By Justin P. Hauke

Last week, Attorney General Jay Nixon called for reform to Missouri’s payday loan industry, arguing that lenders engage in predatory practices targeted at uninformed consumers. Nixon proposes legislation to cap payday loan rates at 36 percent, and eliminate the practice of renewing outstanding loans — a practice, many argue, that traps borrowers in a vicious cycle of spiraling debt. But capping the rate of interest will do little to alleviate debtors’ financial burdens.

Rather than passing new regulation, the Legislature should encourage programs that increase financial literacy, and encourage borrowers to seek alternative sources of short-term financing — such as lines of credit, or credit unions.

Consumer advocate groups claim that payday loans — shortterm loans intended to cover borrowers’ expenses until their next paycheck — are predatory, with lenders preying on uninformed consumers who have little access to credit. As evidence, they cite the
exorbitant fees and interest charged by such lenders, ranging from 422 percent to as high as 1,950 percent in Missouri. They point out that when borrowers can’t repay under such terms, lenders encourage creditors to “roll” their outstanding debt into new loans with new fees, making the original loan even more expensive.

But in their zeal to protect consumers, regulatory advocates ignore basic tenets of supply and demand, falsely concluding that payday lenders are charging these exorbitant rates out of sheer whim, rather than because of market forces. What they fail to consider is that if lenders are earning abnormally high profits, why don’t new lenders enter the market and compete rates down to lower levels? There are few barriers to entry in the payday loan industry. In fact, anyone with some spare cash could conceivably start such a business.

The reality is that consumer interest rates are primarily determined by credit risk, and higher risk requires greater compensation. When a bank issues a loan, it goes through a lengthy process to determine whether or not the borrower will default. For example, it may require verification of income, a cosigner, or some form of collateral. In contrast, payday lenders are often unable to verify their borrowers’ backgrounds, and have no way of knowing whether any particular borrower is a good credit risk. Moreover, since payday loans generally represent “credit of last resort,” it may be that borrowers seeking payday loans are precisely the borrowers most likely to default — what economists refer to as adverse selection.

In other words, payday lenders charge high fees to ensure that they collect enough money from borrowers who are able to pay to compensate them for loans that end in default. If the Legislature caps payday loan rates, lenders will be forced to issue fewer of them — and then only to lower-risk creditors. And since payday loan consumers have the highest risk of default, they are the people most likely to be priced out of the market.

Several states have passed legislation in recent years limiting payday loan interest rates. Oregon passed such a law in June, arguing that it would help save consumers millions of dollars in interest. But in subsequent months, payday loan revenues have dropped more than 70 percent, and more than 100 loan establishments have closed. The result has been less access to credit for the thousands of Oregonians who rely on payday loans to offset unexpected expenses — such as emergency medical care — forcing them either to forego such expenses or seek credit in the black market.

Fortunately, there are ways in which the Legislature can help consumers. Several states have encouraged credit unions to expand existing short-term loan programs as alternatives to payday loans. Credit unions are better able to “pool” risk on short-term loans, allowing them to charge lower rates than payday lenders. But most importantly, the Legislature should encourage programs that promote financial literacy, so that consumers are better aware of loan costs and the alternatives they can seek.

In short, payday loan reform is a “feel good” legislative issue that does little to address the problem it is designed to fix. If legislators are concerned with predatory lending practices, they should work to increase education rather than pricing consumers out of the market entirely, forcing them to obtain funds under much worse conditions. Those willing to borrow money at a rate of 1,950 percent are likely in such desperate financial straits that they will find creditors in any case — whether legally with a payday loan, or illegally in the black market. At least with a payday lender, default is settled in court. In the black market, it usually involves a crowbar.

Justin P. Hauke is a research assistant for the Show-Me Institute, a Missouri-based think tank, and a graduate student at Washington University’s Olin Business School.

Comments

comments