How the other half banks.

Commentary about business and finance.
May 10 2004 5:37 PM

How the Other Half Banks

The depressing, amazing "payday loan" business.

Many Americans—particularly those who don't live paycheck to paycheck—are unfamiliar with the payday-loan industry, one of the nation's fastest-growing and most depressing businesses. Payday advance companies offer tiny, short-term loans—a few hundred bucks for a few weeks—while charging annual interest rates that top 500 percent. Borrow $200 today, pay back $240 or $250 on payday. (Some may think that charging those kinds of rates must be illegal, that it's equivalent to loan sharking by mobsters. In this Slate article, Brendan Koerner explained why loan sharking, which actually charges much lower rates, is against the law and payday loans aren't.)

For millions of Americans, these high-interest short-term loans are a way of life. Just before Christmas last year, more than 10 million people took out a payday loan, according to industry statistics. Between 2000 and 2003, the number of outlets offering these loans more than doubled to 20,000—not counting the many Web sites such as sonicpaydayland.com, mycashnow.com, and so forth that give high-interest quickie loans. Ohio-based Check 'n Go opened 100 new stores last year and anticipates opening another 100 this year. Advance America, a company that only started in 1997, already has more than 2,000 stores. The businesses are thriving in about 35 states. Other states, including New York and Massachusetts, impose interest-rate caps—25 percent in New York—that effectively bar payday loan operations. Stocks of the five publicly traded companies that focus on the payday loan business—four of them are publicly traded pawn shops—all more than doubled in 2003.

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The business is booming because of the massive growth in low-wage service-sector workers. People on the edge have turned payday-advance outlets into a kind of alternative banking sector. It's not illogical. The payday loans are safer than dealing with loan sharks—they won't break your legs if you don't pay, only break your credit rating. And, the industry claims, payday loans may end up being cheaper than actual banks. Despite the sky-high rates, the loans may cost less than the $60 to $70 penalty for bouncing a check, or the $30 in late fees, not including interest, that credit card companies extract for missing a payment. "Our customers don't think they're making a bad financial decision," says John L. Rabenold, a spokesman for Check 'n Go.

(Rabenold says that one customer recently contacted the company to thank Check 'n Go for giving her a $200 advance so that she could go shopping with her friends. Still, that $200 advance wound up costing the woman an additional $40, assuming she paid it off within a week. Enduring that kind of penalty may make sense if your car broke down and you need to pay the mechanic. But it's pretty hard to justify it as a form of retail therapy.)

Despite the industry's übergrowth, the three largest payday-advance companies—Advance America, Check 'n Go, and Check into Cash—are all still privately owned. Perhaps that's why Wall Street is so excited about Dollar Financial, one of the remaining prizes. Dollar, based in Berwyn, Pa., a Philadelphia suburb, expects to go public sometime this summer. Dollar operates about 1,100 stores in the United States, the United Kingdom, and Canada and offers check-cashing, payday loans, and other financial services aimed at those with low incomes. Of its 319 U.S. stores, about 30 percent operate under the name Loan Mart and focus on payday loans.

Wall Street is lining up to support Dollar's offering, which points to the ambivalent relationship it has with the payday-loan business. Despite the huge potential profits, retail banks have shied away from offering payday loans, because they know it would tarnish their reputation. This hurts payday-loan customers, because big banks could turn the business upside down. They have the financial might to cut rates down to much lower levels, but they don't want to be seen as exploiting the poor—after all, they would still charge 10 times the interest rate on a small, short-term loan as on a large, long-term one. "A company like Bank of America knows they're missing out on a multibillion dollar business and they know that if they got into this and charged 60 percent even, it would still be a significant savings for consumers. But they don't want to make their reputation on undercutting a payday lender," says Michael A. Stegman, a professor of public policy and business at the University of North Carolina at Chapel Hill.

Yet at the same time banks avoid issuing payday loans, they happily accept the payday-loan companies as clients. Citibank won't operate a payday-loan business, but Citigroup is going to be the lead underwriter on Dollar's IPO. And you can be sure that brokers won't be shy about recommending Dollar's stock to investors. Instead of getting its hands dirty, Wall Street will happily settle for being a middleman—nibbling off a small piece of the industry's big profits and avoiding responsibility for how those profits were earned.

Michelle Leder writes a daily blog at www.footnoted.org that looks at SEC filings and is the author of Financial Fine Print: Uncovering a Company's True Value.

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