Rhode Island is in its fourth year of trying to reform payday lending in the state, and here at Capital Good Fund (CGF) not only have we been part of the lobbying effort, we’ve also launched our own payday loan alternative product. Funded by United Way of RI, this loan ranges from $300 - $500, carries an interest rate of 30% + a 4% closing fee, a one-year term and very flexible requirements.
In the 5 months since the product launched we’ve done nearly 70 loans with phenomenal repayment rates. Still, compared to the payday loan industry, which did $70 million in lending in 2011, that’s peanuts. And indeed our tiny scale fuels the industry’s argument that only by charging an effective APR of 260% can they afford to deliver these “essential loans.”
However I’m not interested in debating what rate should be charged, or whether payday loans are essential. Instead, I have a simple point to make: payday loans are a fundamentally flawed product; so flawed, in fact, that they shouldn’t exist in the first place.
Here’s why. Ask anyone in the lending business and they will tell you that it costs just as much to underwrite a $2,000 loan as a $20,000 loan, but the larger loan brings in 10 times the revenue; that’s why banks and credit unions shy away from small dollar lending.
Now imagine you want to get into the business of $200 - $500 loans, and not only that, but you want to make them to people with low incomes, poor credit and difficult circumstances, and you want to be able to do same-day lending: walk-in with a need and walk-out with a loan. How on Earth are you going to profitably make that loan? The first tactic is to do no underwriting—no credit check, no ability-to-pay test, nada, zip, zilch. All you do is require a paycheck and a bank account, and you’re golden.
Okay, so we’ve thrown underwriting out the door. You want a loan? You got it, whether you can afford it or not. But you, the payday lender, still have a problem: even the maximum you can charge—$10 per $100 lent out—isn’t enough. $10 would barely cover the underwriting cost, but even then you have rent, utilities, marketing, payroll, and so on. In fact, the only way you can make money is if people don’t pay you back on time. Once you realize that, you can actually use the lack of underwriting to your advantage: if most of the people to whom you lend can’t really afford the loan, then when the loan comes due at the next pay period, they have to “rollover” that loan. Put simply, the borrower takes out another loan to pay off the first loan. Each rollover, each new loan brings in more fees, more interest, more revenue.
And now you’re in business: pump loans out the door as fast as you can, make it easy to keep rollin’ ‘em over so as to maximize profits, automatically pull the payments from the borrower’s bank accounts—frequently resulting in overdraft fees to the client—and you’ve got a wildly profitable enterprise. Of course, to make any of this happen, you convince the state legislature to create a special loophole that allows you to make these loans (which Rhode Island did in 2001), and then, when the public realizes what a bad deal this is for working families, you argue that your industry creates jobs, pays taxes, is highly regulated and transparent, and of course is indispensable.
Here’s the simple truth: payday loans are a fundamentally flawed concept. They can’t work in a responsible way. The data proves this, and the industry knows it. According to the Consumer Financial Protection Bureau (CFPB), “Over 80% of payday loans are rolled over or followed by another loan within 14 days.” Boom. No more data needed, because were this not the case the business model wouldn’t work. Or, to quote the communications director for the payday loan industry’s lobbying arm, “Most borrowers fully plan and expect their payday loans to be outstanding for more than one pay cycle…” Why? Because someone earning $2,000 a month and borrowing $500 is highly unlikely to be able to magically pay back the $500, plus $50 in fees, two weeks later.
So what’s the answer? Consumers absolutely need access to affordable financial products and services. Responsible lenders, be they nonprofits or financial institutions, should be incentivized, encouraged and allowed to make small dollar installment loans at up to 36% APR (which is the maximum interest rate that can be charged to military families). When paid back over the course of a year, a lender making a $300 loan can at least break even. From there, smart lenders will leverage this relationship to provide more profitable—and responsible—products and services to the customer, such as credit cards, auto loans and mortgages. In our case, we start clients off with $300 - $500 loans, and once the client demonstrates an ability to make on-time payments, we begin offering them loans of up to $2,000. From there, we offer paid one-on-one Financial and Health Coaching, free tax preparation, and referrals to other services.
In short, the math of payday lending demonstrates unequivocally that payday loans have an inherent and fatal flaw: they must be predatory for them to be profitable. Once we recognize that, we can craft legislation that encourages business models—and business practices—that are beneficial to both the lender and the borrower.