Payday loans can be tempting. Advertisements promising money to tide you over until your next paycheck appear at check cashing outlets, in pawnshops, within the classified ads and increasingly, online. Cyberspace is the new marketing frontier for payday loans with check-based lenders promoting their services through pop-up ads, in junk e-mail and on Web sites. While those cash until payday services sound helpful, consumers need to know the risks. Cash-strapped consumers can find themselves enmeshed in an endless cycle of repeated borrowing at extremely high costs.
Small, short-term, high-rate loans are marketed under a variety of names: payday loans, cash advance loans, check advance loans, post-dated check loans or deferred deposit check loans. To obtain the payday loan from a storefront lender, a consumer writes a check payable to the lender for the amount he or she wishes to borrow plus a fee. The lender gives the borrower the amount of the check, minus the fee. The lender then holds the borrower's check until his or her next payday, when the borrower can do one of three things: allow the check to be cashed, redeem it by paying cash to recover the loan plus a fee or roll it over by paying the fee to extend the payday loans for two or more weeks.
If the borrower chooses an Internet payday lender, the loan is applied for online and the funds are delivered and collected through electronic fund transfers between the lender and the borrower's bank account. The loan is based on electronic access to the borrower's bank account. While borrowers must have a bank account in relatively good standing and a source of income or benefits to qualify for payday loans, lenders typically do not perform conventional credit checks. Some borrowers complain to the Better Business Bureau that lenders encouraged them to write checks without funds for deposit and then used those checks to coerce them to extend their loan. Called loan flipping, this practice can trap vulnerable consumers in debt.
Under the Truth in Lending Act, the cost of the payday loans, like other types of credit, must be disclosed. Among other information, a consumer must receive, in writing, the finance charge (a dollar amount) and the annual percentage rate, or APR (the cost of credit on a yearly basis). Finance charges can range from $15 to $30 per $100 borrowed. This may not seem like a lot of money until you look at the APR for the payday loans. A credit industry survey found the average APR for payday loans to be 300%. A recent report found the average rate in most states of America to be 408%!
There are risks to payday borrowers: the possibility of further overextension of credit, higher payments for payday loans. Yet there are risks of restricting their ability to access that type of credit. Absent payday loans, some borrowers may have to pledge a needed household good to a pawnbroker or face possible bankruptcy; some would be forced to deal with less desirable lenders or loan sharks. In devising policy changes, regulators should be cautious that while addressing the perceived risks to payday loan borrowers and to the institutions providing those loans, they do not increase borrowers' risks by restricting the availability of that type of credit.
Various studies have shown that payday loan borrowers are strapped for ready cash to meet their obligations and with few other options available. They do have checking accounts-a requirement for payday loans- and many have a higher-than- average ratio of debt to income. Lacking the discretionary income and liquid assets that would help tide them over, and, in many cases, not having access to revolving credit, their options are often confined to smaller unsecured loans at higher rates.
For such consumers, payday loans provide a valuable short- term financial option. However, regulators often assume that firms providing such loans are somehow less legitimate than institutions serving the more credit-worthy. However, if payday loan firms had not met the demands of those customers, then the scope of the legitimate marketplace would have been restricted and that of the illegal underground would have expanded.
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