In April, I attended a hearing of the House Committee on Financial Institutions in Jefferson City. Three different matters were under discussion that evening, but I traveled there to watch a presentation on payday lending — the practice of making mostly small, short-term loans at what many consider to be unreasonably high interest rates, which, if annualized, often reach more than 400 percent. Such seemingly outrageous rates have led some states to cap the level of interest, usually at 36 percent, and a bill to do just that was proposed in the Missouri House of Representatives during this year’s legislative session. However, such interest rate caps drive lenders out of business, leaving the people that lawmakers intended to help with even worse credit options.
Payday loans are far from a perfect source of credit, and the desire to protect people from the high interest rates that typically accompany such loans is certainly well-intentioned. However, good intentions do not necessarily lead to good public policy. We must look at the concrete outcomes that would likely result from a law capping interest on payday loans.
An article in the October 2009 issue of Reason magazine explored the consequences in some detail and cited studies showing that interest rate caps are detrimental to those who most need help. For instance, Dartmouth University economist Jonathan Zinman examined the effects of Oregon’s cap on payday loan interest rates in a 2008 study. The most predictable consequence was that most payday lending institutions closed, but Zinman also found that people who had once used payday loans subsequently relied on even more damaging options, like utility shutdowns and overdrafts. Overall, Zinman concluded, “restricting access caused deterioration in the overall financial condition of the Oregon households,” and “restricting access to expensive credit harms consumers.”
The Federal Reserve Bank of New York found much the same thing in a 2008 study. After Georgia banned payday loans in 2004, research economists Donald P. Morgan and Michael R. Strain found that, “Compared with households in states where payday lending is permitted, households in Georgia have bounced more checks, complained more to the Federal Trade Commission about lenders and debt collectors, and filed for Chapter 7 bankruptcy protection at a higher rate.”
North Carolina followed Georgia’s lead and banned payday loans in 2005, after which Morgan and Strain found the same set of problems: “This negative correlation—reduced payday credit supply, increased credit problems—contradicts the debt trap critique of payday lending, but is consistent with the hypothesis that payday credit is preferable to substitutes such as the bounced-check ‘protection’ sold by credit unions and banks or loans from pawnshops.”
The annualized percentage rates (APR) paid on the relevant alternatives to payday loans are frequently so large as to make the cost of a short-term loan seem minute by comparison. According to information provided by QC Holdings — owner of more than 500 payday lending locations across the country — the APR for a $100 credit card bill with a $37 late fee is 965 percent, and the combination of $46 in reconnection and late fees on a $100 utility bill represents an APR of 1,203 percent. Moreover, thinking about any of these charges in terms of APR is somewhat misleading, because very few people incur such fees repeatedly over the course of a year.
In an ideal world, no one would ever need a payday loan. But this is not an ideal world. Sometimes people require money on short notice with no cheap and easy way to obtain it. Eliminating their least bad credit alternative is no way to help people in such dire straits, and could send them to truly ruthless loan sharks who operate outside the scope of the law.
Before attending the hearing in April, I coincidentally checked out an audio recording of Shakespeare’s The Merchant of Venice to listen to during the drive. The plot of the play revolves around a moneylender named Shylock who loans a large sum to the merchant Antonio with the contract specifying that if the debt is not repaid on time, Shylock will be allowed to cut out the pound of flesh nearest Antonio’s heart, which amounts to a death sentence.
Although payday loans are far from inexpensive, no payday lender has ever attempted to exact repayment through death or grave bodily injury. However, if we force short-term, high-risk borrowers to seek out loans from the criminal world, we should not be surprised if Shylock’s method of contract enforcement gains renewed popularity.
John Payne is a research assistant at the Show-Me Institute, a Missouri-based think tank.
