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Hot Pursuit of Customers: The Real Reason More People are Turning to Payday Loans

posted by Nathalie Martin

As one who studies the advertising and marketing plans of payday and title loan companies, I was interested in two Wall Street Journal articles published this week on the topic of payday loans, one claiming that Dodd-Frank has pushed many consumers into the hands of payday lenders, and another describing how hard payday lenders are working to steal customers from banks. Since many payday loan customers do not fully understand the terms of the loans, it isn’t that hard to steal customers from banks.  Payday loans, often at least ten times more expensive than credit cards, are easier to get. The lenders are far friendlier to customers and have more locations and business hours.  Plus, have you seen the advertising? It makes it sound easy and even fun to take out a 500% loan.  Payday loan industry experts now claim that their toughest business challenge going forward is not collecting on bad loans but finding enough new customers to keep the hundreds of thousands of stores afloat. Payday loan volume dropped $38.5 billion in 2009, or 24% since 2007, in part because of state regulation. Industry has successfully dodged regulation in some state, mostly by claiming that customers desperately need these loans for emergencies. The truth of this statement seems critical to the survival of this industry, but let’s look at the industry’s advertising and the real uses of these loans.

Payday lenders are getting quite desperate for customers, and thus now offer loyalty programs to get people to refer their family and friends, whether these friends and family members have an emergency or not. They offer similar loyalty programs to get people to keep the loans out longer, whether they have a continuing emergency or not. They offer more loans as soon as one loan is paid off, whether the customer has an emergency or not. The advertising suggests that people use the loans to get through the holiday gift-giving season, even to go out to eat! It is time to really study how these loans are being advertised, and also to look at how they are actually being used. My own data show that less than 10% of the loans are actually used for emergencies. 

As for this idea that Dodd-Frank is the driving force in pushing people into the hands of payday lender, this is not the case. Customers were borrowing from payday lenders when they could use banks well before Dodd Frank or the Credit Card Act. The real cause of this shift is the payday loan industry’s own search for customers, as well as their advertising, which claims loudly and repeatedly that payday loans are good for anyone or everyone, any time, and are not just for emergencies.



Absolutely, these loans are rarely used for emergency or important needs. The WSJ article talked about the one gentleman who was taking out a loan for Christmas presents. How sad.
On another blog, a lady who said she has 10 online payday loans that she can't pay (she didn't give any amounts but I can imagine how big they are at the interest rates they charge) was asking if bankruptcy would clear those debts.
Bankruptcy? She would probably need a good lawyer and I doubt she could afford one (without taking out another payday loan).
One of the biggest problems is that many people have no concept of self-control or personal responsibility. They think they need something (even if it's a luxury) and so they borrow money to buy it. Then they want to bail out of everything through bankruptcy. How sad.

Jim, I must say, I agree with every single thing you just said.

Great, another industry argues it can't be regulated or it will be forced to contract at dire cost to the public. Unless it's bailed out. The problem with declaring something too important to regulate or too big to fail is that those thresholds keep expanding.

One reason they need so many more new customers because there are so many of them -


Payday loans can be tempting, but critics like the Christian Life Commission say they are milking Texans out of $3 billion in high-cost loans every year.

CLC’s Suzii Paynter said there are more than 3,500 of these lenders in Texas right now – more locations than McDonald's and Whataburger combined.



More Payday Lenders In Arizona Than McDonald's And Starbucks Combined

By Meg Marco on March 28, 2007 3:17 AM


Payday lenders vs. McDonalds by state:



That's a whole lot of "emergencies" that are going on out there....

There is a Dollar Store that I frequent with a payday lender right next door. The other day, upon running my errands, I noticed a very attractive woman, all decked out, including a fur coat, standing in line at the payday lender. Kinda shrugged it off until I ran into this same woman about an hour later at the all too ubiqutous "nail salon" where I get my real nails manicured and kept short. She, on the other hand, was getting a full set - no doubt from money "borrowed" at the payday lender.

Just sayin...

We do have information about why people get payday loans from the FDIC Unbanked/ Underbanked Survey Study Group. 2009. FDIC National Survey of Unbanked and Under‐ banked Households. Washington, DC: Federal Deposit Insurance Corporation.

The FDIC found on page 43 that "These underbanked households obtained AFS credit funds
for a variety of reasons. Nearly 40 percent of underbanked households that have used some form of AFS credit product did so to pay for basic living expenses (see Figure 5.15). Another 15.4 percent of underbanked households that used AFS credit products indicated a need to make up
for lost income. Relatively few underbanked households use AFS credit products for specific expenses such as home repairs or appliances (7.0 percent), gifts or luxuries (6.2 percent), car repairs (4.5 percent), medical expenses (2.3
percent), or school or childcare expenses (1.6 percent)."

Of course, some people are using the loans for luxuries, but it does not seem like the majority of people are using them frivolously.

Thanks so much for all these interesting comments. Great discussion! Jim Hawkins, the FDIC underbanked data is super-close to that in my little New Mexico study. Most loans are used to meet regular expenses, not emergencies and not luxuries.The reason I also agree with Kay and Jim Collins is that money is fungible. You'd need to know how all money in a household is being spent to really know if there were luxuries like the nails or some other budgeting problem. In any case, if you are borrowing money at 500% per annum to meet regular expenses, you need to have fewer regular expenses, whatever that takes. Paternalistic, I know, but this just isn’t viable over the long haul.

Excellent post, Nathalie. In my brief experience litigating against the industry, I've learned that a lot of payday companies don't even bother touting the value of their services to borrowers facing financial emergencies--at least not in the courtroom (the legislative arena is another question). Instead, they fall back on neoclassical arguments about the sanctity of "revealed preferences" and the importance of preserving the freedom to contract.

Nevertheless, there is no doubt (in my mind, and given the specific advertising material that I've seen) that the marketing strategies these companies employ are designed specifically to take advantage of sanguine borrowers who often lack the financial wherewithal required to price-shop the payday product against cheaper credit alternatives. When coupled with complementary strategies aimed at converting otherwise short-term borrowers into "semi-permanent cash annuities" (Mann & Hawkins), these practices have the empirically demonstrable effect of trapping borrowers in a cycle of debt. That *some* of these borrowers may have had true financial emergencies when they first took out a loan from a payday outfit shouldn't provide an enduring justification for the borrower-as-cash annuity.

While I do believe it is important to critique the payday-loan industry, and that it is accurate to label it as "predatory," I don't see the use in jabbing the people who use the loans- for whatever reason.

Plenty of people don't know how to budget. I wasn't able to keep a budget myself until just the past couple of years. I have used payday loans before. It's not an indicator of low moral character. I would use them when my paychecks were so small that I couldn't afford to pay rent, etc, and just simply have enough food or enough left over to pay utilities.

We live in an economic culture where it's very evident that people with one kind of paycheck are considered more "deserving" of items/goods/services (such as manicures) than people with smaller paychecks who might feel the need to take out payday loans to make ends meet. Being judgmental or trying to take on the role of "the ultimate arbiter of who deserves those little extras and who doesn't" doesn't really aid the discussion or find any solution to the problem.

John, thanks for the comment. You've given this a lot of thought. And, I hear your long hours are paying off. Congratulations!

AMC, thanks greatly for the charts. They are depressing but very interesting. I see that New Mexico has more of these per capita than any other state.

Finally, Elaina, I thank you the most of all. You are so right about the budgeting. People do not know how to do it. I do not judge anyone for using a payday loan, ever. Even for a manicure. What does bother me is how much it ends up costin,g when a person who understood the loan might be able to get the manicure (with cash in hand) for a fifth or a tenth of the price, just by waiting a few days. Knowledge is power, and like John said, this industry does best when people have less knowledge. That is never a good thing.

Question for all of you: AMC’s link notes one fact I have noted for a long time. In the poorer states, politicians from both parties seem to favor industry. I am not being cavalier, I’d really like to know. Why is this? Shouldn’t the opposite be true, given how few payday loan places are locally owned and how much of the money involved goes out of state?

Alright I have a great business opportunity we are going to start a business called "Ethical Payday Lenders" and charge only 36% interest on our loans (the high rate for Oregon). To keep it simple we will say that we are going to lose 20% of every dollar we lend. Also, the lending horizon of our loans and this is important is 2 weeks meaning good customers will pay us off or roll to the next period or we will incur the losses from those who do not pay us.

We start with 100,000 in capital.
First two week period - Lend 100,000, Lose 20,000 to losses, collect interest of 1,108 (you only collect interest on people who paid you back, the 80K). At the end of the 2nd week then we have 81,108 - 80K in principal paid back and 1,108 in interest collected.

Starting Balance 100,000
Losses (20,000)
Principal Repaid 80,000
Interest Collected 1,108
Ending Balance 81,108

We now repeat the process but lend out 81,108.

at the last 2 week period of the year given the assumptions above our "Ethical Payday Lenders" business looks like this

Starting Balance 533
Losses (107)
Principal Repaid 426
Interest Collected 6
Ending Balance 432

So in 1 year we lost 99.5% of our investment.

Two things work against here. First and foremost are losses. They are higher then just about any other form of credit available. This necessitates a higher interest rate to compensate because again you only collect income from those who pay you back. All customers served must make up for the losses - higher the losses, the higher the rate. Second and equally difficult is the lending horizon. The average horizon is no more then a few weeks, which means the portfolio turns over quickly making it more likely every time you lend a dollar out that we will lose it.

To break even in the scenario above we would have to lend at a 650% annualized interest rate or 25% per 2 weeks.

Let's say we cut the loss rate on dollar lent to 10%, we would then need close to a 300% rate.

The moral of this story is when you have a portfolio with high losses that turns over quickly, you need an extremely high rate to compensate.

Natalie you are right the customers for this industry do not know the interest rate, but most people do not know the interest rate on their credit card either (saw a metric that said 75% could not quote their rate). We as a society are bad at math. Its why people would rather have a 5 cents off per gallon of gas rather then 5% off. Its why I never see someone who is well dressed playing a scratch off game.

I am all for finding alternative solutions for folks in these situations, payday lenders are not ideal. However, with the losses generated from this population its incredibly difficult to serve them unless you keep the loans small, the payments low, and a very high interest rate. Personally, I would rather keep them in the financial system where they are afforded some protection rather then pushed out into underground funding.

Just as a follow-up the only time we could make money at given the 36% annualized interest rate above is if our loss rate every time we lent was ~1%. To put it in better context. If we lent $1,000 out to 100 people we could only have one person NOT pay us every 2 weeks. Given this population that number is an impossibility.

@Jim Hawkins
"Underbanked." Snort. On to the serious point. People don't have to be spending these loans on frivolities for them to be bad. If they start using them for everyday expenses, they're in a death spiral.

20% of your borrowers don't have a paycheck to pursue when the loan comes due? You need to change your collateral and due diligence models.

Kunte - I was speaking of unsecured loans, not title loans so other then a post-dated check there is no collateral.

The 20% was more of way of demonstrating the incredibly difficult economics associated with this sort of lending. Take the assumptions above and use 5% - keep in mind credit cards run between a 1 - 3% unit loss rate depending on the portfolio. The ending number is 37,677 vs 432. Better but still a 63% loss. To break even once again at a 5% loss you would have to charge a 137% rate.

Losses and portfolio spin work against you in a way that only high rates can compensate otherwise you have to reduce your risk which means collateral ie auto title loans.

This has been an interesting back & forth. The main point that continues to be missed in this debate is that it is the small amount of actual dollars earned on smaller credits that creates the need for a higher APR in order to offset overall costs.

While losses are a factor in the return of the lending economic business model, it is the operating expense that is the biggest factor.

Thats why licensed and regulated small loans were created over 100 years ago with the repeal of usury laws.

The problem with payday loans is not its pricing, which is appropriate for the size and duration (two weeks), it is its impact of its application of the repayment terms on the borrower who can't pay it back going into it.

If it is repaid back in two weeks, it is a vey cost effective product for the consumer.

But if it is placed onto someone who clearly can't repay back in two weeks, then the problem begins.

Find a way to offer small dollar loans that amortize and are underwritten for repayment (which might require an APR of 60% to 90%), and price so that a lender can make a reasonable return, then you will address the payday issues.

I do know this. 36% is not the number as the FDIC small dollar project found that small loans could not be made profitability at that level. Not without significant taxpayer money or granting CRA credit for offering loans at a loss. We know that doesn't work well.

re: bad debt: I just checked AEA's most recent 10Q, and their reserve for doubtful accounts is just north of 20%. In light of that, the business model does require high interest rates. The upshot is that interest rate caps will just shut down the market. That's all fine and good, but one wonders what the consequences will be (increase in the black market for lenders? More utility shut offs?).

JPE. You have to look at ROA and see the impact of both loss % and operating expense % have on loan yield %.

Yes, losses can be higher but it is principally the need to generate enough interest dollars to offset the operating costs that is the primary consideration of a higher yield.

This is why the FDIC small loan program demonstrated that a 36% cap, small dollar loans could not be made profitably by banks, even with losses in the 8% to 10% range. In other words, their initial goal for the program failed. It just demonstrated the obvious.

As for consequences, one only has to look at North Carolina which banned storefront payday lending. It was proclaimed that consumers would not miss it but the subsequent facts have proven otherwise.

There has been an explosion of compliants filed with the NC AG about internet payday. 80% or more of the payday/title lenders business in boarder states are from NC. The demand/need does not go away simply by banning the product.

These misguided attempts to legislate/regulate a social agenda always end up hurting the very people that the agenda is trying to protect. This is a statement that echoed over 100 years ago when this same debate was going on.

Chris- Can you refer me to the source of your information that North Carolina residents are turning to Internet payday lenders or those in nearby states? Thanks!

Jeff - Source for internet payday loan complaints is from Consumer Protection Division of the North Carolina Department of Justice in a report provided to the North Carolina Commissioner of Banks Consumer Credit meeting held on November 17th, 2010.

2008 - 150 complaints
2009 - 219 complaints
YTD 2010 - 445 complaints (don't know exactly when the cut off date was)

As for the border state comment, I should have better described it as storefronts located near the NC border. Park your car in a lot and count the NC license plates.

I am sure that contacting that office that the information can also be obtained since it is public information(but not always readily accessable unless it is specifically requested).

The Payday Loan report that was issued in late 2007 in NC through the Center for Community Capital had what I believe were statiscial sampling issues which would make the conclusions suspect at best.

It also contained a reference to an economic analysis and conclusion concerning the State Employees Credit Union SALO (payday) loan product. That source document contains a faulty analysis of the ROA calculation which also leads to a fasle conclusion with respect to the products profitability and sustainability to provide the product at a low APR.

Unfortunately, both these flawed documents have been repeatedly cited in subsequent papers and books as referenced support for their positions. This includes works by some current regulatory leaders (I have to believe that they really don't recognize the flaw; I hope).

Regardless, in the end a decision is as only good as the information you are using to make it. Unless you want that decision to be direction focused.

Simple question: Can a high-cost small lender like, say, Green Cap Financial in North Carolina profitably operate without >80% of their borrowers being repeat customers (i.e. cash annuities for the lender)?

If the answer to that question is "no," then I don't see the point in discussing whether lender margins are reasonable or in line with industry norms. The justification for regulating the loan products out of existence is the same as that for banning for lead-paint toys. We don't eliminate lead-paint toys because their producers are reaping insuperable profits; we eliminate them because they are demonstrably harmful to consumers.

Simple answer. Can any legitimate business survive without repeat business, whether that be a private enterprise or social enterprise? The obvious answer is no. Seems like a simple enough question to answer. Since the legitimate business you speak of is licensed and strictly regulated, and offers one of the most financially disciplined methods for small dollar credit, one would have to politely disagree with the "demonstrably harmful" opinion.

As for the term "high cost" the facts would take the position that it is a relative term in that the dollar costs of a 36% APR amortizing installment loan can be, and often is, significantly less than say an 18% credit card loan given the repayment requirements. Even lower than say, a 12.75% credit union credit card since only 2.5% of the principal is required as a monthly payment.

So assigning the term high "high cost" is both subjective and in many cases, inaccurate.

As a follow up, one might say that a small loan borrower could make comparable payments on the lower APR credit cards as the installment loan requires, thereby actually achieving a lower cost. Yet that lack of discipline is often too tempting and ultimately the borrower, who is better served with a more disciplined loan structure, is mired in more debt & interest costs.

The facts have proven that. And as a recent discussion with both lenders and consumer advocates brought out, small dollar installment loans had no discernable contribution to the factors that drove distressed borrowers into credit counseling offices. While that was state specific, I suspect it holds elsewhere. So simply linking a given APR to the term "high cost" is both financially inaccurate & intellectually dishonest.

If one believes that the best solution to small dollar credit is to implement artificially low interest rates, then say so and then honestly discuss the need for the significant government subsidies to support it (which in some cases is happening now). While social enterprises that are focused on lending have filled a necessary niche in a useful & productive way, it is just a niche and they are ill prepared to expand beyond the limited objective for which they were created. The same was true for their predecessors at the turn of the last century.

If one believes that the best solution is to allow private enterprises to service the small dollar credit need, allowing for sound regulation and consumer protections, then an appropriate rate must be established which strikes a legitimate balance between the rate charged & a reasonable rate of return on the capital invested in the business. That is how private enterprise works.

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