"Robert DeYoung on payday loans
I thought this was an interesting editorial in Tuesday's WSJ.
For those who depend on taking out a loan in advance of a paycheck, life may soon get harder if Congress passes the Payday Loan Reform Act.
The bill's sponsors, which include Rep. Luis Gutierrez (D., Ill.), say they want to clean up abuse in credit markets by clamping down on the prices lenders charge for payday loans. In reality, the legislation will reduce the supply of these loans and make borrowing more expensive.
The reform is based on the false premise that consumers take out these loans without realizing how much they are paying. True enough, these loans are expensive. A two-week payday advance of $300 typically comes with a $45 finance charge-- an implied annual percentage rate (APR) of 391%. Critics say borrowers could not possibly intend to pay that much for an advance on their paychecks, and that the cost alone is evidence of exploitation of the working poor.
But new research suggests that most payday borrowers are more rational and informed than critics believe. A January 2009 study by Gregory Elliehausen at George Washington University found that payday borrowers make informed choices. About half of the 1,173 payday borrowers he surveyed considered other credit alternatives-- such as bank, credit card, or personal loans-- before taking out a payday loan. Over 80% lacked sufficient funds in their bank accounts to meet their expenses, so by taking out a payday loan they avoided expensive checking account overdraft fees. Nearly 90% said they were either very or somewhat satisfied with the transaction.
A November 2008 FDIC report on overdraft protection provides the context. According to this exhaustive study, the average APR on a two-week checking account overdraft is 1,067%, more than double the rate on the typical payday loan. Worse, a large percentage of banks studied by the FDIC take deliberate measures to increase the frequency of customer overdrafts-- such as displaying account balances on ATM screens only after the overdraft has occurred, and increasing the number of insufficient funds checks by clearing large customer checks before small ones. Compared to these overdraft practices, payday loans are transparent.
Nonetheless, the legislation pending before the House would cap payday-loan finance charges, even though government price limits almost always have negative effects. Price controls are especially harmful when competition is robust, as in payday-loan markets.
Ron Phillips of Colorado State University and I examined seven years of payday-loan prices in 117 Colorado neighborhoods. We found that local markets with more payday stores tend to enjoy lower prices, but that the benefits of competition were largely been washed away when Colorado imposed a cap on finance charges. Over time, the longer a price cap remains in place the more borrowers get charges the legal maximum price. Price caps make these loans more expensive and less available.
Details of the proposed legislation can be found here, and the DeYoung Phillips paper is available here.
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