Tuesday , 22 August 2017

When Money Tight: The Anatomy of Payday Lending And Its Alternatives

When Money Tight: The Anatomy of Payday Lending And Its Alternatives
contributed by CherylCorley

When Money Tight: The Anatomy of Payday Lending And Its Alternatives

With the current economic situation, many of us may feel a bit depressed. I meet people who are living through tough times, literally, – their houses and cars being taken away, hospital bills piling up and the world crashing all around them. And as they carry on with their daily chores, constantly thinking where to get more money, the ubiquitous cash advance stores may well seem like the only option left to get that desperately needed $400.

And yes, the idea is scary because statistics show that many people, who take out such loans, are the ones who should stay away from them at all costs. But how can you explain this to someone who needs that money urgently just to make their ends meet, even if it is a temporary financial relief, at best.

Why are these loans so expensive? Isn’t there enough competition to bring the loan rates down?

These are the questions that politicians are struggling with across many American states as consumer advocates have stepped up the fight against payday lending. The issue is complicated partially due to the “free choice” argument put forward by proponents of payday loans. Dire financial circumstances, lack of viable alternatives and the ubiquity of payday loan shops basically eliminate the free choice, claim the opponents, making a payday loan the only choice thinkable.

The exorbitant rates on such loans come from two sources: operating costs and risk premiums. The former are high because payday stores are everywhere and usually open 24/7 and provide instant cash on demand. But the major driving factor behind such high APRs is the risk premium that lenders have to add to take into account the probability of default on a loan. And defaults happen in great numbers. The default rate on typical two week payday advances is in the range of 10-20%. In comparison, the national average default rate on credit cards (the rate at which consumers allowed their credit card debt to be passed on to collections by their lenders after repeated failure to pay their bills) is around 5-7%. You do the math.

The studies do show that consumers prefer no credit checks, instant payday loans online to more cumbersome traditional bank loans, but the convenience comes at a very high price. Major payday loan operators boast robust stock market performance which is expected due to current recession. But these also point to the profitability of this business model.

Why don’t we have more competition in this sector to drive the rates down?

This is a classic market problem that stems from the nature of competition which is monopolistic. While anyone can start a payday loan business, there are no incentives to undercut the rates charged by the incumbents. Not only could this result in a price war with no winners, it is counterintuitive to operate at a zero profit point of perfect competition.

The only way to bring down the cost of payday loans is not through promoting competition but through funding innovative alternatives. These alternatives should address the risk premium and the high default rate, as a result.

The alternatives that exist now all revolve around the following ideas:

  • Bank advances to clients;
  • Credit Union loans to members;
  • Employer based community lending projects.

The first two are based on some banking history. Before one can be eligible for a small line of credit, an active direct deposit as well as employment verification are often required. The checks that must be run by the bank often result in high costs of such loans despite the fact that the bank has access to the client’s monthly statements.

The third option works a bit differently. It works with employers directly who spread the word and refer their employees to the program.

All three approaches have been implemented at local levels in different states. Some are more successful than others. Better government funding of these alternatives could assist in developing them into large scale solutions.

Cheryl Corley is a journalist at NPR. She writes about personal finance and money management. You can find more articles by her at http://www.npr.org/people/2100387/cheryl-corley

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