Wishful thinking solves no problems. Instead, laws and policies based on wishful thinking create problems, usually for the people the policies are intended to help. A Virginia delegate’s proposal to eliminate payday lenders is a case in point. Similar bans were implemented in Ohio and Colorado — both of which didn’t work.
The mechanism for eliminating payday lenders is capping the annualized interest rate. In this case, the cap is set at 36% per year. Of course, for many loans (such as mortgages and most car loans) 36% is well in excess of any rate charged by lenders. This is a good sign these lenders can cover their costs with an annual percentage rate that is much lower than 36%.
However, payday loans are short-term loans for relatively small amounts. The term is typically for two weeks and the loan amounts vary from $100 to a few thousand dollars. With the proposed cap in place, the maximum allowed charge for a $100, two-week loan would be $1.38. For perspective, parking meters in Richmond are $1.50 an hour. That is, with the cap in place, payday borrowers could pay more for parking in front of the payday storefront than they would pay in interest on the loan.
Don’t worry, that is not going to happen because there would be no payday lenders with the interest cap. The borrowers would not get these loans at a lower rate. Instead the loans would disappear. Payday lenders have left every state that has imposed the 36% cap. Of course, forcing out payday lenders seems to be the whole point. Del. Mark Levine, D-Alexandria, where the meter rate is $1.75 an hour, said, “I have no sympathy for those lenders.”
Me either, but if you have sympathy for payday borrowers, you need to have some concern for payday lenders. Here’s the hard fact: Payday borrowers borrow from payday lenders because these borrowers do not have better options.
According to a recent study from the Federal Reserve Board, 40% of American adults cannot absorb a $400 emergency expenditure. Though many of these 40% may have prearranged overdraft protection on their checking accounts, or the ability to get cash advances from credit cards, or personal loans from their banks, these options are not available to others.
In addition, a report by the Federal Deposit Insurance Corporation found that more than 20 million people live in unbanked households. That is, they have neither a checking nor a savings account. The limited options available to these households are not improved by eliminating one of the few that are available. This is where wishful thinking isn’t so helpful. There is no ruby-heel clicking or wand waving that transforms unbanked households into banked ones or increases anybody’s savings when rate caps shut down payday lenders.
In fact, the data show what common sense would predict: Things get worse for borrowers when they have fewer options.
An article in the Journal of Law and Economics finds that payday borrowers do not switch to better options when payday lending is driven out. On the contrary, the researchers find that these limited-option borrowers resort to worse choices. In states that banned payday lending, pawn-shop borrowing was 60% higher than in states that did not ban payday lending. Another, even more worrisome, finding is the level of involuntary checking account closures — a financial death penalty. The study’s authors estimate banning payday-lending triples the number of these involuntary closures.
Desperate borrowers need protection, but they need it from legislators whose wishful thinking turns into harmful policy. Payday-loan bans are bad for borrowers.