In 2012, on the corner of Park and Minnehaha in South Minneapolis, a Cash Express storefront opened, and members of nearby Holy Trinity Church took note. At first they were optimistic – there was now one less empty storefront – but soon they started asking questions. How does a payday loan work? What type of people do payday lenders generally serve? How does payday lending impact the community's financial stability?
Payday lenders typically offer small, two week loans that are to be repaid at a borrower’s next ‘payday’ through direct access to the borrower’s bank account. Nationally, borrowers are spending an average of $520 in interest to repay an average of $375 in credit, a study by PEW Charitable Trusts reported. Indeed, payday lending has swept the country in recent years, both in storefront proliferation, and in a growing public dissatisfaction.
Most people can agree that access to credit is a good and necessary thing. Payday loans, however, lack the fundamental qualities that make credit beneficial, and they instead create a debt trap. More than half of all payday loans get ‘rolled over’ – meaning the borrower pays down the interest on the current loan, then takes out an equivalent loan to repay the previous loan. According to a recent statement by a faith-based coalition, the average Minnesota payday lender charges a 273 percent annual percentage rate (APR).
In fact, a recent Minnesota Public Radio article reported that the average borrower had paid 228 percent of the original loan by the time the loan was repaid due to accruing interest at each due date. The payday loan industry markets their loans as a short-term solution until the next paycheck; however, the Minnesota Department of Commerce calculates the average borrower took out 10 loans per year.
A Church’s Response
By the time the topic of payday lending arrived at the doorstep of Holy Trinity Church, it was clear that borrowers were already suffering the negative impacts of these high interest, short-term loans.
“Above all, payday lending drains resources from our neighborhood,’ said Meghan Olson, a Community Organizer for Minnesotans for Fair Lending, an advocacy group that resulted from Holy Trinity’s action on the issue. Three years after the Cash Express opened, the church also launched Exodus Lending, a comprehensive service provider for payday borrowers trapped in debt.
“We didn’t want to be a better loan,” Adam Rao, Director of Exodus Lending, said. “We want people to get out of needing loans.”
To do this, Exodus Lending offers a 12-month program that includes financial counseling and incentivized savings.
“I don’t think of us as a lender,” he said. “‘Lending’ is in our name, but in reality we are a service provider, a comprehensive program, and at the front end of that is refinancing a payday loan.”
These are not topics typically discussed in church, but as demonstrated by Holy Trinity Church, debt and financial literacy are issues central to many families’ well being. It is certainly a topic churches should discuss more – and an opportunity for church members with financial training or knowledge to fill in a gap where general education may be lacking. It’s very encouraging that two impactful initiatives like Minnesotans for Fair Lending and Exodus Lending both grew out of church-based discussions.
A core characteristic of a strong community is that each institution is functioning within its own sphere. And while a church is a great place for financial training and openness, it’s not an institution meant to replace an actual bank or lender. Churches don’t have access to much liquid capital, and to charge any interest at all (even a “fair” rate) may muddy the relationship between its members. The church is a community made up of bankers and borrowers – among many other professions, of course – and the very place to be reminded, “It is well with those who deal generously and lend, who conduct their affairs with justice.” (Psalm 112:5)
Both initiatives exist because payday lending has hurt the community, and the local church met the challenge of serving their neighbors enslaved to debt. Leaders of both organizations make clear they don’t want to be doing payday lending debt relief work forever. Lasting prevention of damaging payday loans resides in government and business policy reform.
What’s striking about payday lending is that the industry continues to grow despite increasingly clear detriments to the consumer and violations of human dignity. If payday loans are so harmful, then why does the industry persist?
An answer to this question may lie in looking through the lens of behavioral economics, which combines psychology and economics to study real human behavior. This perspective is contrasted with economists’ classical assumption of perfect human rationality.
One lesson of behavioral economics is that humans have a limited amount of mental computing power; when we focus attention on something we naturally lose focus on something else. While often a good habit – for example, focusing on driving and not the radio – this same tendency becomes problematic when stressful life situations take up a majority of our mental bandwidth.
The average payday loan borrower – someone who has experienced an economic shock – may be stressed and mentally taxed. What harms borrowers is that while stress allows us to perform remarkable feats, it pulls mental energy away from other important aspects of life.
When customers aren’t able to focus on everything, the task they are most focused on (getting fast cash now) is what they demand. Unfortunately, this focus comes with a trade-off. Customers let slide the calculations of complex fees and the likelihood of timely repayment. As a result, we have a payday industry that offers fast cash, but is rife with complex fee structures and rolled over loans.
To be clear, payday lending provides a service many people desperately need. Traditional banks do not offer small loans for customers struggling with bad credit history. Fulfilling this market need could be a social good; however, we must address important questions. Do we want a society that capitalizes on the financial vulnerabilities of others, or one that minimizes the potential damages of our collective vulnerabilities?
Looking at the payday loan industry through this lens of behavioral economics suggests several policy recommendations for our elected officials and the wider community.
1. Clarify interest rates and fees
Payday loans are marketed as a two-week solution until the next paycheck, meaning the interest rate is reported for a two-week loan. As previously stated, however, the average borrower in Minnesota has taken out 10 loans per year with ballooning interest rates also owed at each roll over. The Consumer Financial Protection Bureau (CFPB) recently released proposed regulations, among them requirements for “easy to understand” disclosures about costs and risks.
This proposal is a good start, as marketing materials may not make the annual rate of the two-week interest rate clear and some borrowers may not convert the rate and reflect on the implications of an APR upwards of 200 percent. Some payday borrowers may, additionally, overestimate their ability to repay their loan within the two-week period.
2. Ensure ability-to-repay
The CFPB's recently proposed rules also include provisions to ensure borrowers can repay loans. Ultimately, the payday loan industry is backwards. Rather than granting a loan based on a borrower’s ability to repay, like traditional banks, the payday industry runs on a lender’s ability to collect an interest payment – most often directly from a borrowers’ bank account. To reverse this reality the CFPB has proposed that lenders must determine ability-to-repay based on a borrowers’ income and financial obligations, or else limit rollovers to 90 days maximum indebtedness.
This policy requires some sort of reporting per borrower, so borrowers aren’t simply moving from store to store, paying off previous loans with new loans. Many lenders already report to commercial databases regarding borrower history, but these CFPB proposals would require such due diligence.
3. Mandate lower rate caps
The CFPB also proposes lower interest rate limits – which would protect consumers from high interest rates, simply making loans more affordable. While the payday industry claims that a rate cap would push borrowers to take even riskier loans (i.e. online or black market), evidence seems to suggest otherwise. In 2010, when Colorado lowered its interest rate cap, a study by The PEW Charitable Trusts reported that half of payday lending storefronts closed, while the remaining locations served 80 percent more customers. Therefore, borrowers’ access to credit was virtually unchanged. This example allays the payday loan industry’s argument that lowering interest rates would push people to even riskier and unregulated sources of capital.
Payday lending provides a loan service that many people need. This much is good. The policies described above aim to protect customers, and prevent a bad life event from turning into an inescapable debt trap.
Our family members and neighbors typically take payday loans because of an unexpected financial need – a health problem, a car accident, or a family issue – and yet payday loans don’t often provide the financial fix they promise. Rather, the data shows that the average payday loan costs twice the amount originally loaned. Under the status quo the payday industry turns something bad into something ugly.
Life oscillates between good events and bad events, success and failure, joy and lament. A just society prevents bad events, failures, and laments from becoming ugly cycles of pain and suffering.
The wellbeing of a community rests squarely on the strength of bonds between families, churches, businesses, banks, and government. These bonds are weakened by unjust lending practices currently exemplified in the payday lending industry. Communities should continue to raise these issues to our elected officials, the central points being: clarifying interest rates and fees, requiring an ability-to-repay provision, limiting the number of loan cycles per person, and legislating a reasonable interest rate cap.
-Lauren Walker is a Masters of Public Policy student at the University of Minnesota studying Global Governance and Human Rights, and a graduate researcher for the Public and Nonprofit Leadership Center. Previously an Organizing Fellow at International Justice Mission, her career interests merge human rights, program effectiveness, and advocacy to our policy makers on these issues. She received her B.A. from Calvin College’s Psychology Department.
-Jeffrey Bloem is a graduate research assistant and student in Michigan State University’s Department of Agriculture, Food, and Resource Economics. His research interests include the effects of human behavior on economic decision-making, impact evaluation in developing countries, and integrating faith in public life. He is a graduate of Calvin College’s Economics Department. Follow him on Twitter (@JeffBloem) and on his blog.
Photo courtesy of Taber Andrew Bain.