The difficulty earning decent yields from traditional investments is well documented. Walk into any community or commercial bank and you’ll see interest rates on savings accounts at less than 1% per year (before taxes). What if there was a business that offered annual interest rates of 400% or more?1 Images of ‘wise guys’ or ‘loan sharks’ probably come to mind.
It’s actually the payday lending industry, where small loans are offered to desperate borrowers on a very short-term basis, at astronomical annualized interest rates. As you might expect, payday lending is a very controversial industry and there is substantial backlash. Consumer advocates claim payday lenders pray on minorities and the poor. Google has even gone so far as to ban advertisements for payday lenders.2
What are Payday Loans?
Payday loans (also known as cash advance loans or payday advances) are short-term loans (typically 90 days or less) intended to provide interim support for borrowers until they receive their next paycheck with which they can repay the loan.
The average duration of a payday loan is two weeks.2 As such, the loans themselves are relatively small in size, often between $100 and $1,000.3
Lenders typically tack on a $15 to $30 ‘finance charge’ to the loan. Here’s the thing, 4 out of 5 payday loans get renewed within two weeks, meaning they are unpaid and get rolled over into another two week loan.4 This begins the cycle that is so profitable for payday lenders. Combine the small loan size and short-term loan length, and you can see how the annual percentage rates (APR) can quickly get out of control, sometimes up to 780% annualized.5 A $15 finance charge on a $100, two week loan balloons to a 390% APR if continually renewed for a year. According to the Consumer Finance Protection Bureau, 1 in 5 payday borrowers end up owing more in fees and interest than the principal amount of the loan they began with.6 Borrowers get caught in the payday lending cycle and may never get out.
Now this is certainly not a new business. Wise guys and loan sharks have been offering high interest loans probably as long as there has been money. But the difference is the scale of the current payday lending industry. Payday lending has grown into a $46 billion industry.7
Despite oversight by the CFPB, there is some backlash against payday lending restrictions. There is a (small) case to be made for payday lending if used sparingly and if the loan is paid back in full, by the loan due date. 10 million Americans use payday lenders and want to continue using their services.8 Without access to the funds they provide, people could experience serious financial hardship.
Defaulting on a Payday Loan
The real problem comes when a borrower stops making payments on his loan. You could be sued in civil court and if you get a court judgement against you, you may have personal property seized, via law enforcement, to repay the loan. A more likely scenario is the debt gets sold to a third party debt collector. The debt collector may even be an offshore entity, so adherence to the Fair Debt Collections Act is doubtful. During communication, the debt collector will accuse you of some type of fraud which could land you in jail if you don’t repay the loan. Assuming you did not commit a fraud, or take out the loan with the intention of not paying it back, you cannot be sent to jail since we do not have debtor’s prisons in the United States.
You’ll likely be harassed by phone calls but there are limits to how collectors can operate according to the Fair Debt Collections Act. If the calls don’t end, here is what Justin Harelik, founder of Westgate Law firm in Los Angeles suggests letting the debt collector know you think he may be a scam and that you won’t be paying.9
The theory goes if the collector thinks you are not afraid of them, he will move on to another, easier victim. If you continue to be harassed by a debt collector, check the Federal Trade Commission’s website to see if there have been any actions against them or file a complaint yourself.10
Further, the longer you delay repayment on the loans, the more fees and interest continue to accumulate. Many would believe that this would be illegal. They’d be partially right. Payday lending is subject to state regulation. Due to backlash, there are regulations (typically caps on the interest rates charged) on the industry by eighteen states.11 But there are 32 states where consumer protections are quite lacking, including Florida, Texas, Illinois and California. Each state may have its own nuances with regards to regulations. Ohio has the most consumer friendly regulations, which caps payday lender’s interest rates at 28%, in line with some credit card rates.12 Other states attacked the problem by targeting the loan lengths.
If you can’t beat them, join them. If you think payday lending is just a shady, back-alley operation, you’d be mistaken. You might be surprised to learn that some payday lenders are actually publicly traded companies. Payday lender QC Holdings (symbol: QCCO), pawn shops owner Cash America International (symbol: CSH), and debt buyer PRA Group (symbol: PRAA) are prominent names in this alternative financing industry.13 If you believe this industry is likely to continue operating, these are some names to follow. Expect continued backlash against the industry by consumer advocate groups met by equally powerful lobbying efforts on the behalf of the industry. It will be a battle to watch going forward.
Another option is talking to your employer. You may be able to borrow from them as an alternative to going to a payday lender or borrowing from your 401(k). The Wall Street Journal ran an article showing a growing number of companies that provide short term lending to employees. Employers are partnering with fintech companies such as Kashable, LLC and Zebit Inc. to fund and service loans. Interest rates on these loans range from 6% to the high teens and are deducted directly from employees paychecks.14 Employers may also offer seminars to help employees better manage their personal finances. The best advice is to not borrow from a payday lender in the first place.