400 Percent APR: Is That Good?Do people take out payday loans because they're desperate, or because they don't understand the terms?
Posted Wednesday, July 22, 2009, at 1:27 PM ET
There's been a lot of finger-pointing lately about who is to blame for the untenable financial circumstances of many American families. Among the usual suspects—Wall Street quants, fly-by-night mortgage brokers, the households themselves—none is an easier target than payday lenders. These storefront loan sharks are portrayed by their detractors as swindlers preying on the desperation and ignorance of the poor. A payday backlash is already well underway—Ohio recently passed legislation capping interest rates at 28 percent per year, and the Military Personnel Act limits interest charged to military personnel and their families to 36 percent. The average payday loan has an annual interest rate of more than 400 percent.
Payday lenders themselves argue that they're being victimized for providing a critical social service, helping the hard-up put food on the table and cover the rent until their next paychecks. Charging what seem like usurious interest rates, they claim, is the only way to cover the cost of making $100 loans to high-risk borrowers.
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StumbleUponIf payday lenders really do provide a much-needed financial resource, why deprive Ohioans and American servicemen of this service? A recent study by University of Chicago economists Marianne Bertrand and Adaire Morse suggests there might be a middle ground, by allowing payday lenders to continue making loans but requiring them to better explain their long-term financial cost. In a nationwide experiment, Bertrand and Morse found that providing a clear and tangible description of a loan's cost reduced the number of applicants choosing to take payday loans by as much as 10 percent. Better information, it turns out, may dissuade borrowers vulnerable to the lure of quick cash while maintaining the option of immediate financing for those truly in need.
An average visitor to a payday loan shop expects to get a loan of around $350. Lenders typically charge a loan fee of $15 for each $100 borrowed, with the principal and interest fee to be repaid at the date of the borrower's next payday. Since most employees are paid twice a month, a customer who takes out a $100 loan each pay cycle and repays it the following one will have spent nearly $400 over the course of a year, making the annual percentage rate on the loan 400 percent. (By comparison, the APR on most credit card debt is 16 percent; for a subprime loan, it's 10 percent.)
Before receiving the loan, borrowers sign an agreement that includes a government-mandated disclosure of this stratospheric APR. So it's natural to wonder why Bertrand and Morse would expect any further information on loan costs to have an impact on the decision of whether or not to take the loan.
The researchers argue that many payday loan customers may not know what an APR is, let alone have any basis for judging whether 400 percent is high or low. (Some states require that applicants sign a waiver confirming that they understand the APR, but they're certainly not tested for APR comprehension.) So Bertrand and Morse devised three alternative ways of explaining the high cost to borrowers and collaborated with a national chain of payday loan stores to see what effect this additional information might have on prospective payday customers in 77 stores nationwide.
On randomly selected days, in addition to receiving the usual loan paperwork, borrowers were given the option of participating in a University of Chicago study. (They were given a free magazine subscription for taking part.) The willing participants filled out a short survey on education background, level of self-control ("Do you describe yourself as a planner? Impulsive?"), purpose of the loan, and the number of weeks they expected to need to repay it. Then, instead of getting a standard-issue package with only with the loan due date printed on the front, participants received an envelope with additional information on the cost of the loan.
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No one is arguing that these sorts of services aren't needed-- clearly they are. But there is no reason to permit such exorbitant interest rates. The owners of these chains are in it for the money, but when it comes to lending money, banks and credit card companies are limited by law to a certain ceiling on the interest they charge. It seems to me that imposing a ceiling of 36%-- roughly twice the average cost of money through regulated institutions-- would provide ample incentive for providing the service. And if not? Too bad. We pass laws in the interest of protecting the public-- and many of those laws are to protect people from themselves. Imposing a more than generous ceiling on interest charged might very well result in more and easier credit of this type. It's not hard to imagine a place combining packaging and mailing services with on-line-auction services and paycheck loans. After all, someone has to be at the counter all day-- this would simply allow the storefront to make more money with the same overhead cost.
Make no mistake, I still think 36% is incredibly high, but for those people living from paycheck to paycheck, and who hit a speedbump (which takes out their muffler), it seems like a much more reasonable rate than 400%.
-- DuckworkerMike
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Instead of berating the payday loan industry, how's about berating the regular banking industry?
Folks who take out payday loans are (generally) faced with an exceptional financial shortfall and no alternative. It can be something as simple as an impending overdrawment of your checking account (something that is entirely too easy to do with today's debit cards).
Overdraw your checking account by 2 $5 debits, and you will pay $76 in fees...I'm not sure what the APR there is, but it's way more than the 400% of a payday loan.
It is misleading to look at a payday loan in terms of "how much it would cost you to have this money for a year", you don't have it for a year, you have it for 14 days. If you choose to refinance your mortgage 26 times in one year, you'd run up an effective APR of over 100% too.
-- AlanMacNeill
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Why deny servicemen? For a few reasons, servicemen shouldn't need the financial services that close relatives may need; they have a steady income and the government will advance them money through their commander, should the need be dire. However, they may go thoughtlessly to a payday lender because their relatives and neighbors and culture has normalized this very costly behavior. Through putting themselves in financial distress, soldiers become vulnerable to security threats, among other things that can harm work performance.
The biggest reason the law exists is because lenders were getting abusive with families that had members deployed or deploying; imprudent spouses and unwise children and distracted or desperate soldiers would make unwise financial decisions and be taken advantage of during the hurry to embark. This is why such loans were made illegal - to pursue the snake oil salesmen who would try to squeeze a soldier's family while he was away.
-- BenK
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