Why Payday Loans are Good for Millions of People
New York state is asking more than 100 banks to choke off access to the automated payments system that unlicensed online lenders use to debit the checking accounts of consumers.
The Justice Department and state regulators are targeting banks that service a broad range of what they consider questionable financial ventures, including some online payday lenders. I applaud the government's efforts to weed out bad actors that engage in fraudulent transactions or violate federal laws. But I'm deeply concerned about the unintended consequences this could have on much needed financial services for underbanked people who rely on legitimate short-term lenders, commonly referred to as payday lenders.
Payday lending is pretty simple. An individual has an urgent short-term need for cash and goes to a payday lender. A person with a job, a checking account and proper identification can borrow anywhere from $100 to $500 until his or her next payday. Such borrowers write post-dated checks or provide written authorizations to the payday lender for the amount of the loan plus a fee, which is typically 15%. On the next payday the loan is either repaid in person by the borrower or the lender cashes the check or initiates an electronic funds transfer. That's it.
The typical first-time payday transaction is completed within 15 minutes. Very few banks are willing to make these loans the transaction costs are simply too high.
Millions of middle-income Americans live paycheck to paycheck. They do their best to manage their finances so that all their obligations are met. But when something unexpected crops up, such as a blown transmission, an unexpected doctor's bill or a badly needed roof repair, their financial schedules are thrown off and the need for short-term credit may arise.
Some turn to relatives or friends for help in a crunch. But many may face the Hobson's choice of deciding between having their electricity turned off, their car repossessed, their job lost, their rent or mortgage unpaid or their check bounced. Payday lenders offer a better way out.
Critics of payday lending cite the high interest rates they charge. A $15 fee on a $100 advance for two weeks amounts to a 391% annual percentage rate, or APR. That's high when expressed as an annual rate, but keep in mind that the typical term of these loans is a couple of weeks. It's also notable that the annualized interest rate on the average payday loans is much lower than it would be for the fee on a bounced check or a late mortgage or credit card payment.
The $15 cost of a $100 payday loan also pales in comparison with the lost income when a car is out of commission and a job lost. Good payday lenders clearly disclose their loan terms and conditions, including the dollar amount of any fees and the APR. Moreover, payday lenders are regulated and supervised by state agencies and also the new federal Consumer Financial Protection Bureau. My firm has worked with payday lenders to get them into compliance with regulations applicable to banks.
Some online lenders avoid regulation by setting up operations offshore or on an Indian reservation outside the reach of regulators. I applaud the regulators for attempting to shut down such operations by denying them access to the banking system.
But I also caution about the potentially unintended consequences of driving all payday lenders away from banks. This is the last thing we need at a time when the economy is languishing, in significant part because only the most creditworthy can qualify for a bank loan.
At this point, banks would be well advised to conduct proper due diligence on their payday lending customers to determine whether they are following state and federal laws, have established written regulatory compliance and anti-money laundering programs, follow trade association best practices and obtain from valid customer authorizations for automatic funds transfers. If a payday lender cannot answer these questions affirmatively, the bank is likely working with the wrong customer.
Some argue that payday loan portfolios have enormous losses imbedded in them because the loans are never really repaid just rolled over and over again. But most states limit the number of rollovers, and most payday lenders impose similar limits, even in the absence of state laws.
The risks of payday lending are ameliorated due to the enormous diversification in the portfolios, and risks are priced into the fees. It's feasible for a reputable and efficient payday lender to maintain high loan loss reserves and substantial capital against payday loans and still achieve decent returns.
The regulators would do well to examine the welfare of borrowers in a variety of regulatory settings before they act in a way that might endanger the very people they are trying to protect the underbanked. The truth is that millions of customers have a very favorable experience with the short-term lending product, and we should be careful not to disrupt this important lifeline.
William Isaac, a former chairman of the Federal Deposit Insurance Corp., is the global head of financial institutions for FTI Consulting, which has worked for payday lenders, and the chairman of Fifth Third Bancorp. The views expressed are his own.