Payday Loan

What It Means

A payday loan is a small cash loan, usually between $100 and $1000, that is extended to a customer over a short time period, typically one to two weeks. The term payday loan suggests that the borrower will be able to repay the loan upon receiving his or her next paycheck.

Payday lenders in the United States generally operate out of either small independent storefronts or franchises (licenses granted to market a company’ goods or services in a certain territory) that belong to multistate chains; some also market loans via toll-free phone numbers and over the Internet. The typical payday loan customer is a low-income earner with little or no means of borrowing money elsewhere.

Also known as a payday advance or a deferred-deposit loan, a payday loan is much quicker and easier to obtain than a traditional bank loan. The borrower simply writes a post-dated personal check (a check dated with a later date that cannot be cashed until that date) to the lender for the amount of money he or she wants to borrow, plus the fee, or finance charge, for the loan. The finance charge typically ranges from $15 to $30 for each $100 borrowed.

When the loan is due to be repaid, the balance and fee(s) must be paid in full. The borrower may pay the money back by replacing the check with cash or by allowing the check to be deposited (so that funds will be withdrawn from his or her checking account). If the borrower cannot repay the loan at the time it is due, he or she may elect to pay only the finance charge and roll over (or renew) the loan for another pay period (at which point another finance charge will be applied).

In spite of its apparent convenience, a payday loan is extremely expensive: the fee associated with borrowing the money is many times higher than the amount a traditional lender would charge in interest. There is much debate about whether payday lending offers a beneficial resource to its customers or whether it preys upon and worsens the circumstances of those who are already financially vulnerable.

When Did It Begin

The practice of borrowing money against a post-dated check dates back at least to the Great Depression (the most significant banking-industry failure in U.S. history, lasting from 1929 to about 1939), when most Americans were struggling to make ends meet, but the astronomical rise of payday lending in the United States occurred only in the early 1990s. The stage was set for this boom in the late 1980s when the federal government relaxed restrictions on how much interest a lending institution could legally charge. Also during this period the banking industry underwent a radical transformation that resulted in a dramatic decrease in the number of banks in the United States; in particular it reduced the small-loan services available to poor, inner-city customers. In the aftermath of these changes, payday loan stores filled the void in lending services available to this segment of the population.

In 1992 payday lending locations were scarce, if not unheard of, in the United States. By 2004 payday lending had become a $40-billion-per-year business (in terms of how much money was loaned out), with more payday loan store locations in the United States than McDonald’s restaurant franchises (according to the Community Financial Services Association of America, there were over 22,000 payday loan stores compared to 13,600 McDonald’s locations).

More Detailed Information

For many people who need fast cash, the convenience of a payday loan is hard to resist. Unlike with most traditional loans, borrowers are not required to provide information about their credit history (a record of other financial dealings). All they need is a verifiable source of income, a checking account, and some valid identification, such as a driver’s license or passport.

Compared to the cost of a typical bank loan or even of a cash advance from a credit card company, however, the cost of borrowing from a payday lender is exorbitant. The APR (or annual percentage rate charged in interest) on a personal bank loan, even for someone with a poor credit history, might be somewhere between 9 and 13 percent; for a cash advance on a credit card, it might be as high as 50 percent. Compare this to a payday loan, for which the average APR is 470 percent!

Here is how it works: Say you borrow $100 from a payday lender for a term of 14 days. The finance charge for the loan is $15. This finance charge is equivalent to an APR of 390 percent, which means that if it took you a full year to pay back the $100, you would pay $390 in interest. While it might seem unlikely that it would take anyone an entire year to pay back a mere $100, data shows that most payday loan borrowers roll over their loan multiple times. This means they pay $15 every two weeks (it is not unusual for a borrower to end up paying $60 in finance charges on a $100 loan) just to avoid having to pay back the original $100. In cases where a lender allows only a limited number of rollovers, the borrower often takes out another payday loan from a different lender in order to pay off the first loan. Many working poor people become trapped in this cycle of borrowing, paying huge sums in finance charges over the course of a year. Although the payday loan industry maintains that its loans are only intended to cover the occasional emergency, national data shows that the average payday loan customer takes out between 8 and 13 loans per year, usually to cover such routine expenses as rent, utilities, and food.

Defenders of payday lending claim that the service represents the democratization of credit, meaning that it makes credit (or loans) available as a financial resource for people who are otherwise unable to obtain a credit card or borrow money when they need it. Further, they argue, it is only reasonable that lenders protect themselves by charging high interest rates, because they are dealing with high-risk borrowers who would never receive a loan from the average bank. Critics of payday lending, on the other hand, claim that these businesses prey on people who are financially insecure and uninformed about other options they might have for making ends meet.

Recent Trends

Controversy over payday lending practices continued to grow between 2003 and 2007, especially as numerous studies conducted by the Center for Responsible Lending, the Consumers Union, the National Consumer Law Center, and other groups revealed that payday lending stores were disproportionately concentrated in African-American neighborhoods and near military bases.

The laws governing the payday lending industry in the United States vary from state to state. In some states, such as Georgia and New York, payday lending is effectively banned by consumer loan laws that cap interest rates in the double digits. In response to public outcry and pressure from numerous consumer protection groups, many other states sought to impose restrictions on the payday lending industry, including limits on the amount of a loan based on the customer’s income, limits on how many loans a borrower could take out at a time, and limits on how many times a borrower could roll over the same loan.

Still, the payday lending industry proved difficult to reform. One strategy lenders used to circumvent (or get around) state laws was to form alliances with banks in less-restrictive states and borrow their charters (which are like licenses) to operate as usual in the state where reforms were imposed. This was referred to as the rent-a-bank tactic.