In this recent article written by George Mason University professor Todd Zywicki and GMU grad student Robert Sarvis, the authors present this argument in favor of payday loans (which happen to be illegal in 13 states and can not be given to active-duty members of the military):
Payday loans… may legitimately be the most attractive option, due to their convenience, reliability, and availability on short notice. Most payday loan customers do not have credit cards or would exceed their allowable credit limits if they used credit cards. Payday loans therefore fill an important gap in the supply of financial services to the poor. These loans do have high effective interest rates, but research shows those high prices can be explained by the high costs of originating and servicing many small loans and their high risk of default.
The authors also defend auto-title loans, in which the borrower uses their vehicle as collateral for high-interest, short-term loans. They claim this allows consumers without bank accounts and credit histories to obtain a loan they wouldn’t normally be able to. Thing is, auto-title loans are outlawed in more states than payday loans.
Zywicki and Sarvis argue against making these loans illegal — and strict regulation of forms of credit in general — saying that it creates a “whack-a-mole” effect in which putting the smack-down on one sketchy form credit just gives rise to a new one.
“The problem with this claim is that it would permit bad practices of any stripe,” rebuts Ginna Green from the Center for Responsible Lending. “Smart regulation works.”
She points to the regulations put in place by the CARD Act, which, unlike the lobbyists predicted, didn’t make credit cards scarcer or more expensive.
Green contends that the biggest problems with payday and car-title loans is the interest rates on these forms of credit “would make loan sharks blush.”
“Payday loans typically carry rates of 300-400% APR, while car title loans charge 100-200% APRs. Both loans feature these astronomical interest rates even though the lenders have lots of collateral against default risks: they either hold a live check from a borrower’s bank account or title to the family car. When things go awry — as they often do for those living on the financial margin — these loans cause of spate of new problems, like repeat borrowing, bounced check fees, overdraft fees, bankruptcy and vehicle repossession—that compound borrowers’ hard times.”
The article’s assertions are not that different from the arguments made during the height of the housing bubble by lenders who pushed borrowers into subprime mortgages — “These loans not ideal but they get people into houses who otherwise could not have gotten standard loans.” And just like those adjustable-rate mortgages, where customers were told not to worry about the fact that the interest rates would skyrocket after only a few years because they could just sell the house at a profit, payday lenders shrug off talk of 300% APRs by saying that, because of the term of the loan, it’s really not that much money.
These loans are advertised as being very short-term, typically one or two weeks. But in a recent letter to regulators calling for an end to payday lending by banks, Sen. Richard Blumenthal of Connecticut pointed to studies showing that that the average payday borrower ends up in a cycle of debt that lasts for around six months and that the typical payday borrower will take out 16 payday loans over the course of a year.
As for the authors’ contention that payday lending fills a need for America’s poor, Consumers Union’s senior policy counsel Pamela Banks says there are better ways to meet the needs of these borrowers.
“Just because consumers need and use credit doesn’t mean they’re fair game for lenders to charge three-digit interest rates, or hit people with pie-in-the sky fees that bear no relationship to actual costs,” explains Banks. “We all know too many stories about abusive practices that trap consumers in debt, rather than help them through the rough patches. That’s why regulatory oversight of payday lending, overdrafts, and other financial products is so important, to make sure that all players in the marketplace follow the rules.”
When stripped of its academic pretense, the Zywicki and Sarvis article is effectively saying that bad loans help people.
“In the real world, it doesn’t help anyone to make unaffordable loans or sell financial products that do more harm than good,” replies CRL’s Green. “The authors’ vision of a free market is really a Wild-West free for all where no sheriff can prevent the equivalent of a financial mugging — or another financial crisis.”