Ken Funnell at Bank Lawyer’s Blog tells us that Ohio is about to put legislation into effect that will kill payday lending:
The new Ohio law would limit borrowers to four short-term loans a year and cap annual interest rates at 28 percent. The bill also would limit loan amounts to $500 per loan, or 25 percent of a consumer’s base monthly pay, whichever is less.
Funnell is a proponent of the view that payday lenders offer consumers a useful choice and are preferable to loan sharks. Other defenders of payday loans argue that the cost of an advance is less than a bounced check fee.
The reality seems more complicated that than, particularly since the spending habits of the poor are not as heavily studied as those of the middle class. The reason that payday loans are viewed with distaste in some circles is that borrowers can become recidivists, unable to get off the treadmill of accessing their paycheck early and racking up large costs. Even worse, the payday lenders have an incentive to create customers of that sort.
And it isn’t low lifes who fall into this trap; anyone who lives paycheck to paycheck (or close to it) can get caught. Armed Forces personnel were getting overstretched sufficiently often that the Pentagon decided to intervene:
The Pentagon is writing a rule to keep the minds of U.S. troops on their missions by shielding them from debt, but the prospect of the Defense Department as a regulator frightens the financial industry….
The rule will limit how much lenders can charge military personnel, and it could affect banks, credit unions, mortgage providers and payday lenders, among others.
The Pentagon is especially concerned about payday loans, which are typically two-week extensions of credit to cover quick cash needs between paychecks. They can have interest rates of 300 percent a year or more, pushing troops so deep into debt that they cannot focus on fighting.
Defense officials and some lawmakers argue that young, financially unsophisticated service members are particularly vulnerable to shady financial practices and deep debt, especially when lenders offering high rates and quick cash set up shop outside the gates of military bases.
The push against payday loans is part of a bigger effort to clamp down on financial practices the Pentagon sees as predatory. It follows efforts to boost standards for insurance sales after reports found the insurance industry had spent years offering unsuitable and expensive products to soldiers.
The limit on loan rates would be set at 36 percent — a number meant to drive the payday loan industry out of military lending.
Now of course, one can argue that these moves are paternalistic. But overseas regulators have pointed out that the US now has fairly sophisticated financial products, combined with widespread financial illiteracy. Thus it isn’t clear that the preferred remedy, disclosure, is as effective as it ought to be.
Another conundrum is that people are optimistic, and that trait is reinforced more strongly in the US than other cultures. It’s also well documented that most (save the mildly depressed) overestimate the odds of things turning out for the best, and particularly overrate those probabilities when they are part of the equation. Thus an emotionally healthy person will overestimate his odds of his ability to repay a payday loan. This is a well proven cognitive bias, not (as is often asserted) character defect of the poor.
So the justification for intervention (via restricting access to the product) becomes more complex. What other recourse might the prospective borrower have? Lower income people frequently hit up family and friends for short-term loans; it isn’t clear how often using payday loans is a necessity versus not wanting to embarrass oneself or go to the well once too often.
The downside may not have been fully captured either. What happens to chronic payday loan users? Do they in the end due to the overburden of financial charges, wind up losing important possession like their car, or make greater use of social services? One of the arguments for the controversial living wage is that without it, employers like Wal-Mart are getting de facto subsidies from the state as inadequately workers use food stamps and other benefits to survive. There may be insufficiently studied social costs of the chronically indebted. If it turns out those recidivist payday loan users wind up in some cases increasing taxpayer expenses, the total costs of the product bear examination.
Thus while Funnell laments the Ohio precedent, I think it’s a great lab experiment. It’s a given that banks will collect data to try to show what a profoundly bad idea this is. I hope social science researchers and other disinterested parties will do the same.
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Does anyone know if it is constitutional for Ohio to restrict payday loans like this? The supreme court shut down state limits on individual interest rates on constitutional grounds.
Payday lending is just one of the gifts Reagan’s financial policies (or lack of them) have given the weakest among us. But maybe the tide is turning. I believe Arkansas also passed a law effectively eliminating this practice, and Pew Research recently announced a project to help the poor and middle class who have been shut out of mainstream banking:
The Pew Charitable Trusts announced a new project today, aimed at helping America’s workers underserved by mainstream financial institutions secure access to safe, affordable, fair, and empowering bank accounts. The Pew Safe Banking Opportunities Project, a two-year $2.1 million initiative, will develop and promote standards for bank accounts so that moderate- and low-income households that are new to or have been left out of the mainstream banking system are less likely to have to rely on overly expensive, income-stripping financial products.
The project will work with industry representatives, state and local governments, consumer advocates, and personal finance experts to develop and promote the standards.
“The three core principles that will guide the development of the standards are clarity, consent and fairness,” said Shelley Hearne, Managing Director of Health and Human Services for Pew. “For too long, millions of households that lack a basic bank account have had to rely on expensive check-cashing establishments.”
Depending on how a State’s check cashing laws work, payday lending often requires a specific exemption from State law to be allowed.
The Supreme Court did not say States could not regulate interest rates, they just said they could not regulate inter-state rates. The pay day lenders tried to use Federal Banks to get around State provisions, but the Fed Regulators in a rare moment of sanity said that payday lending by Federal Banks was not good practice. One of the current run-arounds is to try and use out of state (but not Federal) banks. However, apparently there have not been enough takers, as another strategy has become more prevalent. The typical strategy is to use some other item as a “proxy’ for the actual loan, and declare it a consumer finance loan. For instance you would finance computer internet access with an additional cash payout option.
Adam Smith had great solution to eliminate predatory lending to profligates over 200 years ago that did not require setting the maximum number of loans or the number of loans that can be made per period per person – cap the interest rate a little above what would now be called the Prime rate.
Years ago I spent a summer as a bank teller and cashed checks for those living paycheck to paycheck. I’m not a social scientist, and I lean libertarian on many things, but it is so obvious to me that a large number of paycheck-to-paycheck people will not be able to evaluate or resist a payday loan. Call me paternalist, whatever that means exactly, but for everyone in Ohio who now must visit a loan shark there are many more who now have some more guardrails keeping them on the right path.
Do you really think that “optimism” has anything to do with going to a Payday Loan Operator? This is called “Denial”….Actually Mutual Denial—denial on your part to use the euphemism of optimism and denial on theirs’.
Additionally, it is asserted “an emotionally healthy person overestimates the odds of his ability to repay”. And that this tendency is somehow “extra” reinforced in the US culture. Are you asserting, then, that the US culture promotes exceptionally “emotionally healthy people”–as opposed to other cultures?
Yves, I had no idea you were so optimisitic–especially when it comes to the USA!
Getting past the silliness that passes for “science” associated with social psychology, if, as Funnell says, Payday Lenders leave with no replacement in the void–what then? Obviously, there’s a demand for immediate cash.
Realistically–a word that must be inserted so the Naked Redistribution of Wealth denizens don’t come out with the troubling Pre-Russian Revolution calls for the blood of the evil Over Lords—to whom will these people turn?
Are you asserting, then, that the US culture promotes exceptionally “emotionally healthy people”–as opposed to other cultures?
That’s not what he said at all. Yves said that emotionally healthy people will overestimate their abilities. The converse is not true: overestimation of one’s abilities is not necessarily indicative of emotional health. Plenty of emotionally unhealthy people are overoptimistic; psychopaths, for example.
B-school organizational behavior courses call this the fundamental attribution error. People attribute success to internal factors, such as their own character and choices. Failure is attributed to circumstances, such as bad luck. The fundamental attribution error affects all emotionally healthy people (except me, of course). If you have a realistic impression of your abilities and prospects, then you are probably clinically depressed.
And payday lending is atrocious. I believe that Canada killed the business by eliminating rollover fees. So “ethical” payday lenders, who don’t intend to roll over loans ad infinitum can still operate… funny how there aren’t many of those.
Dear Macndub.
It was a joke…that Yves would asssert such a thing.
BTW: What do “B-schools” call being “exceptionally literal”?
Excellent post, Yves, and thank you. And thanks for pointing out that poor people do not have some “character defect” but simply hope for the best, as all desperate people do. Regulating the predatory payday loan “industry” is a no-brainer, but how about cutting the Gordian knot by simply paying poor people a living wage? Call me a Red, but I think members of our Armed Forces–and yes, people who simply work at Walmart–should make enough money to cover their basic human needs, without resorting to a-rose-by-any-other-name loan sharks. That’s not redistribution of wealth, that’s making the super-wealthy pay their fair share. There are huge social costs from having people living in a perpetual state of debt, chaos, and near or actual hunger. Essentially, the middle classes are making up the gap in wages, via taxation for social services. That is the true redistribution of wealth that is occurring: from the middle and upper-middle classes, to the super-rich.
It is a known fact that people who are depressed tend to overspend and have all kinds of unrealistic financial windfall expectations.
Anon of 9:23 PM,
By whom? Manic depressives (oh we call them bi-polar now) overspend in their manic phase, not in their depressive phase.
I provided a link to a paper that cites research supporting the argument. Do you have any research that confirms your views?
Although it is anecdotal evidence, the depressives I have known have had trouble getting out of bed and interacting socially with people. They often report fatigue, which may be a separate symptom or may be caused by depression. I have not know of a single one who has had windfall expectations (and that even includes some bi-polars). They to a person had a dark view of their future and accordingly were not engaging in retail therapy as a form of self treatment.
The payday lenders have been lying to Ohio voters in attempt to overturn one of the nation’s best consumer protection laws in November.
Watch here: http://www.youtube.com/watch?v=zDoeXujagE4.
The payday lobby is spending millions on TV to deceive voters and convince Ohioans that 391% amounts to financial freedom! 391% is not freedom, it’s a trap! Payday lenders need to acknowledge that their business is predicated on their ability to trap people in debt!
Payday lending is a scourge on our families, our communities and our economy! VOTE YES ON OHIO ISSUE 5!
http://www.yesonissue5.org