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The Myth vs. the Truth About Regulating Payday Lenders

When state laws drive so-called "debt traps" to shut down, the industry moves its business online. Do their low-income customers follow?

(FlickrCC/Taber Andrew Bain)
In 2010, Montana voters overwhelmingly approved a 36 percent rate cap on payday loans. The industry -- the folks who run the storefronts where borrowers are charged high interest rates on small loans -- predicted a doomsday of shuttered stores and lost jobs. A little over a year later, the 100 or so payday stores in towns scattered across the state were indeed gone, as were the jobs. But the story doesn’t end there.

The immediate fallout from the cap on payday loans had a disheartening twist. While brick-and-mortar payday lenders, most of whom had been charging interest upward of 300 percent on their loans, were rendered obsolete, online payday lenders, some of whom were charging rates in excess of 600 percent, saw a big uptick in business. Eventually, complaints began to flood the Attorney General’s office. Where there was one complaint against payday lenders the year before Montana put its cap in place in 2011, by 2013 there were 101. All of these new complaints were against online lenders and many of them could be attributed to borrowers who had taken out multiple loans.

That is precisely what the payday loan industry had warned Montana officials about. The interest rates they charge are high, the lenders say, because small-dollar, short-term loans -- loans of $100 or $200 -- aren’t profitable otherwise. When these loans are capped or other limits are imposed, store-based lenders shut down and unscrupulous online lenders swoop in. 

Scenarios like that have played out in other states and cities. One year after Oregon implemented a 36 percent rate cap, three-quarters of lending stores closed and complaints against online lenders shot up. In Houston, a 2014 law restricting the activities of small-dollar lenders resulted in a 40 percent drop in the number of licensed loan and title companies in the city. But the overall loan volume declined only slightly. This year, just two months after South Dakota voters approved a 36 percent cap on loans, more than one-quarter of the 440 money lenders in the state left. Of those that stayed, 57 told local media they would shut down after collecting on existing loans. 

These situations raise questions about how states should deal with usurious lenders and the harm they do to the mostly poor people who turn to them for ready cash. These borrowers typically end up in a debt trap, borrowing repeatedly to pay off the money they owe. If local payday stores close when limits on short-term loans become law, will people who need a quick infusion of cash turn to online lenders who charge even higher rates? Where does that leave states that hope to protect consumers and curb abusive practices? 

That’s what Assistant Attorney General Chuck Munson initially wondered when he began reviewing complaints in Montana against online lenders. “As a consumer advocate, the argument [that borrowers will just go online when stores disappear] appealed to my economic sensibilities,” he says. “Whatever black market you’re talking about, people find a way to it.”

But as it turns out, there are more twists and turns to the payday story in Montana and elsewhere. To be sure, online lending is a problem -- but it’s not ultimately where most former payday borrowers turn for a solution to their cash needs. Rather than filling a void left by storefronts, online payday lenders simply represent the next fight for states that regulate payday lending. When it comes to keeping people safe from predatory lenders, it seems there’s always another battle around the corner.


State-approved, high-rate lenders are a relatively new phenomenon. Following financial deregulation in the 1980s and early 1990s, the payday industry successfully lobbied dozens of states to give short-term lenders exemptions to their usury laws. The number of payday loan offices went from 300 in 1992 to nearly 10,000 a decade later. At the height of the industry, 42 states and the District of Columbia allowed the high interest rate loans -- often around 300 percent but sometimes topping 600 percent -- either directly or through a loophole. 

Payday loans are, as the name suggests, due on the next payday. The lender is given access to the borrower’s bank account, and loans are made with little, if any, regard to a borrower’s ability to repay that loan and meet other obligations. When the loan comes due, the amount is immediately taken out of the borrower’s paycheck or bank account, usually leaving borrowers without the means to cover their expenses for the next two weeks. So they turn back to the payday lender for more cash. 

It’s not unusual for a $300 loan to be rolled over many times and ultimately cost more than $800 in principal and interest, according to the Center for Responsible Lending, a North Carolina advocate for reform. “Their business model is based on keeping people trapped in unaffordable loans,” says Diane Standaert, the center’s director of state policy. The repeat borrowing is called loan churn, and roughly two-thirds of the $2.6 billion in fees lenders charge each year is from loan churn. In fact, during the first year they seek a loan, typical payday borrowers are indebted for more than 200 days out of that year.

It eventually became clear that the terms around this access to quick cash were keeping many consumers in a cycle of debt. In 2001, North Carolina became the first state to repeal its payday lending exemption and restore its usury laws. Since then, five other states and D.C. have followed, bringing the total number to 15 states in which payday loans are outlawed. Another five states have made other changes to protect consumers against the payday loan debt trap. These changes include limiting the percentage of a consumer’s paycheck that can be withdrawn to make loan payments and lengthening the duration of the loan. 

Nationally, progress has been piecemeal. The federal government outlawed payday loans to military members in 2006, but action for all consumers is still a work in progress. Last year, the Consumer Financial Protection Bureau (CFPB) announced proposed rules that would make payday loans more affordable, in part by requiring that lenders ensure the borrower’s ability to repay the loan. But the underwriting standards only kick in after a borrower has taken out at least six loans in a year, which has led some payday reform advocates to argue that the final rule’s protections don’t do enough to keep borrowers out of debt.

Those in support of payday loans have not been quiet. The CFPB has been inundated with more than 1 million comments on its proposed rule, with slightly more than half in total opposition to it. The story has been the same in states. Most recently in South Dakota, industry supporters spent in excess of $663,000 -- more than 14 times what their opponents spent -- in a failed effort to defeat a rate cap ballot measure. 

The industry’s argument against regulation has a simple logic: Payday loans offer fast cash for emergencies in a way that banks or credit unions typically don’t. Sure, the annual percentage rate (APR) is high, but the loan terms aren’t for an entire year. Most are two- or four-week loans of less than $500. A $15 charge on every $100 borrowed, the industry argues, is tantamount to a 15 percent interest charge. Imposing a 36 percent APR cap would reduce those charges to a mere $1.36 per $100 loaned. “No one can loan money at that rate,” Bernie Harrington, president of the Montana Financial Service Center, warned his state legislature in 2009. “The losers will be the residents of Montana who need to borrow $150 to make a car payment and the hundreds of people who will lose their jobs.”

But in practice, the evidence tells a different story. Studies show that when the state-based payday loan option is taken away, consumers may flock online -- but only temporarily.

In Montana in 2014, after complaints against online lenders spiked at more than 100 a year, the number began to plummet. In 2016, they totaled seven. What had looked like a crisis turned out to be an adjustment period. That is, while some Montanans may have turned to online lenders to fill their need for ready cash, they eventually weaned themselves off the payday practice. They turned to friends and families for financial help. In some cases, credit unions offered loans as a way to attract people into opening a bank account. “People went back to the exact same things low-income families did before 1999 when we allowed payday lending,” says Montana state Rep. Tom Jacobson, who is the CEO of a financial counseling business. “They got by.”

The Montana experience is backed up by research in other states. In a 2014 study on the topic, the Pew Charitable Trusts found that the rate of online borrowers in states that banned payday lending was only slightly higher (1.58 percent) than in states that allowed payday lending stores (1.37 percent) -- a difference that is too small to be statistically significant. Moreover, focus groups of borrowers in states that restrict payday loans reported resorting to other means like selling or pawning possessions; borrowing from family or friends; calling bill collectors to work out a payment plan; and picking up extra hours at work. Separate studies commissioned by Arkansas and North Carolina found similar results. “It’s kind of a false choice that either you have a 400 percent APR loan, or no credit at all,” says Pew’s Alex Horowitz. “People take various steps when payday loans are unavailable, but they don’t seem to go online [and accept] higher rates.” 

(SOURCE: The Center for Responsible Lending)
NOTE: The payday interest rates in each state are based on a typical loan. Each interest rate is the average annual percentage rate for short-term, small-dollar loans, or a $300, two-week loan as advertised by the largest national payday chains in 2016.

Some people still do turn to online payday loans, however. They may not realize that high interest rate loans are illegal in their state. Or an online loan might be the quickest and least embarrassing option available. It’s almost a matter of course for regulating the payday industry that when one door closes, another door opens. For instance, getting rid of payday stores in a state opens the door for attorneys general to start suing companies that are based elsewhere but lending money to their citizens.  

Among agencies that have been zealous in pursuing predatory payday lenders is the Vermont Office of the Attorney General. Although the state never allowed high-rate loans, legislators in 2012 made illegal payday loans a violation of the state Consumer Protection Act. The law is the strongest in the nation because it extends payday loan violations to associated loan parties, such as collection agencies. It essentially gives the attorney general’s office a larger hammer with which to go after online payday lenders. Since the law was passed, the state has reached settlements with 10 online lenders or payment processors resulting in more than $1.2 million in refunds to Vermonters. 

Arkansas and New York are also actively pursuing online lenders. During just one month in 2013, New York Attorney General Eric Schneiderman announced settlements with five debt collection companies attempting to collect on payday loans in the state. 

The CFPB’s proposed rules limiting payday loans could help states by putting a dent in the online lending industry nationwide. But closing that door opens yet another: Online lenders have begun affiliating themselves with Native American tribes, claiming sovereignty under various Indian nations. Occasionally, states have been successful in pursuing these lenders who escape to reservations. Take the case of a company called CashCall. It claimed exemption from state usury laws because the loans from which it received payments were issued by a partner company, Western Sky Financial, which is located on the Cheyenne River Sioux Tribe’s reservation in South Dakota. After several states took CashCall to court, judges ruled that the company wasn’t actually affiliated with the Cheyenne River Sioux Tribe. The lenders have settled with more than a dozen states and returned millions of dollars to consumers. 

But more commonly, judges dismiss these kinds of suits for lack of jurisdiction, citing the lender’s entitlement to tribal sovereign immunity. It’s what Vermont Assistant Attorney General Justin Kolber sees as an emerging challenge. What makes the situation particularly frustrating is that most tribal agreements allocate only about 1 percent of the company’s profits to the tribes -- a pittance compared to what the lending company itself is making. “I haven’t figured out what a solution is for that right now,” Kolber says. “That is the next frontier that has to be dealt with.”

Tribal immunity isn’t the only escape hatch for payday lenders that consumer advocates are worried about. This past December, the U.S. Treasury’s Office of the Comptroller of the Currency announced that it was exploring a proposal that would allow financial technology companies to apply for nonbank charters. The draft proposal, which recently closed its comment period, doesn’t specifically exclude online payday lenders. There is concern among consumer advocates that a payday lender could apply for a nonbank charter designation and then use that to claim exemption from state rate caps. It would render control efforts over the past decade obsolete. Consumer advocates are urging the comptroller not to preempt state laws in this area.

In this world of never-ending loopholes, it isn’t reasonable to expect states to squash out high interest rate loans entirely. Aware of their limitations, consumer protection departments in state AG offices are looking beyond the courtroom. D.C. Attorney General Karl A. Racine’s office says it focuses just as much on financial literacy and counseling as it does on suing payday lenders. Vermont’s AG office successfully worked with Google to ban payday loan advertisements on that company’s Internet browser and search engine. These actions are saving consumers millions of dollars in fees and interest payments, but they don’t reach everyone. 

And always, it seems, there is something else to battle. Take Ohio, where voters approved a 28 percent payday loan cap in 2008. Payday loan stores closed, but then re-registered as mortgage lenders or credit service organizations -- thereby exempting them from the rate cap. Today, Ohio is home to the nation’s highest average payday loan APR. “It is a bit like whack-a-mole,” Vermont’s Kolber says. “We’ve done as much as we can do, but there will always be people who are committed to going out and getting a loan no matter what.” And there will always be lenders ready to take their money. 

*Source for first chart: Montana Office of the Attorney General

Liz Farmer is a former GOVERNING fiscal policy writer.
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