Payday loan
Encyclopedia
Loan
A loan is a type of debt. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the lender and the borrower....
that is intended to cover a borrower's expenses until his or her next payday. The loans are also sometimes referred to as cash advance
Cash advance
A cash advance is a service provided by most credit card and charge card issuers. The service allows cardholders to withdraw cash, either through an ATM or over the counter at a bank or other financial agency, up to a certain limit...
s, though that term can also refer to cash provided against a prearranged line of credit such as a credit card
Credit card
A credit card is a small plastic card issued to users as a system of payment. It allows its holder to buy goods and services based on the holder's promise to pay for these goods and services...
. Legislation
Legislation
Legislation is law which has been promulgated by a legislature or other governing body, or the process of making it...
regarding payday loans varies widely between different countries and, within the USA, between different states.
To prevent usury
Usury
Usury Originally, when the charging of interest was still banned by Christian churches, usury simply meant the charging of interest at any rate . In countries where the charging of interest became acceptable, the term came to be used for interest above the rate allowed by law...
(unreasonable and excessive rates of interest), some jurisdiction
Jurisdiction
Jurisdiction is the practical authority granted to a formally constituted legal body or to a political leader to deal with and make pronouncements on legal matters and, by implication, to administer justice within a defined area of responsibility...
s limit the annual percentage rate
Annual percentage rate
The term annual percentage rate , also called nominal APR, and the term effective APR, also called EAR, describe the interest rate for a whole year , rather than just a monthly fee/rate, as applied on a loan, mortgage loan, credit card, etc. It is a finance charge expressed as an annual rate...
(APR) that any lender, including payday lenders, can charge. Some jurisdictions outlaw payday lending entirely, and some have very few restrictions on payday lenders. Due to the extremely short-term nature of payday loans, the difference between nominal APR and effective APR (EAR) can be substantial, because EAR takes compounding
Compound interest
Compound interest arises when interest is added to the principal, so that from that moment on, the interest that has been added also itself earns interest. This addition of interest to the principal is called compounding...
into account. For a $15 charge on a $100 2-week payday loan, the APR is 26 × 15% = 390% but the EAR is (1.15
− 1) × 100% = 3,685%. Careful reporting of whether EAR or APR is quoted is necessary to make meaningful comparisons.Payday loans carry substantial risk to the lender; they have 10-20% default rate, and according to one study, defaults cost payday lenders around a quarter of their annual revenue.
The loan process
The basic loan process is simply that a lender provides a short-term unsecured loan to be repaid at the borrower's next pay day. Typically, some verification of employment or income is involved (via pay stubs and bank statements), but some lenders may omit this. Individual companies and franchisesFranchising
Franchising is the practice of using another firm's successful business model. The word 'franchise' is of anglo-French derivation - from franc- meaning free, and is used both as a noun and as a verb....
have their own underwriting criteria.
In the traditional retail model, borrowers visit a payday lending store and secure a small cash loan, with payment due in full at the borrower's next paycheck. The borrower writes a postdated check
Postdated
In banking, postdated refers to checks which have been written by the drawer for a date in the future. In the United States, postdated items are described in Article 3, Section 113 of the Uniform Commercial Code...
to the lender in the full amount of the loan plus fees. On the maturity date, the borrower is expected to return to the store to repay the loan in person. If the borrower does not repay the loan in person, the lender may redeem the check. If the account is short on funds to cover the check, the borrower may now face a bounced check fee from their bank
Bank
A bank is a financial institution that serves as a financial intermediary. The term "bank" may refer to one of several related types of entities:...
in addition to the costs of the loan, and the loan may incur additional fees and/or an increased interest rate as a result of the failure to pay.
In the more recent innovation of online payday loans, consumers complete the loan application online (or in some instances via fax
Fax
Fax , sometimes called telecopying, is the telephonic transmission of scanned printed material , normally to a telephone number connected to a printer or other output device...
, especially where documentation is required). The loan is then transferred by direct deposit
Direct deposit
Direct deposit also known as Direct credit is a banking term used to refer to certain payment systems used to transfer money where a payment is initiated by the payer not the payee, namely:* In Europe, the giro system...
to the borrower's account, and the loan repayment and/or the finance charge is electronically withdrawn on the borrower's next payday. According to some sources, many payday lenders operating on the internet do not run credit checks or verify income.
Opponents' charges
Payday lending is a controversial practice and faces both legal battles and public perception challenges in nearly every place where it is practiced.Draining money from low-income communities
Although also many normal-income people resort to payday lending, many people who use it are low-income people with few assets because these people are least able to secure normal, lower-interest-rate forms of credit. Since payday lending operations charge higher interest-rates than traditional banks and less commonly encourage savings or asset accumulation, they have the effect of depleting the assets of low-income communities.Exploiting financial hardship for profit
Critics such as the Consumers UnionConsumers Union
Consumers Union is a non-profit organization best known as the publisher of Consumer Reports, based in the United States. Its mission is to "test products, inform the public, and protect consumers."...
blame payday lenders for exploiting people's financial hardship for profit. They say lenders target the young and the poor, particularly those near military bases and in low-income communities. They also say that borrowers may not understand that the high interest rates are likely to trap them in a "debt-cycle," in which they have to repeatedly renew the loan and pay associated fees every two weeks until they can finally save enough to pay off the principal and get out of debt. Critics also say that payday lending unfairly disadvantages the poor, compared to members of the middle class
Middle class
The middle class is any class of people in the middle of a societal hierarchy. In Weberian socio-economic terms, the middle class is the broad group of people in contemporary society who fall socio-economically between the working class and upper class....
, who pay at most about 25% on their credit card
Credit card
A credit card is a small plastic card issued to users as a system of payment. It allows its holder to buy goods and services based on the holder's promise to pay for these goods and services...
purchases.
Aggressive advertising practices
The debt charity Credit ActionCredit Action
Credit Action is a UK charity founded in 1994 that promotes money education and financial literacy. Credit Action works with government, regulators and the lending industry and has a close partnership with the Consumer Credit Counselling Service , a debt counseling and management service.The...
made a complaint to the UK
United Kingdom
The United Kingdom of Great Britain and Northern IrelandIn the United Kingdom and Dependencies, other languages have been officially recognised as legitimate autochthonous languages under the European Charter for Regional or Minority Languages...
Office of Fair Trading
Office of Fair Trading
The Office of Fair Trading is a not-for-profit and non-ministerial government department of the United Kingdom, established by the Fair Trading Act 1973, which enforces both consumer protection and competition law, acting as the UK's economic regulator...
(OFT) that payday lenders were placing advertising
Advertising
Advertising is a form of communication used to persuade an audience to take some action with respect to products, ideas, or services. Most commonly, the desired result is to drive consumer behavior with respect to a commercial offering, although political and ideological advertising is also common...
on the social network
Social network
A social network is a social structure made up of individuals called "nodes", which are tied by one or more specific types of interdependency, such as friendship, kinship, common interest, financial exchange, dislike, sexual relationships, or relationships of beliefs, knowledge or prestige.Social...
website Facebook
Facebook
Facebook is a social networking service and website launched in February 2004, operated and privately owned by Facebook, Inc. , Facebook has more than 800 million active users. Users must register before using the site, after which they may create a personal profile, add other users as...
, which violates advertising regulations. The main complaint was that the APR
Annual percentage rate
The term annual percentage rate , also called nominal APR, and the term effective APR, also called EAR, describe the interest rate for a whole year , rather than just a monthly fee/rate, as applied on a loan, mortgage loan, credit card, etc. It is a finance charge expressed as an annual rate...
was either not displayed at all or not displayed prominently enough, which is clearly required by UK advertising standards.
Aggressive collection practices
In US law, a payday lender can use only the same industry standard collection practices used to collect other debts.In many cases, borrowers write a post-dated check (check with a future date) to the lender; if the borrowers don't have enough money in their account, their check will bounce. Some payday lenders have therefore threatened delinquent borrowers with criminal prosecution for check fraud. This practice is illegal in many jurisdictions.
Ignoring legal restrictions
Payday lenders have been known to ignore usury limits and charge higher amounts than they are entitled to by law. On May 30, 2008, the Illinois Department of Financial and Professional RegulationIllinois Department of Financial and Professional Regulation
The Illinois Department of Financial and Professional Regulation is an executive agency of the U.S. state of Illinois. It was created in 2004 by an executive order promulgated by Governor Rod Blagojevich....
fined Global Payday Loan $234,000—the largest fine in Illinois
Illinois
Illinois is the fifth-most populous state of the United States of America, and is often noted for being a microcosm of the entire country. With Chicago in the northeast, small industrial cities and great agricultural productivity in central and northern Illinois, and natural resources like coal,...
history against a payday lender—for exceeding the $15.50 per $100 limit on charges for payday loans. A customer, known only as J.M., had borrowed $300 and repaid $360 ($13.50 more than the company was legally entitled to collect under the Illinois Payday Loan Reform Act), but the company kept sending her warnings that her account was 'seriously delinquent' and that her unpaid balance was $630.
Pricing structure of payday loans
Issuers of payday loans defend their higher interest rates by saying processing costs for payday loans do not differ much from other loans, including home mortgages. They argue that conventional interest rates for lower dollar amounts and shorter terms would not be profitable. For example, a $100 one-week loan, at a 20% APR (compoundedCompound interest
Compound interest arises when interest is added to the principal, so that from that moment on, the interest that has been added also itself earns interest. This addition of interest to the principal is called compounding...
weekly) would generate only 38 cents of interest, which would fail to match loan processing costs.
Critics say payday lenders' processing costs are significantly lower than costs for mortgages and other traditional loans. Payday lenders usually look at recent pay stubs, whereas larger-loan lenders do full credit checks and make a detailed analysis of the borrower's ability to pay back the loan.
Charges are in line with costs
A study by the FDIC Center for Financial Research found that “operating costs are not that out of line with the size of advance fees” collected and that, after subtracting fixed operating costs and “unusually high rate of default losses,” payday loans “may not necessarily yield extraordinary profits.” Based on the annual reports of publicly traded payday loan companies, loan losses can average 15% or more of loan revenue. Underwriters of payday loans must also deal with people presenting fraudulent checks as security, ordering a check stopped, or closing their account.Critics concede that some borrowers may default on the loans, but point to the industry's pace of growth as an indication of its profitability. Consumer advocates condemn the practice as a whole, regardless of its profitability, because it "takes advantage of consumers who are already hard-pressed to pay their debts".
According to the Dallas Morning News, in 2008 the U.S.'s largest payday lender, Advance America, "made $4.2 billion in payday loans and charged $676 million in interest and fees." And "Cash America, a pawnshop operator and payday lender based in Fort Worth, recorded net income of $81 million last year – a 132 percent increase in just four years – on total revenue of $1.03 billion."
Markets provide services otherwise unavailable
Opponents of government regulation of payday loan businesses argue that some individuals that require the use of payday loans have already exhausted or ruined any other alternatives. Such consumers could potentially be forced to turn to loan sharks or other illegal sources if not for payday loans. Tom Lehman, an advocate of unfettered payday lending, said,- [P]ayday lending services extend small amounts of uncollateralized credit to high-risk borrowers, and provide loans to poor households when other financial institutions will not. Throughout the past decade, this "democratization of credit" has made small loans available to mass sectors of the population, and particularly the poor, that would not have had access to credit of any kind in the past....
Lehman attacked proponents of increased regulation of the lending industry, arguing that,
- These allegations against the payday-lending industry are largely without merit, and generally reflect the views of "do-gooder" anticapitalist elites who abhor the "messy" and unplanned outcomes in low-income consumer finance markets. Rather than seeing payday lending practices as a creative extension of credit to poor households who may otherwise be without loans, these critics see it as yet another opportunity for government intervention in the name of "helping" the poor.
Lehman has in turn been criticized for presenting himself as an independent voice while taking money from the payday loan industry.
Household welfare increased
A staff report released by the Federal Reserve Bank of New YorkFederal Reserve Bank of New York
The Federal Reserve Bank of New York is one of the 12 Federal Reserve Banks of the United States. It is located at 33 Liberty Street, New York, NY. It is responsible for the Second District of the Federal Reserve System, which encompasses New York state, the 12 northern counties of New Jersey,...
concluded that payday loans should not be categorized as "predatory" since they may improve household welfare. "Defining and Detecting Predatory Lending" reports "if payday lenders raise household welfare by relaxing credit constraints, anti-predatory legislation may lower it." The author of the report, Donald P. Morgan, defined predatory lending as "a welfare reducing provision of credit." However, he also noted that loans are very expensive, and that they are likely to be made to under-educated households or households of uncertain income.
Other studies have questioned this claim. Petru Stelian Stoianovici, a researcher from The Brattle Group
The Brattle Group
The Brattle Group provides consulting services and expert testimony in economics, finance, and regulation to corporations, law firms, and public agencies...
, and Michael T. Maloney, an economics professor from Clemson University
Clemson University
Clemson University is an American public, coeducational, land-grant, sea-grant, research university located in Clemson, South Carolina, United States....
, found "no empirical evidence that payday lending leads to more bankruptcy filings, which casts doubt on the debt trap argument against payday lending."
An aid in disaster areas
A 2009 study by University of Chicago Booth School of Business Prof. Adair Morse found that in natural disaster areas where payday loans were readily available, consumers fared better than those in disaster zones where payday lending was not present. Not only were fewer foreclosures recorded, but such categories as birth rate were not affected adversely by comparison. Moreover, Morse's study found that fewer people in areas served by payday lenders were treated for drug and alcohol addiction.Australia
The Australian states of New South WalesNew South Wales
New South Wales is a state of :Australia, located in the east of the country. It is bordered by Queensland, Victoria and South Australia to the north, south and west respectively. To the east, the state is bordered by the Tasman Sea, which forms part of the Pacific Ocean. New South Wales...
and Queensland
Queensland
Queensland is a state of Australia, occupying the north-eastern section of the mainland continent. It is bordered by the Northern Territory, South Australia and New South Wales to the west, south-west and south respectively. To the east, Queensland is bordered by the Coral Sea and Pacific Ocean...
have imposed a 48%-APR maximum loan rate, including fees and brokerage.
Canada
Payday loans in Canada are limited by usuryUsury
Usury Originally, when the charging of interest was still banned by Christian churches, usury simply meant the charging of interest at any rate . In countries where the charging of interest became acceptable, the term came to be used for interest above the rate allowed by law...
laws, with any rate of interest charged above 60% per annum considered criminal according to the Criminal Code of Canada
Criminal Code of Canada
The Criminal Code or Code criminel is a law that codifies most criminal offences and procedures in Canada. Its official long title is "An Act respecting the criminal law"...
. In addition, the provinces of British Columbia
British Columbia
British Columbia is the westernmost of Canada's provinces and is known for its natural beauty, as reflected in its Latin motto, Splendor sine occasu . Its name was chosen by Queen Victoria in 1858...
and Saskatchewan
Saskatchewan
Saskatchewan is a prairie province in Canada, which has an area of . Saskatchewan is bordered on the west by Alberta, on the north by the Northwest Territories, on the east by Manitoba, and on the south by the U.S. states of Montana and North Dakota....
have imposed specific regulations on payday loans, including lower interest rate caps.
UK
Payday loans in the United KingdomUnited Kingdom
The United Kingdom of Great Britain and Northern IrelandIn the United Kingdom and Dependencies, other languages have been officially recognised as legitimate autochthonous languages under the European Charter for Regional or Minority Languages...
are a rapidly growing industry, with four times as many people using such loans in 2009 compared to 2006 - in 2009 1.2 million people took out 4.1 million loans, with total lending amounting to £1.2 billion. The average loan size is around £300, and two-thirds of borrowers have annual incomes below £25,000. There are no restrictions on the interest rates payday loan companies can charge, although they are required by law to state the effective annual percentage rate
Annual percentage rate
The term annual percentage rate , also called nominal APR, and the term effective APR, also called EAR, describe the interest rate for a whole year , rather than just a monthly fee/rate, as applied on a loan, mortgage loan, credit card, etc. It is a finance charge expressed as an annual rate...
(APR).
United States
Payday lending is legal and regulated in 37 states. In 13 states it is either illegal or not feasible, given state law. When not explicitly banned, laws that prohibit payday lending are usually in the form of usuryUsury
Usury Originally, when the charging of interest was still banned by Christian churches, usury simply meant the charging of interest at any rate . In countries where the charging of interest became acceptable, the term came to be used for interest above the rate allowed by law...
limits: hard interest rate caps calculated strictly by annual percentage rate
Annual percentage rate
The term annual percentage rate , also called nominal APR, and the term effective APR, also called EAR, describe the interest rate for a whole year , rather than just a monthly fee/rate, as applied on a loan, mortgage loan, credit card, etc. It is a finance charge expressed as an annual rate...
(APR). Since Oct. 1, 2007 a federal law has capped lending to military personnel at a maximum of 36% APR as defined by the Secretary of Defense.
Alternatives to payday loans
Other options are available to most payday loan customers. These include pawnbrokerPawnbroker
A pawnbroker is an individual or business that offers secured loans to people, with items of personal property used as collateral...
s, credit union loans with lower interest and more stringent terms, credit payment plans, paycheck cash advances from employers, bank overdraft protection, cash advances from credit cards, emergency community assistance plans, small consumer loans and direct loans from family or friends.
Payday lenders do not compare their interest rate
Interest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...
s to those of mainstream lenders. Instead, they compare their fee
Fee
A fee is the price one pays as remuneration for services. Fees usually allow for overhead, wages, costs, and markup.Traditionally, professionals in Great Britain received a fee in contradistinction to a payment, salary, or wage, and would often use guineas rather than pounds as units of account...
s to the overdraft
Overdraft
An overdraft occurs when money is withdrawn from a bank account and the available balance goes below zero. In this situation the account is said to be "overdrawn". If there is a prior agreement with the account provider for an overdraft, and the amount overdrawn is within the authorized overdraft...
, late payment, and penalty fees that will be incurred if the customer is unable to secure any credit whatsoever.
The lenders therefore list a different set of alternatives (costs expressed here as APRs for two-week terms):
- $100 payday advance with $15 fee = 391% APR;
- $100 bounced check with $48 NSF/merchant fees = 1,251% APR;
- $100 credit card balance with $26 late fee = 678% APR;
- $100 utility bill with $50 late/reconnect fees = 1,304% APR.
Other alternatives include the Pentagon Federal Credit Union Foundation (PenFed Foundation)
The Pentagon Federal Credit Union Foundation (PenFed Foundation)
The Pentagon Federal Credit Union Foundation is a nonprofit national charity working to meet unmet needs of the military personnel and their families in the areas of financial literacy, housing and support for the wounded.-Overview:...
Asset Recovery Kit (ARK) program. Through the ARK program, the foundation has helped nearly 4,000 military families with over $1.6 million worth of emergency loans and financial counseling from the highly regarded Consumer Credit Counseling Service.
Variations on payday lending
A minority of mainstream bankBank
A bank is a financial institution that serves as a financial intermediary. The term "bank" may refer to one of several related types of entities:...
s and TxtLoan
TxtLoan
Txtloan provides instant short term loans through mobile phone text messaging. The service is marketed as a convenient alternative to payday loans and to unauthorised bank overdrafts and associated penalty charges, although The Guardian called it "a hi-tech version of the 'payday loan'".How it...
companies lending short-term credit over mobile phone text messaging offer virtual credit advances for customers whose paychecks or other funds are deposited electronically into their accounts. The terms are similar to those of a payday loan; a customer receives a predetermined cash credit available for immediate withdrawal. The amount is deducted, along with a fee, usually about 10 percent of the amount borrowed, when the next direct deposit is posted to the customer's account. After the programs attracted regulatory attention, Wells Fargo called its fee "voluntary" and offered to waive it for any reason. It later scaled back the program in several states. Wells Fargo currently offers its version of a payday loan, called "Direct Deposit Advance," which charges 120% APR. Similarly, BBC
BBC
The British Broadcasting Corporation is a British public service broadcaster. Its headquarters is at Broadcasting House in the City of Westminster, London. It is the largest broadcaster in the world, with about 23,000 staff...
reported in 2010 that controversial TxtLoan
TxtLoan
Txtloan provides instant short term loans through mobile phone text messaging. The service is marketed as a convenient alternative to payday loans and to unauthorised bank overdrafts and associated penalty charges, although The Guardian called it "a hi-tech version of the 'payday loan'".How it...
charges 10% for 7-days advance which is available for approved customers instantly over a text message.
Income tax refund anticipation loan
Refund Anticipation Loan
A refund anticipation loan is a short-term consumer loan secured by a taxpayer’s expected tax refund, and designed to offer customers quicker access to funds than waiting for their tax refund...
s are not technically payday loans (because they are repayable upon receipt of the borrower's income tax refund, not at his next payday), but they have similar credit and cost characteristics. A car title loan is secured by the borrower's car, but are available only to borrowers who hold clear title (i.e., no other loans) to a vehicle. The maximum amount of the loan is some fraction of the resale value of the car. A similar credit facility seen in the UK is a logbook loan
Logbook loan
A logbook loan is a British term for a bill of sale securing a loan on a debtor's vehicle . The structure of the loan means that the lender can repossess the debtor's vehicle without a court order...
secured against a car's logbook, which the lender retains. These loans may be available on slightly better terms than an unsecured payday loan, since they are less risky to the lender. If the borrower defaults, then the lender can attempt to recover costs by repossessing and reselling the car.
See also
- Alternative financial servicesAlternative financial servicesAlternative financial services are financial services provided outside traditional banking institutions, on which many low-income individuals depend. In developing countries, these services often take the form of microfinance...
- Predatory lendingPredatory lendingPredatory lending describes unfair, deceptive, or fraudulent practices of some lenders during the loan origination process. While there are no legal definitions in the United States for predatory lending, an audit report on predatory lending from the office of inspector general of the FDIC broadly...
- Loan sharking
- Community Financial Services Association of AmericaCommunity Financial Services Association of AmericaThe Community Financial Services Association of America is the national organization dedicated to advancing financial empowerment for consumers through small dollar, short-term loans...