The Alabama Department of Banking has proposed new regulations on pay day lenders. The specifics of the proposed regulations, known as the Deferred Presentment Services Act, are less important than whether we view pay day lenders as performing a service or as predatory vultures. If pay day lenders are predators, they should be strictly controlled.

Although widely denounced, pay day lenders provide access to credit for thousands who lack the collateral and credit scores to be served by, or have exhausted credit available from, banks and credit unions. Pay day loans on net improve the well-being of their customers, who choose to take out these loans.

Critics often object to the high rates of interest on pay day loans, which appear shocking when reported as an annual rate. But the loans are for 30 days or less, and interest rates reflect the risk and cost of the loans. Borrowers who lack collateral or have already maxed out credit cards may well not repay a loan. Other costs, like processing the loan application, do not depend on the size of and thus are significant for small loans. Pay day loans are priced similarly to fees for overdraft protection from banks, further evidence that the interest rate reflects costs.

Despite their high cost, pay day loans allow people to avoid even higher fees and disconnection charges. In Troy, electric service can be cut off by the city after as little as 20 days, with a minimum of $45 in late and reconnection fees. Paying $17.50 for a $100 pay day loan to pay an electric bill is a better deal. Fees for a bounced check, from both the bank and the merchant, can easily exceed $50.

If pay day lenders were truly charging predatory interest rates, the companies should be making handsome profits. Yet their rate of profit is below that of traditional banks. Current and potential competition provides a further check on pricing. The nearly 1,000 pay day lenders in Alabama compete for customers and provide an opportunity to shop around for the best rates. And if pay day lending were too profitable, traditional banks could compete for this business.

Critics point to customers who take out multiple pay day loans over the course of a year, an average of eight in a recent study by Pew Charitable Trusts. A small number of customers who take out a dozen or more loans in a year inflates this average. The typical customer takes out a handful of loans, consistent with use of this lending to manage their precarious finances.

Many critics of pay day lending ultimately make a paternalism argument: they believe they can manage the borrowers’ finances better than the borrowers themselves. The data suggest that most borrowers benefit from pay day loans, but a minority probably could benefit from protection from themselves. But should these loans be restricted or prohibited for all because of misuse by some? If so, why stop here? Many Americans take on excessive debt through credit cards and student loans. Should politicians restrict any source of lending which is misused?

And politicians are some of the most irresponsible borrowers. Politicians in Washington have run up a Federal debt that exceeds GDP, while Detroit’s recent bankruptcy was a result of unsustainable borrowing. Perhaps government should correct its own ways before restricting others’ borrowing.

If critics are correct, restricting pay day lending should make customers better off. Georgia’s experience after enacting tight restrictions on pay day lending a few years ago offers evidence on this point. A study by economists at the Federal Reserve found that low income households in Georgia bounced more checks and made more complaints to Federal regulators about aggressive bill collectors afterwards. This doesn’t sound like improvement.

Pay day lenders do not force people to take out loans, and do not create the financial circumstances which lead customers through their doors. Hopefully innovation in the industry will reduce costs and allow lower interest rates. In the meantime, politicians can help out by not further burdening the lenders with costly regulations.

 

Daniel Sutter is the Charles G. Koch Professor of Economics with the Manuel H. Johnson Center for Political Economy at Troy University. Talk back to Dan at dsutter@troy.edu