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.