Payday Lending

Throughout the 1990’s and 2000’s, payday loans became increasingly more popular as consumers were looking for more liquidity without having to apply for traditional loans like lines of credit and credit cards. The payday loan market was growing despite concerns that the interest rates were more than 10 times those of the typical credit card and had the potential to take advantage in neighbourhoods with large minority and immigrant populations, as well as general consumers with poor credit ratings. Despite having massive interest rates that far exceed those of the average bank-issued credit card or line of credit, these loans became a popular last-chance option for people who find themselves short on cash; due to their high interest rates and short terms, it is believed that customers often default, thus worsening their financial position. Their rapidly increasing popularity and potentially negative influence on society led 11 states, as well as the District of Columbia, to outlaw the practise by 2006, with an additional six states banning such loans by 2012 (Caskey, 2005). The article Payday Loans and Consumer Financial Health (2013) by Neil Bhutta aims to examine exactly how these loans affect the financial health of those who borrow them, and whether other socio-economic factors contribute to whether these cash loans prove useful or harmful to the borrower.

Bhutta, in an effort to put forth the most accurate results, included only residents with access to payday loans in his study. This study breaks down the population not only by state, but by ZIP code as well in order to account for the idea that people who are truly in need of such a loan would go to great lengths to acquire one, thus by crossing state lines. Those residing in a state that has outlawed payday loans, but in a ZIP code within 25 miles of a neighbouring state that allows payday loan stores to operate are included as having access. Many residents of Connecticut, for example travelled to neighbouring states such as Vermont and New Hampshire to acquire payday loans; living in close proximity to states with unregulated access to payday lending stores allowed a massive loophole for desperate borrowers to slip through.

Bhutta’s paper presented other general findings of other researchers’ studies. Some stated that access to extra funds have actually helped consumers remain solvent and avoid bankruptcy following extraordinary events such as natural disasters and sudden shocks to the economy that led to widespread layoffs. Michael Stegman’s article about the industry was published in the Journal of Economic Perspectives’ Winter 2007 issue, leading to a wide increase in state regulation for payday lenders. Stegman’s research found over 20,000 payday loan stores through the United States, despite a ban on the practice of payday loans in 12 states. Bhutta’s article presents the perspective of borrowers desperate for easy, highly liquid loans (Bhutta, 2013), while Stegman discusses the payday lending industry focused on the point of view from the lender’s side. Bhutta’s focus on profiling payday borrowers is related to Stegman’s in that he discusses the reasons behind the rapid increase in payday loan shops throughout the United States. The major correlation between Stegman and Bhutta’s papers is the areas where each found their targeted population; Missouri, Florida and Oregon’s payday lending market grew nearly exponentially over the last 15 years (Stegman, 2007).

While Bhutta’s main purpose is to determine whether or not the use of payday lending has an effect on credit scores, it is important to keep in mind that payday lenders are not required by law to report to any credit bureau; therefore, such loans have no direct effect on credit scores. Despite being able to avoid the sort of formal reporting systems that banks and traditional credit providers must use, these short-term loans with high-annualized interest rates affect the overall financial health of the borrower (Bhutta, 2013). It is assumed that if payday loans were negatively affecting the financial well being of consumers, this would hinder their ability to meet other financial obligations that directly affect credit scores.

The data set is further focused on those who felt an immediate obligation to borrow from a payday-lending store after attempting to obtain, and being rejected, from other more traditional forms of credit such as credit cards. There are concerns that payday lenders use this to manipulate and target minority and low-income neighbourhoods. One of the few explanatory and sensible reasons for Bhutta’s focus is the assumed potential for more defaults in lower income areas. These targeted borrowers could have other more pressing financial obligations, forcing them to default on the payday loan, which would, in the end, create higher returns for lenders.

In his article, “The Real Costs of Credit Access: Evidence from the Payday Lender Market”, Brian M. Melzer finds people who take out payday loans report difficulty making payments on other obligations such as mortgage and utilities. Melzer’s data set is composed of purely voluntary participants; these reports are based on their personal feelings, and do not necessarily reflect actual occurrences. In other words, they reported strain on their finances, but it does not mean that they have missed any payments because of the pressure they were feeling (Melzer, 2011). Bhutta’s research suggests the opposite, beginning with the assumption that lower-income residents would be more likely to default on their loan payments. Melzer’s research could be considered biased because his participants were voluntary. Bhutta’s data was collected through census, and the results could be interpreted to reflect a wider variety of people. Census data collection provides an indiscriminate group of research candidates for an unbiased population data set. That being said, Melzer’s sample was less focused on zip-code location, meaning that they could have been exposed to different cultural and socioeconomic behaviours (Melzer, 2011). These learned behaviours and opinions influence the financial transactions of consumers across the globe.

A limitation of the research into the payday lending market is the dependency on credit scores as a means of depicting financial health and behaviours regarding the use of payday loans. Firstly, it assumes that borrowers even have a credit score to begin with. Although payday lending requires that borrowers have a chequing account and proof of income to ensure ability to pay back the loan, this does not necessarily mean that the consumer has other accounts that contribute to a credit score. Although a bank account and any delinquency involving it would be reflected on a credit score, there is no guarantee that the consumer has other sources of credit such as a mortgage, credit cards,