In Defense of Payday Lending

Payday lending, sometimes known as a "payday advance" or a "deferred deposit" loan, is a short-term two to four-week loan backed by a postdated personal check that a borrower agrees to cover with sufficient funds out of his or her next paycheck.

The payday lender holds the check until the agreed-upon date, at which point it is cashed and (hopefully) covered by the borrower’s payday deposit.

So, what’s the problem? Plenty, according to the critics of the payday lending industry. First, the effective annualized interest rates charged on payday loans are relatively high when compared with the rates charged on more conventional consumer credit or on credit card purchases.

The critics of payday lending view these relatively high interest rates with much alarm, arguing that the fees charged are exploitative of poor borrowers lacking in personal financial management skills.

Second, critics argue that payday lending impoverishes poor households by encouraging chronic borrowing from paycheck to paycheck, putting them deeper and deeper in debt.

This "predatory" lending is seen by critics as a way for the payday lending firms to increase profits and keep customers in chronic dependency on payday loans.

The critics do not acknowledge that because payday lending establishments are admittedly dealing with a high-risk clientele, the effective annual interest rates charged on these types of small loans are going to be considerably higher.

Because the risk is relatively higher, the risk premium on the loan will naturally be higher.

Because payday lending institutions provide high risk borrowers with this opportunity to borrow when other institutions will not does not mean that payday lenders cause this behavior.

Government regulations in the form of price caps on payday loan fees or a mandated "cooling off" period between payday loans are "solutions" in search of a problem that does not exist.

The Uniform Consumer Credit Code adopted by most states already sets maximum interest rates that may be legally charged on consumer loans of varying amounts.

This rate ceiling may be well above the market interest rate charged to the typical loan applicant or credit-card borrower with a solid credit history through an established bank.

However, to the extent that the mandated rate ceiling is below the market rate that would be charged on a similar unsecured loan to, say, a low-income loan applicant with limited employment and a poor credit history, it is "binding."

For the sake of unestablished and low-income borrowers everywhere, we can only hope that federal and state governments can be prevented from further disrupting this consumer lending market.

Tom Lehman is assistant professor of economics at Indiana Wesleyan University (Tom.Lehman@indwes.edu). Recommended Reading: M.A. Stegman and R. Faris, "Payday lending: A business model that encourages chronic borrowing," Economic Development Quarterly 17 (1): 8–32.