Acton Institute Powerblog

What’s the Real Problem with Payday Loans?

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and112812blogSince its inception in the 1990s, the payday lending industry has grown at an astonishing pace. Currently, there are about 22,000 payday lending locations—more than two for every Starbucks—that originate an estimated $27 billion in annual loan volume.

Christians and others worried about the poor tend to be very uncomfortable with this industry. While there may be forms of payday lending that are ethical, the concern is that most such lending is predatory, and that the industry takes advantage of the poor and others in financial distress.

So what makes a payday loan a predatory loan? The obvious answer would seem to be “high interest rates.” But interest rates are often tied to credit risk, and so charging high interest rates is not always wrong. Another answer may be that the loans appear to be targeted toward minorities. But research shows that the industry appeals to those with financial problems regardless of race or ethnicity.

What then tips a loan into the predatory column? At a blog hosted by the New York Federal Reserve, Robert DeYoung, Ronald J. Mann, Donald P. Morgan, and Michael R. Strain attempt to answer that question:

Except for the ten to twelve million people who use them every year, just about everybody hates payday loans. Their detractors include many law professors, consumer advocates, members of the clergy, journalists, policymakers, and even the President! But is all the enmity justified? We show that many elements of the payday lending critique—their “unconscionable” and “spiraling” fees and their “targeting” of minorities—don’t hold up under scrutiny and the weight of evidence. After dispensing with those wrong reasons to object to payday lenders, we focus on a possible right reason: the tendency for some borrowers to roll over loans repeatedly. The key question here is whether the borrowers prone to rollovers are systematically overoptimistic about how quickly they will repay their loan. After reviewing the limited and mixed evidence on that point, we conclude that more research on the causes and consequences of rollovers should come before any wholesale reforms of payday credit.

The authors briefly consider a range of factors and are convincing on all but one: the problem of “spiraling” fees, which I believe are the core problem with rollovers.

But first, here’s a brief reminder of how payday lending—and rollovers—works. If you have a job (and pay stub to prove it), a payday lending company will allow you to write and cash a post-dated check. For this service the company will charge a high (sometimes absurdly high) interest rate. The authors of the article give this example:

Suppose Jane borrows $300 for two weeks from a payday lender for a fee of $45. If she decides to roll over the loan come payday, she is supposed to pay the $45 fee, and then will owe $345 (the principal plus the fee on the second loan) at the end of the month. If she pays the loan then, she will have paid $90 in fees for a sequence of two $300 payday loans.

They make the peculiar claim that this is not “spiraling”:

Perhaps it is just semantics, but “spiraling” suggests exponential growth, whereas fees for the typical $300 loan add up linearly over time: total fees = $45 + number of rollovers x $45.

Indeed, it is just semantics since most loan consumers would not see a much difference between “exponential growth” and “linear growth,” especially when in a matter of weeks the fees can exceed the amount of the loan.

They do admit, though, that the problem is “all about the rollovers”:

So if payday loan fees are competitive and don’t spiral, and if lenders don’t target minorities, and if the academic research on the pros and cons of payday credit is so mixed, what’s left in the critique against payday lenders? Rollovers. Payday lenders often pitch their two-week loans as the solution to short-term financial problems, and, true to form, about half of initial loans (those not taken out within fourteen days of a prior loan) are repaid within a month. Potentially more troubling is the twenty percent of new payday loans that are rolled over six times (three months) so the borrower winds up paying more in fees than the original principal.

Critics see these chronic rollovers as proving the need for reform, and in the end it may. A crucial first question, however, is whether the 20 percent of borrowers who roll over repeatedly are being fooled, either by lenders or by themselves, about how quickly they will repay their loan. Behavioral economists have amassed considerable evidence that, contrary to tenets of classical economists, not all people always act in their own best interest; they can make systematic mistakes (“cognitive errors”) that lower their own welfare. If chronic rollovers reflect behavioral problems, capping rollovers would benefit borrowers prone to such problems.

The authors correctly identify the problem but they assume the “cognitive error” must be in being “fooled” (either by the lender or by oneself) about how quickly the loan can be repaid. I think there is another explanation.

About twenty years ago I made some terrible choices and found myself in a serious financial bind. The amount I needed wasn’t much—about $200—but without it I wouldn’t have been able to pay my rent. I took out a payday loan that cost me $30 every two weeks. It took about eight weeks to get clear of the loan, resulting in a cost of $120 to borrow $200 for two months.

Was I fooling myself thinking the loan could be paid in two week? Not at all. In fact, I knew quite well that there was likely no way possible for me to pay it off in that timeframe. I knew precisely how much money I was going to be able to earn and how much my expenses would be during that two-week period. I had, roughly speaking, about $40 a week that I could apply toward the loan.

But $40 was not sufficient to cover the balloon payment of $200 that was due at the end of two weeks. So I had to roll over the loan, applying $15 a week to the new fees and saving $25 a week to be paid toward the principal. That is why it took me eight weeks to pay off the original loan: $25 a week for principal + $15 a week for fees = $40 x 8 weeks = $320 ($200 for principal + $120 for fees.

If you’re middle class and think of it in terms of interest rate, that repayment cost sounds appalling usurious. And it is. But as the poor will tell you, man does not live on APR alone. Having to pay an extra $120 was cheaper than having to find a new place to live. Yes, it was a bad deal. But it was better than all my other choices. I didn’t agree to the loan because I was bad at a math; I did it because I was desperate. And the payday lending company was more than willing to take advantage of my desperation.

How then do we solve the problem of rollover fee that take advantage of the poor when they are in dire straits? I believe a helpful first step would be to get more churches and other faith-based organizations involved in providing alternatives to commercial lending agencies. After all, caring for the poor is not just about food banks and handouts. Sometimes the best way to help those in need is to provide a financial bridge during desperate times.

Joe Carter Joe Carter is a Senior Editor at the Acton Institute. Joe also serves as an editor at the The Gospel Coalition, a communications specialist for the Ethics and Religious Liberty Commission of the Southern Baptist Convention, and as an adjunct professor of journalism at Patrick Henry College. He is the editor of the NIV Lifehacks Bible and co-author of How to Argue like Jesus: Learning Persuasion from History's Greatest Communicator (Crossway).


  • Philosophical Actuary

    Where does the idea that usury is only charging excessive interest come from? By which I mean, who said it? The formal definition of usury is “when gain is sought to be acquired from the use of a thing not fruitful in itself, without labor, expense, or risk on the part of the lender.” Note this definition makes no reference to money or excessive interest. This definition is a kind of lending, not something of excess. The notion that usury concerns only excessive interest was addressed in the papal encyclical Vix Pervenit.

    • As Calvin wrote, charging interest on loans is no different from charging rent on land or a house. The Biblical use of the term shows that it was intended to prohibit charging poor people interest for loans, not prohibiting all interest on any loans. But Calvin thought that somehow 5% was the God-given rate of interest and any charge greater than that was evil. The idea that only high interest, greater than 5%, is usury comes from Calvin. From a Biblical perspective, usury is charging interest on loans to poor people. The Bible prefers loans to the poor rather than charity because it preserves the dignity of the poor.

      • Philosophical Actuary

        Does Calvin give rational or philosophical arguments for his position or is it merely based upon his interpretation of Scripture? Does Calvin address the traditional definition of usury? In what work(s) does he talk about usury? Is he novel in this position or did he draw from others? I recall reading that Luther took a more traditional position along with some of the other Protestant leaders.

        • Actually he just mentions it in a letter to someone without much explanation. But church scholars had gradually refined the definition of usury until Lessius made almost all interest on loans legit. Meanwhile, the Catholic church borrowed and loaned at interest pretty much its entire history and allowed wealthy people to loan to monarchs with interest. It’s seems pretty clear that the Church originally got its ideas about economics and interest from pagan sources and not the Bible.

          • Philosophical Actuary

            I Googled and found that he also mentions it in more detail in a commentary on Ezekiel, but I did not take the time to read it closely.

            I don’t quite understand the impetus to redefine usury. If you want to claim that money in itself is not sterile, as it seems Calvin and most modern economists wants to, then loaning money and charging interest is not usury by the traditional definition. Certainly overcharging or charging an excessive interest is a species of injustice, but it isn’t usury.

          • As I posted above, the idea that money is sterile comes from Aristotle, not the Bible. But as the church began to create modern science its scholars questioned Aristotle’s physics and cosmology which gave others the courage to challenge his economics. The church got it’s theology of interest from the pagan Aristotle, not from the Bible.

  • John Bolin

    A $45 fee (really interest) on a two week loan of $300 computes to an annual fee (annual interest rate) of 390%. Semantics aside, that’s usury in my book.

    • Lots of studies have shown that the fixed costs of loaning such small amounts are so high as to justify that interest rate. The fixed costs of a bank are essentially the same for a $10 million loans as for a $100 loan, so the only way banks can pay those fixed costs are by charging a much higher interest rate.

      BTW, the church scholars of Salamanca determined that any price is a just price if the parties in the transaction agree to it and there is no coercion by the seller and no fraud.

      There would be no demand for payday loans if churches were doing their job and offering them at no interest.

  • Lawrence Meyers

    Your opening sentence undermines your entire argument. Payday lending has HUGE DEMAND because PEOPLE LIKE THE PRODUCT.

    • There’s a huge demand for a lot of unethical activity (e.g., prostitution). Also, demand itself is not necessarily a sign that people like a product. It could be they have no other alternative.

      • Lawrence Meyers

        So your brilliant solution is to take that option away, and force them to other options that THEY’VE ALREADY REJECTED. You yourself said you were in a bind. But YOU planned poorly. Contrary to what you may think, there are a litany of studies that show that 93% of all loans are paid off on time, and 80% are either satisfied or very satisfied with the product.

        The worst case scenario is that YOU ask the lender for an extended payment plan. If he says no, you just default on the loan. Your credit isn’t affected. You just get sent to a collection company.

  • Here is a video by Alejandro Chafuen:
    Chafuen has a great book – The Economic Thought of the Late Scholastics.
    Rothbard’s “An Austrian Perspective on the History of Economic Thought” has a lot of church history and economic theology.

    I can’t provide all of the sources I have read over the years. But if you read the two above I think you’ll find that the church revered Aristotle a little too much and it’s theology of interest came from him and not the Bible. Aristotle thought interest was evil because money, gold and silver, were sterile and couldn’t produce anything, so interest must be some kind of robbery. When church scientists began to question Aristotle’s cosmology that caused scholars to question other aspects of his teachings such as interest on loans.

    • Philosophical Actuary

      Thank you for these links. I’ll look into them.

      I’m not entirely sure what you mean by the Church revering Aristotle as his arguments and there interpretations were hotly debated and some arguments refuted. If the Israelites could take the riches of Egypt, why not take the riches of the pagan philosophy, as one of the Church Fathers (whose name escapes me) suggested in response to Tertullian’s quip, “What has Athens to do with Jerusalem?”

      I can’t say that I know everything about what Aristotle thinking about interest, but his arguments about the sterility of money and Aquinas’ arguments against the charging of interest on certain types of loans seem sound taken in themselves and not on the author’s authority. Invoking Scripture seems to beg the question, namely how Scripture is to be interpreted as we do not get our astrophysics from Scripture, but I think we have different views of the unity of faith and reason and certainly the authority to interpret Scripture.

      With regard to questioning of Aristotle’s cosmology, I’m familiar with some of it. Some of Aristotelian (as the tradition proceeding from Aristotle) conclusions are known with certainty while others were only probable. That everything that is moved is moved by another is a necessary principle for understanding the universe and is consistent with modern cosmology, but that there are 55 heavenly bodies in crystalline spheres is probable based on empirical observations (which accords with the Scripture’s talk of the firmament). That money, whether gold, fiat currency, wheat, cars, or what have you, is sterile is known with certainty because it is a conclusion that proceeds from the nature of money as such.

      However, I am uncertain of the historical connection between questioning of Aristotle’s cosmology and his economic teaching. I know that there was general contempt and rejection of Aristotle’s principles rather than refutation of his arguments.

      Yet, to return to my question, I still do not understand the reason to redefine usury. If we turn to Scripture and the word translated to “usury” has a different meaning, then the word used in the original text was mistranslated to “usury” because they have different meanings. If Aristotle, Aquinas and others are wrong about money lent at interest, then usury simply is not intrinsically evil. If money is not sterile, then lending money is not usury. Charging excessive interest may be unjust but it is not what usury means.

      • Well of course money is sterile because it is not biological. Money cannot have children as animals and humans do. But what theologians began to understand that sterility had nothing to do with the issue of lending money. They discovered what economics calls “opportunity cost.” When they made loans, they gave up the use of that money. Had they not loaned it, they might have earned a profit of say 5% in business. The interest on the loan is to compensate them for the potential profit they give up to make the loan.

        Lending money at interest is no different from renting out land. The rent payment is compensation for giving up the produce that the land could generate for the owner. The principle of Jubilee is similar. Jubilee meant that owners couldn’t sell their land but could only lease it for 49 years. The lease payments were based on how much the land could produce, so the owner received compensation for the produce he was giving up by leasing his land to another for 49 years.

        It’s not that theologians discovered that in some way money was not sterile; they realized that sterility had nothing whatsoever to do with lending.

        • Philosophical Actuary

          If opportunity cost is salable, then lending money and charging for that is not usury. Usury is the charging of interest for lending money itself. The charge is for the sake of something extrinsic to the lending itself. This is the distinction between intrinsic and extrinsic titles.

          However, opportunity cost is not salable. It is not a real asset. It is as you said a “potential profit,” i.e. not real profit. This is essentially different from renting land, because land is a real asset and fruitful in itself that can be rented, while charging for a “opportunity cost” is, as Aquinas says, charging for what does not exist, which is usury. Opportunity cost is related to the hotly disputed “profit ceasing” (the Latin escapes me) extrinsic title. I haven’t read about this closely and examined the argument but it was not meant as a blanket cover to recoup “opportunity cost,” but to account for the loss of actual profit when taking money out of an actually profitable venture to loan it.

          I think there is some confusion in saying money is sterile. It does not simply mean a sort of biological sterillity, but that its use does not produce something in addition to itself. Land can produce crops while not consuming the land. A chainsaw can produce lumber without consuming the chainsaw. Money, sugar, wine and, as Aquinas says, anything of which the use consumes the thing itself are sterile in the relevant sense.

          Now the nature of lending in itself is the transfer of the use of a thing without the transfer of ownership. I lend my pen to a friend that he may use it, but eventually return it as I do not give him ownership but use. So, when I rent land or my apartment, I don’t own the land or the apartment, but I pay for its use. The justification for the rent cannot be the potential produce, because this is not real and if the season is bad and no crops grow then I would be liable for no rent but our contract stipulates that I pay rent. I pay for the use of the thing which is real and related to but not identical with the potential produce which as potential is not real.

          Money for exchanging, sugar for a cake, wine for drinking, and so on cannot be lent without also transferring ownership. To charge rent or interest is then to double charge or charge for what does not exist, because I’m paying for ownership and use which are inseparable or I’m paying for nonexistent “opportunity cost.”

          I’m still not quite sure how you account for the multiple condemnations of loaning money at interest in the Scriptures unless you use Austrian economics to interpret Scripture, which as I said begs the question.

          • You’re trying to get around the obstacle with very finely splitting hairs and definitions. I never said opportunity cost is salable. What I said, and what economics teaches, is that people naturally won’t give up the use of something from which they could obviously earn a profit unless they get some kind of compensation. That’s human nature and there is nothing wrong with it. It’s legit use of property. Without it, property means nothing.

            And opportunity cost has nothing to do with mere potential, but actual profits given up. If something cannot earn rent or profit, then I have no opportunity cost. If I can’t charge rent on a pen, then there is no opportunity cost in loaning it. It’s not an economic good. Any land, such as swamp land, that cannot earn a profit through its use has no opportunity cost. But any land that can produce even grass for hay has actual, not potential, earnings capacity which I give up if I rent it to someone. In the same vein, money of any kind can earn a profit if invested in a business, so their no potential but real, actual profits given up.

            Clearly you paid no attention to my references to the prices of land in the Jubilee commandments because those refer to opportunity costs. Those prices are based on the number of years to Jubilee and the amount that the land can earn.

            No, I don’t use Austrian economics to interpret scripture, but if you take all of the prohibitions of usury in context they clearly refer to lending to the poor and not to business loans or loans to people wealthy enough to make the loan payments.

            Besides,if you would read the history of the Catholic Church, as I mentioned and again you ignore completely, the Church always engaged in borrowing and lending at interest. So do you think the Church was hypocritical?

          • Philosophical Actuary

            I doubt a careful response would be much appreciated, but I’ll address some major issues.

            That charging opportunity cost, like human desire to procreate, is part of human nature does not imply that it is morally licit in every instance. That opportunity cost concerns only potential (i.e. future, not real/actual/today’s) assets is part of its definition. I made no reference to the Jubilee issue because the major premise was false, namely, that charging interest on money lent is like renting land, which I argued was false.

            We must distinguish between loans to individuals and loans to corporations (Scholastics called these societitas). In lending to a corporation, I have a property claim against the corporation, which is a bundle of assets. I can justly claim rent on this from the property claim as I might claim produce from a farm for which I purchased the seeds for the season. My claim would be against the farm and not the farmer. In the case of lending to a person, who cannot be property, I have no property claim and thus cannot charge interest. This is the distinction made by the Scholastics between a census and a mutuum loan. There are further distinction we can make to talk about mortgages, student loans, credit cards, etc that may or may not be morally licit.

            “The Church” can be taken in many ways. As the people of God with broken human natures, we will fall short in any number of ways. That people in the Church at every level have sinned is manifest from history. I’m not sure how it is relevant to the is of the evil of usury, whether “the Church” has committed such sins.

          • No, opportunity cost does not involve any kind of speculation, otherwise it’s not opportunity cost. Yes, it is legit in every instance excepting only in charity. One way to look at charity is that you give up your opportunity costs when giving to the poor. Yes, as Calvin and the Salamancan scholars recognized, lending money is no different from renting land. Both are mere rational uses of one’s property. If you don’t want to recoup opportunity costs, then your action is charity and not business.

            Yes, the scholastics through most of church history split fine hairs trying to keep the ban on interest alive as long as possible, but they were wrong as the Salamanca scholars proved.

            BTW, no one can lend to a farm because the farm cannot pay anyone back. Neither can it produce anything without someone working it. That distinction is just silly. No, there are not many kinds of loans for interest. There is only the loan and the use the borrower will put the loan to. Loans can be to corporations or individuals, but the principles involved don’t change.

            You know how I intended the term “Church” – the Roman Catholic Church headquartered in the Vatican. Again, you’re using the sophist tactic of trying to define terms in such a way that your argument wins by definition. Do your really want to say that the Popes were sinning when they made and accepted loans at interest?

            BTW, the Roman Catholic Church located in the Vatican has today a bank that I believe makes loans at interest.

          • Philosophical Actuary

            I think we’ve reached the end of any rational discussion. I would suggest that you read up on the Salmancan Scholastics a bit closer, because from what I’ve been reading you are simply incorrect about history.

            As concerns the Church, I meant that the Church is made up of sinners, even the pope. Even if the pope himself lends at usury (or sins in anyway whatsoever) does not change the reality that usury is an evil. You may be confusing impeccability with infallibility, a common Protestant error with respect to the papacy.