are typically accessible to people who have poor (or not even) credit.The interest rate can be as high as 35 times higher than the rate charged by regular credit card loans, and around 80 times that of auto loans and mortgages for homes.On the other hand, on this ledger, the procedure is simple and easy one needs only a driver’s license and Social Security card, proof of income, and a bank account number.After writing a postdated cheque in the amount of the loan amount, plus fees and interest, the client is able to leave with cash on hand.

It’s likely that what you’re not surprised by is that both payday loans cater to various market segments.For instance, in California (one state, however, it’s likely a representative one) the payday store dominates lending to the poor, particularly people who identify as Latino or African-American.

It is not necessarily the case that payday loan borrowers are taken advantage of in the sense that lenders have to be earning profit monopolies. First of all, the transaction costs associated with lending these loans are quite high. Another reason is that one can anticipate that defaults will be large since these loans aren’t secured and the borrowers tend to be poor.

However, the evidence from pilot programs in which banks are competing directly with payday loans indicates that the traditional lender can make a profit at much lower interest rates than the ones offered by stores.So the question for policymakers is: why do banks leave the ripe fruits to be picked for payday lending companies?There’s another question: what can be done to help banks to compete in the market?

What and Where

In the late 1990s, the payday lending industry was comprised of just a handful of lenders across the nation, and today, over 20,000 establishments operate throughout 32 states.Additionally, a growing amount of payday lenders offer loans via the Internet.In actual fact, Internet payday loans accounted for 38 percent of the total in 2012, a rise of over 13 percent in 2007.The typical payday loan is $375 and is usually repaid in two weeks.However, the average loan amount varies substantially from state to state and includes Tennessee at the lower end ($202) as well as Texas at the top ($533).

In the year 2006, Congress restricted the rate of interest charged to those in the military as well as their families at an annual amount of 36 percent.In other cases, state regulators manage this show with the maximum APR that ranges from 196 percent for Minnesota to 574 percent for Mississippi as well as Wisconsin.

California first approved payday loans in the year 1996. The practice is controlled by the State’s Department of Business Oversight.The law permits these lenders to delay the deposit of a client’s personal checks for up to 30 days. It limits the value that a check can be worth to $300, and limits the maximum amount to 15% of the amount of the check.Additionally, payday lenders are forbidden from lending money to those who have outstanding loans with their lenders – they are not permitted to increase the amount.It isn’t a limit, however, on the number of payday loans that a customer can recycle in a year.

In 2005, California had 245 payday loan stores.The market then collapsed, leaving just 2,119 locations at the close of 2011.The total amount of loans repaid went up between $2.6 billion to $3.3 billion during the time and the number of individual customers increased from 1.4 million, to 1.7 million.In 2011, the 12.4 million payday loans made 2011 averaged $263, and the average duration was 17 days.The maximum legal fee is the same as the previously mentioned APR of 460 percent for a loan of two weeks.While there’s no official information on the actual fees paid, the places we tested averaged near the maximum amount.

Compare that APR to the current rates for auto credit (about 6.4 percent), credit card loans (13 to 25 percent), and subprime mortgages (5.5 percent) in California.Of course, risks for lenders differ also: mortgages or auto loans have security (that is that the lender is able to take the property in the event that the borrower fails to pay) in contrast, credit card or payday loans are unsecured.

The cost of the $200 two-week loan might not seem a bit excessive for the average borrower.However, those who take out at least six loans per year earn more than half the total payday store revenue in California.All across the country, the majority of customers are in debt to payday loan lenders for five months of the year. They typically spend $800 which is equivalent to a $300 Revolving loan.

California’s Financial Landscape

California represents around 7 percent of branches of banks and over 10% of all payday stores across the nation.A more interesting picture is revealed from the level of the counties.There is only one county without banks and 14 counties that have no payday loan stores.On the other end of the range, Los Angeles County has the highest number of payday lenders and banks with 521 and 2,120, respectively.The situation is very different when viewed on a per capita basis. In all counties except one, there are more bank branches per person is more than the amount of payday lending stores per person.

We gathered demographic and personal financial data for each county in order to determine how they are related to the locations of banks as well as payday loan lenders.The first thing to consider is the negative and strong relationship to the numbers of branches of banks in addition to the total number of payday lenders stores, adjusted to the population.

It’s possible that this is the result of market forces, that payday lenders and banks have their headquarters in the areas where their customers reside.This could indicate that banks aren’t willing to face the task to expand into other demographic groups despite the potential for profit.In either case, the residents of counties with fewer banking institutions are at an advantage with regard to borrowing.This is especially troubling since it could decrease economic and social mobility. For instance, counties with fewer banks have a higher proportion of people of low income and minorities and the residents of counties that are more banked have higher education levels and higher incomes.

What Could – and Should – be Done

A relatively non-controversial reform could concentrate on transparency.Customers should be aware of more than the amount they receive from the payday lender currently and the amount that will be taken from their bank accounts within two weeks.The cost of interest for making use of a credit card to pay for $300 in debt is approximately $2.50 for two weeks, and 15 for the duration of three months.The charges for a payday loan of $300 are just $45 for two weeks and $270 for three months.A greater emphasis on transparency could result in greater vigilance for those who may be payday loan recipients.

However, transparency isn’t the only solution. If the payday lender in town is the only one in town, and the children are hungry, the those who borrow will pay whatever they can afford.

Payday lenders claim that the high rates they charge are justified because of the nature of lending to short-term customers such as the paperwork, small amount of loans offered per store and so on. and also by the risk-averse nature of those with lower incomes. Some lenders, according to claim they have not been willing to provide loans without collateral to those with low or not even credit. Also, the possibility of borrowing for 460 percent or more is more advantageous than being unable to even borrow.

Recent evidence suggests that banks and other financial institutions may actually offer alternative loan options that satisfy the needs of people currently confined to payday lenders at lower rates. The Small-Dollar loan pilot program of the FDIC Program has provided valuable insights about how banks can provide low-cost Small-dollar Loans (SDLs) without loosing funds in the process.

In the pilot program that ended at the end of 2009, financial institutions offered loans of up to $1000 with APRs less than one-tenth the rate that payday lenders charge. They typically didn’t check the borrowers’ credit scores, but those that did would accept borrowers who were on the lower portion of the subprime range. But, SDL charge-off rates were similar with (or lesser than) losses for other forms of credit like credit cards. It is worth noting that banks that had basic financial education within the lending process gained additional advantages by cutting SDL losses by half.

The success of the bank’s SDLs has been mostly attributable to the fact that they extended the loan’s term beyond the two-week pay period.While reducing expenses associated with transactions involving the multiple loans of two weeks, longer terms allowed borrowers the opportunity to bounce back from financial crises (like laid-offs) and cut down regular payments to smaller amounts.

The benefits for consumers of SDLs as compared to payday loans are obvious.It’s no surprise, however, that banks will not stay in this field in the event that, one way or the other, SDLs prove to be profitable.As part of the FDIC pilot, the majority of banks said that SDLs aid in cross-selling other financial services and build long-lasting and profitable relationships with customers.Because of the limited number of SDLs the banks offered at the beginning of the program phases, however, the success of SDLs as standalone products was mostly not tested.

It’s a great space where new thinking and technology can be a major impact.Start-ups such as ZestFinance founded by the former Google chief executive officer for investment and head of the engineering division are utilizing Big Data Analytics to boost traditional underwriting models, based on FICO scores.

Another brand newcomer, Progreso Financiero, employs an exclusive scoring system that allows small loans to underserved Hispanics.Progreso’s loan offerings follow the same pattern that was uncovered during the FDIC pilot program, which is bigger loans than payday offers with terms that span months instead of days and, most importantly the less expensive APRs.Furthermore, Progreso has demonstrated that its business model can be used on a large scale. It originated over 100,000 loan loans in 2012.

LendUp the online firm provides loans 24 hours a day and charges very high rates for extremely short-term, small loans.However, it also offers the option of loans for durations of up to 6 months at rates that are comparable to those of credit cards, as long as the customer has proven creditworthiness by repaying loans with shorter terms.The company also provides the opportunity to learn about financial issues online for no cost to help prudent decisions.

Each of Progreso and LendUp was part of a 2010 pilot program designed to improve the accessibility of low-cost credit within California.They are also both supporting the replacement program, which has guidelines similar to those of the FDIC initiative.Sheila Bair, the former director of the FDIC believes in SDLs becoming a common bank product.In reality, as banks confront growing criticism for being dependent upon “gotcha” fees on regular consumer accounts, it is now to create feasible credit services for people who do not have bank accounts that can improve the image of the industry.

Sallie R. Loera