Everyone—including the poor—benefits from having access to financial services that enable them to finance small and large purchases and pay for emergencies. But some lawmakers are working to kill short-term lending in its current form, arguing that it hurts the low-income Americans it serves.
Reuters reported that short-term loan rates for small-dollar amounts, sometimes pejoratively labeled “payday loans,” can be well into the triple digits, thus trapping borrowers in debt. But is this true?
“While the median interest rate on small-dollar loans is between 25% and 38%, rates on some short-term loans of hundreds of dollars can be as high as 251%, trapping low-income borrowers in debt, according to the Consumer Federation of America.” – Reuters
Selectively true. True only in context. Partly make believe.
While it is technically true that short-term loan rates can be incredibly high, these loans are used differently than the long-term loans that most people use for, say, a house or car. So the annualized interest rate is misleading and should be understood as a separate type of product.
Tom Lehman, associate professor of economics at Indiana Wesleyan University, points out the real-world intellectual sleight-of-hand when using these inflated annualized, triple or quadruple digit interest rates. At the Mises Institute, he gives the example of a typical payday loan fee, of $15 per $100 borrowed for a typical loan term of just 14 days, making the annualized compound interest rate “easily in the triple-digit range.”
Lehman also writes about an academic analysis estimating that the median payday loan fee in North Carolina is $36, with a median, two-week loan of $244, which is an effective annual percentage rate of 419 percent.
“The critics of payday lending view these relatively high interest rates with much alarm, arguing that the fees charged are exploitative of poor borrowers lacking in personal financial management skills,” Lehman writes. “Yet, the effective annual interest rate on the payday loan may not even enter the mind of the borrower. In all likelihood, the borrower cares not what the ‘effective APR’ is on the loan. The real price signal to which the borrower responds is the flat fee that is charged to hold the postdated check. If the value attached by the borrower to the immediate cash advance exceeds the value of the principal plus the fee one or two weeks hence, then the borrower will undertake the transaction, pure and simple.”
Similarly, economist Thomas Sowell has written, “Using this kind of reasoning—or lack of reasoning—you could … say a hotel room rents for $36,000 a year, [but] few people stay in a hotel room all year.”
Thomas Miller Jr., professor of finance at Mississippi State University, wrote that “a 2013 Pew Charitable Trusts survey found that more than 60 percent of payday loan users would have to delay paying other bills without access to these loans. The alternative to short-term loan debt is being indebted to existing creditors—where failure to pay might mean losing access to utilities, like water and electricity.”
Lawmakers are working to shut down short-term lending as we know it. This would force low-income Americans to seek pricier options, including even higher-priced overdraft protection, bouncing personal checks or underground market alternatives. For lower-income Americans, these alternatives to installment or “payday” lending could push them over a financial edge.
To learn more about lending services for low-income and unbanked Americans, check out this month’s policy focus.