AN ANALYSIS OF CONSUMERS’ USE OF PAYDAY LOANS

Payday lending is a controversial segment of the consumer finance industry. A payday loan is a small, single-payment loan that is repayable on the borrower’s next payday. Typically, payday loans are between $100 and $500 and have a term to maturity of about 14 days.

Because of the small loan amount and short term to maturity, annual percentage rates for payday loans are commonly between 390 and 700 percent. Not surprisingly, the high annual percentage rates have led to allegations that payday loans are predatory.

Industry critics often argue that the high interest charges and single-payment feature of the product make repayment of the debt difficult, trapping many borrowers in a series of renewals that ultimately lead to insolvency.

Payday lenders contend that the product satisfies credit-constrained consumers’ liquidity needs for short-term credit to manage unexpected expenses and shortfalls in cash. Although payday loans have a high price, the costs arising from delinquencies and late payments that such unexpected events could trigger may be even higher.

These contentions need not be mutually exclusive. As with other credit products, some borrowers may have problems repaying while others are able to pay on time and receive benefits from the item being financed.

Historically, consumer finance companies provided small loans to relatively highrisk, credit constrained consumers. Finance companies have largely abandoned the small loan market (Brito and Hartley 1995). Finance companies along with banks and credit unions prefer to provide access to such credit to more creditworthy consumers through revolving accounts.

A notable characteristic that distinguishes payday loan customers from customers of other high-price lenders—such as pawnbrokers and rent to own companies—is that all payday loan customers have a banking relationship.

Payday loan customers must have a checking account to qualify for a payday loan, and most have an automobile loan or other type of consumer debt with a bank or finance company. The modern payday loan industry developed during the 1990s.

The industry originated as an innovation in the check cashing industry: The check cashing firm took the customer’s post-dated personal check and agreed to defer cashing the check until a few days later (Mann and Hawkins 2007). The payday loan industry has grown considerably since its inception.

The number of payday loan offices grew from under 200 offices in the early 1990s (Caskey 2001) to over 22,800 offices at the end of 2005 (Samolyk 2007). Check cashing companies remain a major source of payday loans, but pawnbrokers and monoline payday loan companies are also important sources of payday loans.

This monograph reviews existing evidence and presents new evidence on the economic and demographic characteristics of payday loan customers, their patterns of payday loan use, their understanding of payday loan costs and alternatives, and outcomes of payday loan use.

This monograph seeks to assess whether payday loan customers know what they are doing when they use such credit and the extent to which payday loan credit benefits or harms consumers. Chapter I provides a brief description of the payday loan product, its costs, and regulation.

Chapter II outlines economic and psychological models for consumer credit decisions. These models are the framework for analysis of the evidence on payday loan decisions. Chapter III describes new survey data.

Chapter IV examines whether or not demographic and economic characteristics of payday loan customers are consistent with predictions from the economic model for consumer credit use.

Chapter V examines payday loan customers’ most recent new payday loan transaction for evidence of whether or not customers’ decisions were purposive and intelligent.

Chapter VI reviews evidence from previous studies that investigate whether or not consumers obtain any benefits from payday loans or whether or not payday loans lead to unsustainable levels of debt that end in default. Finally, Chapter VII provides a brief summary and conclusions.

A. The Payday Loan Transaction

A payday loan is a small, short-term, single-payment consumer loan. In a payday loan transaction, the customer writes a personal check for the sum of the loan amount and finance charge. The payday loan company agrees in writing to defer presentment of the check until the customer’s next payday, which is typically 10 to 30 days later.

At the next payday, the customer may redeem the check by paying the loan amount and the finance charge, or the payday advance company may cash the check. In some states, the customer may extend the payday loan by paying only the finance charge and writing a new check.

Payday loans usually range from $100 to $500, although some states permit payday loans up to $1,000. Finance charges are typically between $15 and $20 per $100 of the loan amount. The calculation of the cost of a payday loan is straightforward.

Consider, for example, a customer borrowing $200 for 14 days, where the finance charge is assessed at a rate of $15 per $100 borrowed. The finance charge is $200 × ($15 ÷ $100) = $30. The annual percentage rate for this transaction is 391.07 percent, which is the periodic rate ($15 ÷ $100) = 15.00 percent multiplied by 26.07, the number of 14-day periods in a year.

The underwriting process for payday loans consists primarily of verifying the applicant’s income and the existence of a bank account. Payday loan companies typically request that applicants provide the last bank statement, the last pay stub, identification (for example, Social Security number and driving license), and proof of residence.

Companies generally limit the maximum amount of the loan to a specified percentage of the customer’s take-home pay. Unlike traditional lenders, payday loan companies do not obtain a credit bureau report.

However, some companies do subscribe to a risk assessment service that provides information on the applicant’s recent payday loan use and warns the company if an applicant uses a fraudulent Social Security number.

The risk assessment service may also provide the company other information about the applicant including charge-offs or payments on charge-offs for non-prime financial, service, or rental agreements; landlord or other business enquiries; evictions; and bankruptcy filings.

In addition, the risk assessment service offers skip tracing services, a payday loan risk score, and automated decision making.

Taking a post-dated check helps reduce the costs of collection. If the consumer fails to redeem the check, the payday loan company has a relatively low-cost method of collection. The company can deposit the check to obtain payment of the loan amount and finance charge.

Depositing the check does not ensure payment, of course, since the customer may not have sufficient funds in his account. But not having sufficient funds in the account subjects the customer to overdraft fees, which makes failure to repay the payday loan costly to the customer.

Thus, the post-dated check provides an incentive to repay the payday loan, thereby reducing the probability of default and the expected value of collection costs.

B. Payday Loan Costs

Studies of costs of consumer lending typically classify costs into operating expense, cost of borrowed funds, and taxes. Operating expense is by far the largest category of costs. Operating expense consists of expenses for loan acquisition, processing of payments, collection of delinquent accounts, and loan losses.

Loan acquisition expenses include taking an application, evaluating an application, preparing loan documents, and dispersing funds. Processing expenses include receiving and recording payments, and monitoring accounts to ensure prompt payment.

Collection costs include monitoring accounts and contacting customers who are late to arrange for collection of late payments. Most of these activities must be performed whenever an application is taken or a loan is extended, regardless of the size of the loan.

Consequently, operating expense is greater relative to loan size for small loans than for large loans. This characteristic of loan costs produces the result that break-even interest rates are higher for small loans than for large loans.

Total revenue and operating costs for payday lending are quite high relative to the loan amount. In an analysis of data from two large, monoline payday loan companies for 2002 through 2004, Flannery and Samolyk (2005) found total revenue of $407.16 per $100 of average outstanding loans and operating expense of $393.08 per $100 of average outstanding loans (table I-1).

These amounts are considerably larger than revenue and operating costs at finance companies making small loans in a size range comparable to payday loans.

A study of lenders in Texas found that these finance companies, which operate under special rate ceilings that permit rates in excess of 100 percent, had total revenue of $102.75 per $100 of average outstanding loans and operating costs of $81.62 per $100 of average outstanding loans (column 2).

Revenues and costs at both payday lenders and these specialized finance companies are large because the small loan size and short term to maturity cause average outstanding loans to be relatively small.

Finance companies that lend larger amounts for longer periods of time had total revenue of $23.73 per $100 of average outstanding loans and operating cost of $12.72 per $100 of average outstanding loans (column 3).

Flannery and Samolyk pointed also to the rapid growth of the companies as a factor contributing to high costs of payday lending. A sizable proportion of new offices at these companies spread overhead and fixed costs over low loan volumes, raising average cost per loan.

Regardless of the cause, the high operating costs associated with payday lending largely offset the revenue generated by this high-annual percentage rate product. The operating profit (that is, profit before funding cost and taxes) of $14.08 per $100 of average outstanding loans for payday lending does not appear to be especially large compared to operating profits of the other high-risk lenders.

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