Payday Loans: What Happens When They're Gone?

[May 29, 2009.]

 

What happens when legislators come between consumers who want to buy a product and entrepreneurs who want to sell it? Check out the history of the 18th Amendment.

Payday Loans and Prohibition

Analogies are never perfect, and it's a mistake to try to draw too many parallels between today's attempts to eliminate payday loans, and the prohibition of alcohol in 1919. But there are similarities.

To start with, booze will always be a problem for a small section of the population. In the same way, a minority of Americans is unable to deal with credit responsibly.

Those who struggle to manage their financial affairs may well live very stressful lives, and bring misery onto themselves and others who are close to them. Similarly, the families and friends of alcoholics are often badly--sometimes tragically-- affected by excessive drinking.

Is Banning Payday Loans Noble?

And those who sought to prohibit alcohol did so for good and noble reasons, just as modern day anti-payday loans campaigners believe that they are saving weak people from their own folly.

But, just as prohibition brought unforeseen side effects, such as bootlegging and gangsterism, so the abolition of payday loans doesn't always turn out as consumer groups hope.

Things Aren't Better When Payday Loans Go

Six months ago, back in December 2008, Professor Jonathan Zinman of Dartmouth College's Department of Economics published a working paper on payday loans that described some research he had undertaken for the Federal Reserve Bank of Philadelphia. The paper was entitled Restricting Consumer Credit Access: Household Survey Evidence on Effects Around the Oregon Rate Cap.

Professor Zinman wrote in the document's abstract: "Many policymakers and some behavioral models hold that restricting access to expensive credit helps consumers by preventing overborrowing. I examine some short-run effects of restricting access, using household panel survey data on payday loan users collected around the imposition of binding restrictions on payday loan terms in Oregon. The results suggest that borrowing fell in Oregon relative to Washington, with former payday loan users shifting partially into plausibly inferior substitutes. Additional evidence suggests that restricting access caused deterioration in the overall financial condition of the Oregon households. The results suggest that restricting access to expensive credit harms consumers on average."

Worse Off Without Payday Loan

Kevin Johnson of Chicago might have been better off if Illinois had not so over-regulated payday loans that lenders closed their businesses or were forced to come up with new, more expensive products.

In a report this week on life after payday loans, Progress Illinois told his story. In June 2008, Kevin had to borrow $700, but he couldn't take out a traditional payday loan because state legislators had effectively banned them. He ended up borrowing the money from a company on a 'consumer installment loan'; a type of borrowing that remains unregulated in the state.

More Expensive Than a Payday Loan

That loan agreement required 24 payments over 12 months, each of $105,30. That should have cost him $2,611, but he fell behind with his repayments and had to take out a second loan. Now, assuming he can keep up with his payments schedule, he'll end up paying almost $3,500 for his $700 loan.

If payday loans had still existed, he'd typically have had to pay $105 to borrow $700 for two weeks.

Not Getting It

Progress Illinois, which is a progressive blog sponsored by the local state branch of the Service Employees International Union, seems to argue that what's needed is more regulation--to prevent 'abuse' by closing 'loopholes'.

But if things got worse when Payday Loans were effectively banned in Illinois, aren't they likely to get even worse if other legal lending is eliminated? Won't desperate borrowers be driven into the arms of loan sharks and gangsters, whose collection methods frequently involve the breaking of limbs?

And isn't it slightly ironic that Progress Illinois is based in Chicago? After Al Capone, one might have expected Chicagoans to have learned the lessons of prohibition.

 

About Author:

Peter Andrew has been writing about -- and for -- business for more than two decades. For the last couple of years, he has found himself increasingly specializing in the U.S. financial sector.