The payday loan is not, as Republican presidential candidate Ben Carson recently wrote, a "short-term loan secured by their next paycheck with an interest rate around 15 percent." Rather than 15%, payday loans, which few borrowers pay off the following week, end up with effective interest rates actually above 300%.
Imagine borrowing $350 on your credit card and not paying it back for six months (just like the average payday borrower). If it were a high-interest card, your interest rate would be around 29%. If you paid the debt off in about six months (like typical payday borrowers do) you would have forked over $51 in interest. For payday borrowers that number would be nine times higher--$458. For the 12 million Americans who borrow from payday lenders each year, collectively paying about $8 billion in fees, these high fees appear to be the only option. While wrong on his numbers, Carson is correct that payday loans are an "essential necessity to get by" for the working poor. The question, however, is not whether to have payday loans, but how to make them more affordable.
The common explanation for these high fees is simple: the borrowers are risky. Higher rates compensate lenders for their higher losses. Yet, as lenders' own public filings have shown, this explanation is wrong.
The main driver of payday lenders' costs are not loan defaults, but old-fashioned overhead. As storefronts with few customers--lenders average just 500 unique borrowers a year--about two-thirds of their costs are in overhead. Only one-sixth of payday lenders' costs come from loan defaults.
One obvious option would be taking payday loans online -- cutting out the rent and increasing the volume -- but the internet savings, it turns out, are offset by the internet fraud.
Carson fears that a "nanny state" will step in to regulate these lenders out of existence, further denying the poor access to financial services. Luckily for policymakers, there exists a far easier option: allow banks to make payday loans repaid in affordable installments.
Instead of pretending that payday loans can be paid off the following week, it would be far better to accept that these loans require a few months to payoff and create an installment plan to match borrower's realities. The Pew Charitable Trusts estimates that a viable $500, 4-month loan from a bank would cost somewhere around $80, compared with $400-$600 from a payday lender. The APR for the bank small loan is higher than a typical credit card APR, but it would represent enormous savings for payday loan borrowers, most of whom do not qualify for other bank credit products and instead pay overdraft penalty fees. To issue these loans, banks would need to be allowed to use simple underwriting standards of the sort outlined by the Consumer Financial Protection Bureau, where monthly installment payments are limited to an affordable five percent of monthly income.
Bank regulators, like the Office of the Comptroller of the Currency, do not currently allow payday loans. These regulators require high standards of underwriting, for even small loans, which is expensive to conduct, preventing banks from lending to their checking account customers at reasonable prices.
Earlier in our history, we confronted a similar situation. In the Great Depression, payday lenders charged high fees to a hard-pressed public. In response, the federal government encouraged banks, through a system of loan guarantees in 1934, to make small personal loans based on little more than proof of a job and an address. These loans programs not only brought down borrowing costs, they also helped banks survive the Great Depression. Americans who had a job rarely defaulted when given a way to systematically, and affordably, pay back their debts.
Today, we can follow this example and once again make it easier for banks to lend to the working poor. Bank locations could easily offer a new small loan to their existing customers without increasing their overhead -- and maybe even draw in those 500 customers from a rival bank. In turn, payday loans could become much cheaper.
Banks, in this way, could compete payday lenders out of business. Regulation is not only about saying no, but helping institutions say yes to innovation. The choice is not either regulation or deregulation, as Carson implies, but smart regulation. If today's federal regulators get the small-dollar loan rules right, payday loan customers could get access to safer loans, save hundreds of dollars annually, and find something better to spend their money on--or even save.
Louis Hyman is associate professor of history at Cornell University and a fellow at Stanford's Center for Advanced Studies in the Behavioral Sciences.