ARE PAYDAY LOANS HARMFUL TO CONSUMERS? RESPONSE TO HOROWITZ

Alex Horowitz's informative essay illustrates three significant points of agreement between us: (1) research on payday lending does not yield a definitive ruling on whether these loans are helpful or harmful, (2) it is possible to make lower priced credit available to a significant number of borrowers who currently rely on payday loans, and (3) loan products whose profitability depends on nonpayment are not good for consumers. In both of our essays, we introduce potential solutions for increasing the supply of safe, affordable credit to people who need it.

Despite our agreement on these three points, we take different stands on the helpful versus harmful debate. Although Horowitz allows that the findings from research into whether payday loans are helpful or harmful have been “decidedly mixed,” he maintains that “the harm that payday loans inflict on consumers is clear and substantial.” I contend that, given the results of the range of available research, the jury is still out on this question. Further, in many cases, for example, the increasing number of borrowers suffering from income volatility, payday loans meet a demand for small dollar credit where no other options exist. For a significant number of borrowers, the cost of the loan is preferable to the alternative, that is, inability to pay bills, buy food, get to work.

Both Horowitz and I believe that much of the demand for small dollar credit can be met with more affordable options. In the next section of this essay, I examine his two proposals: (1) shifting from lump sum loans to less expensive installment loans, as Colorado has done; and (2) getting banks to provide small dollar credit.

The primary best practice Horowitz puts forward in his essay is the Colorado example, which resulted in: (1) a large decrease in annual percentage rate (APR); and (2) smaller payments for borrowers. Indeed, in anticipation of the forthcoming Consumer Financial Protection Bureau (CFPB) rules, many payday lenders have begun to offer installment loans in addition to lump sum loans (National Consumer Law Center, 2015).1

The number of borrowers also decreased by 9 percent, and we do not know what happened to the 20,570 people who did not appear in the follow-up study. It is possible that a smaller number of people needed loans at the later date. But, because the Colorado study covers only storefront lenders, it is also possible that people shifted their borrowing from storefront to online lenders,2 the fastest growing segment of the payday lending industry (Quittner, 2015). The 9 percent may also have incurred greater overdraft fees, a much more expensive form of short-term loan, or had to deal with arguably worse consequences than high-cost credit.

It is unclear whether Horowitz is advocating that a Colorado-like system, including the 120 percent APR lenders currently charge, should be expanded. There is a disconnect between this interest rate and the much lower rates most consumer advocacy groups support—36 percent is common (Saunders, 2013); these lower rates would make credit much less available than it is under the Colorado model. Is the Colorado case offered as a best practice, perhaps a form of “harm reduction,” or is it simply forwarded to prove the point that lenders can charge less and still be profitable?

There are two additional problems with the Colorado example. First, loan payments are calculated as a share of income, no more than 5 percent of a borrower's paycheck, a recommendation that clearly lowers the total cost of the loan. However, any formula that calculates repayment as a share of income is too simplistic (Klein, 2016). First, it fails to take into account the other credit obligations borrowers face. Second, other research shows that income and ability to pay are not highly correlated (Nuñez et al., 2016). And third, debt-to-income formulas assume that borrower income is relatively stable. The combination of high income volatility and the fact that borrowers often derive their income from multiple sources (Hacker, 2008; Morduch & Schneider, 2013) makes it difficult for borrowers to reliably calculate their income.

The second problem with the Colorado example is the wide variation in states’ interest rates and in states’ ability to charge fees along with interest. Although the CFPB has proposed some rules for specific installment loans, the bureau does not have the power to limit interest rates (National Consumer Law Center, 2015). If Colorado-style installment loans, with their 120 percent interest rates, are the answer, interest rates this high are only allowable in a handful of states. It is not currently possible for lenders in all states to shift from lump sum to installment loans and continue to make a profit.

Changing states’ laws is a complex, lengthy process. In the meantime, the CFPB's proposed rules, if enacted, will eliminate 70 to 75 percent of the current lump sum loan industry, according to the Bureau's projections (Consumer Financial Protection Bureau, 2016).

The second solution Horowitz proposes is for banks and credit unions to offer small dollar credit, and he cites a set of comparative advantages these institutions enjoy over other lenders. It's true that banks and credit unions could provide these loans. However, although both Horowitz and I cited banks that make affordable small dollar loans (KeyBank and Fifth Third Bank) in our earlier essays as best practices, it is unlikely that other banks will follow suit in large enough numbers to move the needle.

Horowitz maintains that the reasons most banks fail to offer small dollar loans concerns “the regulatory uncertainty around acceptable underwriting practices, loan terms, and pricing.” Indeed, it would require a regulatory reversal to get banks back into this market. Payday-like deposit advance loans, which many banks offered, were effectively regulated away by the FDIC in 2013 (Federal Deposit Insurance Corporation, 6714-01-P, 2013).

But it's difficult to position banks as the white knights in this conversation. Despite the comparative advantages banks enjoy relative to other lenders, most have neither the desire nor the incentive to offer small dollar loans. Overall, banks have pulled back from serving lower income and less financially stable consumers in the wake of the financial crisis, and a rash of lawsuits over the past several years concerning practices that maximize overdraft fees (Servon, 2017; The Pew Charitable Trusts, 2015), discriminate against African-American consumers (Gordon, 2015), and opening false accounts, illustrate that many banks’ practices are less than ethical. The Pew Charitable Trusts, the organization for which Horowitz works, has done terrific work to expose these practices, some of which has resulted in meaningful change. Given the track record of banks, it seems overly idealistic to presume that they will begin to provide payday-like loans.

Horowitz observes that borrowers spend “roughly $9 billion annually on payday loan fees as part of the more than $30 billion they spend annually on finance charges for small nonbank credit.” But consumers paid $32.5 billion to banks in overdraft fees alone in 2015 (Moebs Services, 2015). Overdraft disproportionately affects young and low-income consumers, the very market that payday lending historically attracts. A 2008 FDIC study found that 84 percent of overdraft revenue was generated by just 9 percent of checking account holders, who tend to be among the most disadvantaged of this group.3 In addition, the majority of overdraft fees were incurred for transactions of $24 or less. As the CFPB reported, “if a consumer borrowed $24 for three days and paid the median overdraft fee of $34, such a loan would carry a 17,000 percent annual percentage rate (APR).”4 And repeated overdrafts negatively affect one's credit score and bankability, whereas defaulting on a payday loan does not.

More important than our differences, Horowitz and I agree that innovations and alternatives can and are being developed and brought to market. These innovations should shift a significant chunk of current borrowers from payday loans to safer, more affordable products. While we work to give promising solutions visibility and support, we must not forget the large group of insolvent and perpetually unstable consumers who have been left behind by economic and policy changes. These consumers are part of the same problem, and they deserve our attention.