The Kentucky Baptist Convention recently approved a resolution call for the General Assembly to limit the annual interest rate on “payday” type loans to 36 percent. The following answers some of the frequently asked questions about payday lending and about why a cap is needed. The material has been provided by the Center for Responsible Lending:
Payday Lending: Frequently Asked Questions
1. Why is 36 percent APR a fair level for interest rates?
For the most of the 20th Century, American usury laws established 18 to 42 percent per annum as the legal limit for lending in this country. Under these rates lenders and merchants were able to extend credit for a host of household necessities- homes, cars, furniture and appliances – and consumers were protected from unconscionable charges. Credit unions extend a variety of loan products to their customers including credit cards and, in some cases, small dollar emergency loans while operating within a federal interest rate cap of 18 percent per year.
2. Since most payday loans are only a few weeks in duration, isn’t it misleading to speak in terms of an annual interest rate (Annual Percentage Rate or APR)?
The Annual Percentage Rate or APR is a sensible and useful measure by which to determine the cost of a payday for several reasons. Much like a car measures speed at miles per hour (whether you are driving for one 5 minutes or 5 hours), the annual percentage rate provides a standard measure of credit that enables consumers to compare cost across different lending products.
Consider this comparison of a credit card with 18% annualized interest and payday loan advertized at 15% interest every two weeks. For the sake of comparison, consider the cost of borrowing money for one month (a relatively short period of time).
Credit Card Cash Advance = interest rate of 18% annually > $300 x 0.18/12 = $4.50 interest paid per month (18% APR)
Payday Loan = interest rate of 15% every 2 weeks > $300 x (0.15 x 2) = $90 interest paid per month (390% APR)
Even over a short duration (one month), the payday borrower pays much more in finance charges. The APR comparison – 18% APR versus 390% APR – accurately describes the difference in price between the two loans.
Moreover, payday loans are not a one time, short-term occurrence. In Kentucky, the typical borrower takes out 10 loans per year and is indebted for 160 days out of the year (KY Dept of Financial Institutions, “Report on Kentucky Payday Lending Activity for April 30, 2010 to April 30, 2011). This means that the annualized interest is an appropriate measure for borrowers who take out and pay interest on payday loans for a significant part of the year.
3. Will a 36% interest rate cap prevent people from getting loans that they need?
Payday industry spokespeople suggest that consumers will lose access to valuable credit were interest rates to be limited to 36 percent, citing large volumes of payday loans as evidence of the need for payday loans.
High loan volume does not necessarily mean high demand for payday loans. Research demonstrates that much of payday loan volume is due to repeat borrowers who find themselves trapped in a cycle of debt. The “churning” of a borrower from one loan to the next every pay period is common. Some lender statistics cite modest rates of loan renewal or loan “rollover” to suggest that payday borrowing is a one-time occurrence for most households. However, these statistics fail to account for the very common need among payday borrowers to take out a new loan within a short time after the first loan.
After repaying the loan and the loan fee, many borrowers do not have enough funds left over for their other basic expenses and must take out a new loan immediately or a few days later when their money runs out. This begins a debt cycle in which borrowers take out loan after loan every pay period, paying a new fee each time.
Among those 85% of borrowers who take out more than one loan per year:
- About half of the time, borrowers take out a new loan at their very first opportunity after repaying the previous one.
- Nearly 90 percent of the time, borrowers take out a new loan in the same two-week pay period in which they’ve paid a previous loan back.
Not only is repeat borrowing common, the payday model depends upon it. 90% of business is generated by borrowers with at least five loans a year. In fact, over 60% of revenues are generated by borrowers with 12 or more loans a year. As the CEO of Cash America remarked, “The theory in the business is you’ve got to get that customer in, work to turn him into a repetitive customer, long-term customer, because that’s really where the profitability is.” (Dan Feehan, CEO of Cash America, remarks made at the Jeffries Financial Services Conference, 6-20-07)
Credit unions and other reputable lenders been able to offer credit at rates of 36 percent APR or less using very different business model than payday lending. For example, many of these loans:
- Require longer repayment periods, enabling borrowers to repay over several months without placing stress on a single month’s budget
- Are extended on the basis of a borrower’s income and ability to pay to ensure that borrower’s do not become trapped in debt
- Dedicate a percentage of each payment toward savings, helping to ensure that borrowers will not need emergency credit in the future.