Payday Loans: Myths and reality

A recent broadcast of NPR’s MarketPlace Money featured a short commentary by Tom Lehman, a professor at Indiana Wesleyan University, defending payday lending.  Responding to widespread concerns about the high cost of payday loans and their tendency to trap borrowers on a treadmill of debt, nearly half of all states have either prohibited payday loans (15 states) or enacted tight limits on fees and loan usage (8 states), according to a recent report by the Pew Charitable Trusts.

In arguing against restrictions on payday lending, Prof. Lehman states that, “You do not help marginal borrowers by laying out their available options and then eliminating by regulation the one they actually choose.” However, his defense of payday lending is based on several major errors and mischaracterizations.

Myth #1: The typical fee for a payday loan is $25

Prof. Lehman claims fees for payday loans are “typically $25 per transaction.” In reality, the average fee on a payday loan in Oklahoma is more than twice that – $52.94, according to the state’s deferred deposit loan database. A borrower taking out the maximum allowable loan of $500 will be charged $65 for a loan of as short as 12 days. That equates to an Annual Percentage Rate of 395 percent.

More significantly, the average borrower takes out 7 loans over the course of a year, which means they incur annual fees of $370.  Over the the most recent 12-month period for which data is available, Oklahomans took out over 1 million payday loans and paid out $54.3 million in fees.

Myth #2: Most borrowers use payday loans for unexpected emergencies

Echoing the official industry line, Prof. Lehman asserts that payday borrowers who take out multiple loans are “almost always” confronted by “unexpected financial emergencies, like surprise medical bills or car repairs.” 

Actually, most of the borrowers surveyed in the Pew Study said they used payday loans for recurring expenses, not emergencies.  More than two in three payday borrowers – 69 percent – used their initial payday loan to cover recurring expenses like utilities, car payments, credit card bills, rent or food. Just 16 percent used a payday loan for an unexpected emergency expense..

The fact that most borrowers turn to payday loans to deal with recurring expenses explains the pattern of repeat and chronic borrowing associated with most customers. In Oklahoma, about 75 percent of loans go to borrowers who take out 9 or more loans over the course of a year, and a full 50 percent average at least one loan every single month (see graph).  Struggling consumers turn to payday loans because they find themselves without enough money to make ends meet. While many first-time borrowers assume a payday loan will provide a one-time fix, the reality is that few borrowers’ financial problems have been resolved by the time the loan comes due two weeks later. Spurred on by ‘helpful’ lenders, borrowers take out a second loan to pay off the first, and then a third and a fourth; it’s like burning your furniture to heat your house.  The typical Oklahoma payday loan borrowers ends up indebted for 212 days of the year. 

Myth #3:  Payday loans are the best recourse for borrowers with no other options

Prof. Lehman refers to payday loans as a vital credit option “for households with no other recourse for loans”, who would otherwise be faced with bank overdraft charges, late fees and disconnect penalties from utilities.

In reality, most payday borrowers have less expensive options. The Pew Survey asked borrowers what they would do if faced with a cash shortfall and payday loans were unavailable. Eighty-one percent said they would cut back on expenses, 62 percent would delay paying some bills, 57 percent would borrow from family and friends, and 57 percent would sell or pawn personal possessions. None of these alternatives is likely to lead to large, recurring fees as borrowers take out successive high-cost loans. What’s more, taking out payday loans fails to avert the worst financial outcomes – research finds that payday borrowers are more likely to become delinquent on their credit cards, pay other bills late, and get hit with bank overdraft fees.

One argument against restricting payday loan stores is that desperate consumers will turn to online payday lending, which is largely unregulated and even more expensive. Yet comparing usage in states with permissive and restrictive laws, Pew was able to conclude that in states that restrict payday lending, 95 out of 100 would-be borrowers elect not to use payday loans at all – just five borrow online or elsewhere.

The Pew report found that more Oklahomans turn to payday loans than residents of any other state. Rather than swallow the myths, Oklahoma policymakers need to look at the reality of payday lending and adopt strong reforms that will protect Oklahoma consumers.