If Payday Loans are Banished, Will Anything Better Replace Them?

One of the biggest questions that arises over the possibility that payday loans could be legislated out of business by the Consumer Financial Protection Bureau, or CFPB, concerns whether any comparable loans will replace these emergency, short-term loans.

Consumers have come to depend on these loans, and most payday borrowers support the industry with high approval rates. Frequently referred to as one of the fringe financial services, payday loans offer easy-to-get loans with fast approval rates to tide people over when they need cash. These loans include payday, installment, auto title and cash advance loans. The CFPB has introduced a slew of new regulations that could drive these lenders out of business, but the question remains, “Will something better replace them?”

The short answer is no according to an article posted on Theatlantic.com website. This study examines lending in previous decades and finds that there has always been a demand for emergency cash that’s been fulfilled by using pawn shops, maxing out credit cards, borrowing from friends and family members, gambling, obtaining loans from criminal organizations, selling plasma and committing other risks to get emergency cash.

The Barriers to Replacing Payday Loans with Something Better Are Substantial

The interest rates for short-term loans must be higher than those for long-term loans and mortgages in order for lenders to cover their overhead and earn reasonable profits. Since these loans are only intended for use as stopgap measures, the high interest rates aren’t really the problem that draws criticism.

Many borrowers take out loans that they can’t afford to repay, so they renew their loans and get trapped into a cycle of debt. An article posted at Bigstory.ap.org reports that about 12 million Americans take out these types of loans each year and spend more than $7 billion in interest charges, bank fees and other costs.

Many borrowers schedule too many automatic debits from their bank accounts or take their cash out before payday lenders can debit the accounts, which causes the banks to charge fees. The default rates on these loans are high, so lenders naturally try to get their money by debiting the accounts several times. Each of these attempts results in additional fees, which payday lenders don’t receive.

The industry doesn’t earn ridiculous profits because the loans are short-term, administrative costs are high and default rates are substantial. In fact, Theatlantic.com article found that the average profit margin for these lenders was only 10 percent, which is perfectly reasonable and less than many investors earn passively in the stock market. Lenders who have storefront operations net even smaller profits due to overhead costs, high employee turnover rates and shrinking markets–payday loan stores now outnumber McDonald’s franchises.

Any bank or credit union strategy to offer short-term loans as replacements for payday lending face these same barriers, and 36-percent caps on short-term loan interest rates, which the CFPB is recommending, won’t work unless other changes are made to the business model such as tightening approval rates or lengthening repayment periods. Two-thirds of payday loan profits are eaten by overhead just to keep the neon lights flashing, and 20 percent of payday borrowers default on repaying their loans.

Alternatives to Payday Lending Would Operate in the Outermost Fringes of Financial Services

Fringe financial services have always targeted low-income families who need options to raise cash or get things for their homes. These services include pawn shops, loan-shark operations, rent-to-own companies, subprime mortgage loans, tax refund loans and other services. Regardless of whether a particular service is legal, the business model is still the same: Interest rates reflect the degree of risk, overhead expenses, default rates, competition and supply and demand forces. Given the hard realities of offering short-term loans to as many people as possible, it’s hard to imagine that any organization could offer substantially lower interest rates for the same types of short-term loan products. Without these loans, low-income families and people with poor credit ratings will often turn to alternative financing methods, many of which are riskier and more expensive than payday loans.

Most payday loan critics expect that banks will take over short-term loans, but even the banking industry has expressed reservations about its ability to offer loans to most consumers at rates that fall within the CFPB’s recommendations. The costs of underwriting these loans would cannibalize profits from other loans. Elizabeth Warren, a chief architect of the CFPB and well-established foe of payday lending commented, “If you’re considering taking out a payday loan, I’d like to tell you about a great alternative. It’s called ‘Anything Else.’” Warren has also recommended that the postal service partner with banks to serve as offices for short-term loans, but this option could create big problems for postal workers who aren’t trained in how to run loan operations.

Payday Lending May Evolve to Continue Offering Short-Term Loans

Regardless of whether the payday loan industry survives, today’s rampant consumerism and high levels of debt have fostered a payday-to-payday culture where fewer than one out of every four Americans could cover six months of expenses from savings according to a Money.cnn.com report. Given the high demand for emergency cash, it’s likely that the payday industry will evolve to offer loans to fewer people over longer repayment periods or come up with other types of financial products. The loans may continue strictly as online products, or lenders could partner with other organizations to offer short-term loans and other products. Find out more about the alternatives to payday lending at the PersonalMoneyStore.com.