The CFPB and Payday Lending Regulations

The Consumer Financial Protection Bureau (CFPB) recently proposed the elimination of new payday lending rules created under the Obama Administration and imposed in 2017. Payday lenders are frequently vilified—a recent New York Times editorial declared that the CFPB “betrayed financially vulnerable Americans last week by proposing to gut rules…that shield borrowers from predatory loans”—but recent evidence indicates that the predatory costs of payday loans may be nonexistent and the benefits are real and measurable. Thus, the original regulatory restrictions were unnecessary.

Most Americans take access to credit for granted, but many lower-income Americans have difficulty meeting the requirements to get a credit card or take out collateralized loans. With minimal approval requirements that are easier to meet—often just a bank account statement, a pay stub, and a photo ID—payday lenders offer short-term, uncollateralized loans. These loans are advances against a future paycheck, typically about $100-$500 per loan, and customers usually owe a fee of around $15 per $100 borrowed for two weeks.

Consumer advocates oppose these terms for two reasons. First, they argue the terms are onerous. They convert the loan terms into an annual percentage rate (APR) that would be disclosed by a conventional credit-card issuer, and the result is 391 percent. This number shocks the sensibilities of the average person and easily leads to the conclusion that the payday lender is ripping off the consumer.

The APR is misleading because the fixed costs of lending as well as the default costs must be defrayed over much smaller sums than conventional loans. According to research reviewed by Victor Stango in the fall 2012 issue of Regulation, the fixed and marginal costs of the average $300 loan are $25. Thus, with no risk of default, the break-even per-loan charge is $25. But 5 percent of customers default increasing the break-even per-loan charge to $40, or $13.33 per $100 borrowed.   

In addition, the revenues of payday lenders do not seem to lead to excess profits. Payday lending appears to be very competitive. There are more physical payday lenders (24,000) than there are banks and credit unions (16,000). And according to research cited in Stango’s article, payday lenders do not earn “excess returns” in the stock market.   

The second objection consumer advocates have against payday lenders is the inability of some consumers to pay back their loans after the initial two weeks. If borrowers rollover their loans, the fees grow larger quickly.

Two papers, which I reviewed in the spring 2017 issue of Regulation, utilize data from the military to investigate the effects of payday loans and challenge this objection. In the mid-2000s active duty military members were three times more likely than civilians to take out a payday loan, and as many as 20 percent of active duty military members had used a payday loan in the past year. The belief that payday loans were predatory and that they adversely affected young soldiers’ performance led Congress to cap the APR on loans for military servicemembers and their families at 36 percent in the Military Lending Act of 2007 (MLA), effectively banning payday lending to the military nationwide. 

The authors of both studies exploit the fact that military members are randomly assigned to bases across the nation (in states that ban payday loans and in states that do not). Thus, using the military’s rich administrative data, the studies are able to analyze differences between individuals in states with and without payday lending bans, before and after the MLA.

In the first paper, Susan Payne Carter and William Skimmyhorn of the United States Military Academy examine labor market and credit outcomes for military members. Specifically, Carter and Skimmyhorn analyze involuntary separation from the military (which may reflect financial mismanagement or stress that affects service members’ job performance) and the denial or revocation of security clearances (which, because the military considers high levels of debt as a threat to individuals with clearances, provides another indicator of negative payday loan effects). The authors find that access to payday loans did not increase involuntary separation or denial of clearances because of bad credit.  

In the second paper, Mary Zaki investigates how access to payday loans allowed service members to smooth consumption over their pay cycle by using data on sales at on-base stores to analyze consumption behavior. Exploiting the same differences between state laws and before and after enactment of the MLA, she finds that after the ban sales on paydays were 21.74 percent higher than sales on non-paydays, but sales on bases before the ban and near payday lenders were only 20.14 percent higher—a 1.6 percent smaller gap between payday and non-payday spending. The variance in spending across the pay cycle was lower (i.e., consumption was smoother) when soldiers had access to payday lending services.  

Together, these results undermine consumer advocates' claims of the negative impacts of payday loans and demonstrate the consumption smoothing benefits. Carter and Skimmyhorn found no negative effects (as measured by involuntary separation from the military or revocation of security clearances) for members of the military even though they utilize payday lending more than civilians. And Zaki illustrates that payday loans, like all loans, allow consumers to smooth consumption.

Though often portrayed as predatory, payday lenders provide many Americans, who often don’t have access to traditional bank services, with the opportunity to smooth consumption or get cash quickly when emergencies arise. The apparently “high” fees are a natural outcome of lending small amounts to riskier borrowers. Any restrictions that limit these fees or impose increased costs on lenders may eliminate access to any loans, leaving former borrowers with less-desirable, higher-cost options.

Written with research assistance from David Kemp.