Do Payday Loan Industry Regulations Hurt the Consumer? Larry Rybarcyck

Introduction:

The payday loan industry provides borrowers with access to the consumer credit market for small-dollar, short-term, unsecured loans. Many in our communities use this service because they are not able to obtain a similar type of loan through more traditional means. In 2010, approximately 5% of the U.S. adult population whose annual income ranged from $15,000 to $25,000 had obtained a payday loan to help cover income shortfalls and meet routine expenses as well as emergency and unplanned expenses (Ramirez 2020). In an unregulated market, this form of credit is much more expensive than what consumers would typically face in the traditional credit markets, e.g., using a typical bank-issued credit card. Consumer advocates have therefore pushed to regulate this industry with the goal of helping those who use this service avoid deeper financial hardship. However, by regulating the payday loan industry, would the government actually be harming the consumer? This literature review seeks to investigate this question. Although harm can come in many forms, Edmiston (2011) summarized the possibilities: denying consumers access to credit, restricting their ability to maintain a credit standing, or forcing them to seek alternative financial services, which might even be more costly. For the purpose of addressing the question in this review, harm is considered to come in the form of higher costs to the consumer and/or a reduction in access to payday loans.

To investigate this question, the review is broken into three topics. The first is interest rate cap regulation, which is a common approach used to limit the amount of fees charged by a payday lender and therefore the price of a payday loan. The second is the requirement for financial disclosures, which forces payday lenders to inform the potential borrower about the cost, etc. of the loan. Finally, the regulations may produce unintended consequences. This is an important aspect since the outcome of the regulatory actions may not be what was intended or beneficial to the consumer.

Interest Rate Cap Regulations:

Interest rate caps are a common type of regulation and place an upper limit on the fees, as a percentage of the principal, that a customer will be charged for a payday loan. This is one of the most contentious aspects of the payday loan industry. Prior to any rate cap restriction, a typical payday loan business would charge a $15 fee on a $100 loan with a two-week term. In addition, if the borrower could not repay the principal at the end of the term, the loan would be rolled over for the cost of the fee. This would be allowed to happen numerous times until the principal was paid back. In this example, the effective annual percentage rate (APR) for the loan is 390%. To combat these excessive rates and help the consumer, many states have enacted legislation to limit or “cap” the effective rates at significantly smaller levels.

The results of studies on the impact of rate cap regulations are mixed and appear to depend upon the magnitude of the rate cap. Ramirez (2019) found that the 28% APR limit enacted in Ohio implicitly banned the payday loan industry from operating in the state. In this study, Ramirez found that the number of payday loan branches dropped 92% after the rate ban went into effect. This prohibitive rate cap resulted in a loss of access to the payday loan services for those who sought to use them. Similarly, Zinman (2010) found that a rate cap with an effective APR of 150% enacted in Oregon resulted in a 76% reduction in the number of payday lender branches, again reducing customer access to payday loans. In this analysis, Zinman also found that the volume of payday loans fell by over 26%. However, a rate cap analysis by Fekrazad (2020) on the payday loan industry in Rhode Island found that a reduction in the effective rate from 390% APR (15% fee on a two-week loan) down to 260% APR (10% fee on a two-week loan) did not result in a change in the number of payday loan branches in Rhode Island. In addition, he found that consumers responded elastically to the reduction in the rate cap with increased loan usage. DeYoung and Phillips (2013) studied the effects of price caps in the payday loan industry in Colorado. Their results indicated that prior to the regulations, the industry was more price competitive, e.g., offering first-time borrowers a better rate than returning customers. Following the price caps, however, competitive pricing slowly disappeared, and overall, the loan prices rose to the cap value, resulting in higher annual borrowing costs to the consumer.

These results suggest that rate cap restrictions can be beneficial for the consumer up to a point. Modest rate caps enable consumers to borrow at lower costs without forcing a reduction in the number of branches and therefore access to them. By contrast, prohibitive rate caps severely limit the availability of payday lenders to those seeking access, which reduces the volume of payday loans. These prohibitive rate caps also have unexpected consequences,

Financial Disclosures Regulations:

Financial disclosure regulations require that lenders must provide loan cost and renewal details to the borrower in advance of providing the loan. When this industry is unregulated, payday loans are typically given with an effective APR of around 400%, which would suggest that there may be information asymmetry present, and that the consumer is at a disadvantage. The ease of obtaining these loans may be a major factor in why consumers choose them. Other credit options require more employment history, financial information, and a better credit rating or collateral. This type of regulation is aimed at mitigating this information asymmetry so the borrower can make the best decision in their situation.

A study by Wang and Burke (2021) found that a disclosure regulation, which requires the lender to inform the customer of the loan costs compared to other credit products, was enacted statewide in Texas and led to a 13% drop in the volume of payday loans. Furthermore, more strict local ordinances subsequently enacted separately in Austin and Dallas ultimately led to a 61% and 44% drop, respectively, in the volume of payday loans granted in those municipalities, but only after the start of enforcement of these laws. Borrowers chose not to use the payday loan services once they were better informed about and understood the terms of the loan agreement and potential costs to them. Conversely, a significant fraction of the individuals that take out a payday loan lack enough information or understanding to make an informed decision.

In support of these findings are the results of a study by Kim and Lee (2018), who analyzed the use of payday loans by people with differing levels of financial literacy. Financial literacy means that one understands the relevant concepts, can process pertinent information, and can make informed decisions regarding financial matters. In this study, they found a strong negative correlation between level of financial literacy and use of payday loans. This suggests that those using payday loan services are not financially literate.

Together, these studies support the idea that a disclosure regulation can be effective in dissuading individuals from using high-cost payday loan services when they are more clearly informed of the alternatives. In addition, the enforcement of these disclosure laws was shown to be necessary to achieve the desired outcome, i.e., reduction in use of the payday loan services.

Unintended Consequences of Regulations:

In the context of the payday loan industry, state legislators write bills with the goal of enacting regulations on this industry that will help those who use these services and are exposed to the excessive fees, etc. that can lead to prolonged financial hardship. However, if legislators enact laws without a holistic point of view, it can lead to unintended consequences.

A study by Ramirez (2019) showed in the case where the rate cap was prohibitive, i.e., 28% APR, consumers chose near and not so near “substitutes” in the alternative financial services (AFS) industry. Pawnbrokers are considered good substitutes for the payday loan service, whereas small-loan and second-mortgage lenders are not. Yet the results of this study showed that after the payday loan ban was enacted, pawnbrokers, small-loan lenders, and second-mortgage lenders experienced an increase of 97%, 156%, and 43%, respectively, in countylevel licensees per million people in Ohio. This indicates that a significant fraction of those consumers shut out of the payday loan service found assistance through response by substitutes in AFS. Similarly, Bhutta et al. (2016) also found that payday lending bans drive consumers to AFS. The increase in loans taken at pawnshops was strongly correlated to the decrease in loans at payday services following the payday lending bans. However, this correlation was not seen in the lowest income consumer group studied and those who most often use these services.

Creating single-purpose regulations, e.g., a rate cap restriction, can result in the unintended consequence of borrowers moving to other AFS. Although the response is not necessarily uniform from the different income groups, the outcome is likely an unintended consequence of enacting the single purpose restrictions.

Conclusions:

From a review of several research studies done on rate-cap regulations in states across the U.S., one could conclude that there is strong evidence to indicate that small to modest rate caps are beneficial but that a severe rate cap is harmful. Up to modest-size rate caps help reduce the cost of the payday loans with limited loan branch closings. This is not harmful to the consumer but is instead beneficial since they can still access payday loan services, albeit at reduced branch locations, and at a reduced cost. However, somewhere between a regulated APR of 150% and 260%, the number of operating payday loan branches starts to decrease. Although the cost of a loan is dropping, which is beneficial, there are fewer operating branches and so access is reduced, which is harmful. Finally, when the regulated caps were severe or prohibitive, the payday loan industry was implicitly banned from operating in that state, which harmed consumers because of complete loss of access to a payday loan.

Financial disclosure regulations appear to be beneficial and not at all harmful to the consumer. From the limited amount of research reviewed, the enforced financial disclosure reduced the number of payday loans taken by about half without driving consumers to AFS. Enforcement appears to be critical in ensuring that the consumer benefits from this type of regulation. The unenforced state regulation was not as effective, reducing the volume of payday loans by about 13%. This conclusion also does not contradict the research findings that show that less financially literate individuals are more likely to use payday loans than those who are more financially literate.

Finally, one can conclude that regulations on this financial industry should not be done with a single restriction in mind. Research has shown that this type of regulation, e.g., a rate cap only, can harm the consumer by potentially driving them to other, costly AFS. This outcome from a narrowly focused regulation is certainly not what was sought by the authors and advocates of the legislation.

Therefore, a more balanced, holistic approach to regulating the payday loan industry might be the best approach that provides benefit and minimizes the harm done to the consumer. This could be to introduce a modest rate cap with an effective APR of between 200% to 250%, which reduces the cost to consumers yet enables most but probably not all of these branches to continue operating. In addition, including an enforced financial disclosure requirement to assist those pursuing a payday loan would help borrowers better understand the cost relative to alternatives. This also has the benefit of potentially increasing the financial literacy of those who use these services. This type of approach would likely not drive borrowers to use either good or inferior substitutes, i.e., high-cost AFS, but would instead help reduce the cost and use of these loans while making them smarter consumers.

These studies, however informative, are limited in number and scope, which suggests that further research is needed to help answer the original question more fully and lead to a better regulatory approach that benefits the consumer. Although a rudimentary trend has emerged from the research performed on the three states discussed in this part of the review, more rate cap data is needed from additional states to better understand how an APR cap impacts payday loan branch numbers and consumer loan volume across the U.S. More state, lender, or consumer survey data from different states, analyzed using the difference-in-differences regression techniques utilized in most of these studies, would better define this trend and increase the applicability of the results to a broader swath of the country.

Although the response to financial disclosure regulations was encouraging, additional data from other states is also needed. The sole research work of Wang and Burke (2021) included in this review found that enforcement was critical in achieving the sizable reduction in volume of payday loans made in the municipalities of Dallas and Austin. Additional research into consumer response to financial disclosure requirements with and without enforcement that encompasses other states would help give a better estimate of the benefits of this type of regulation and whether enforcement is warranted.

In addition, a more complete review would also require consideration of other impacts from these and other types of regulatory requirements. The impact to the consumer might include changes in payday loan sizes, loan sequences, loan durations, loan defaults, overall consumer welfare, and bankruptcies due to the introduction of the regulations. Furthermore, including demographic information in the data collection process could allow researchers to understand the impact to different groups as well. The addition of this information could help to better understand the level of harm (or benefit) that different payday loan industry regulations have on borrowers and ultimately help government officials to craft legislation that best serves the interests of the more vulnerable in our society.

References

Bhutta, Neil, Jacob Goldin, and Tatiana Homonoff. 2016. “Consumer Borrowing after Payday Loan Bans.” Journal of Law and Economics 59 (1): 225–59.

DeYoung, Robert, and Ronnie J. Phillips. 2013. “Interest Rate Caps and Implicit Collusion: The Case of Payday Lending.” International Journal of Banking, Accounting and Finance 5 (1–2): 121–58.

Edmiston, Kelly D. 2011. “Could Restrictions on Payday Lending Hurt Consumers?” Federal Reserve Bank of Kansas City Economic Review 96 (1): 31–61

Fekrazad, Amir. 2020. “Impacts of Interest Rate Caps on the Payday Loan Market: Evidence from Rhode Island.” Journal of Banking and Finance 113 (April) 105750.

Kim, Kyoung Tae, and Jonghee Lee. 2018. “Financial Literacy and Use of Payday Loans in the United States.” Applied Economics Letters 25 (11): 781–84.

Ramirez, Stefanie R. 2019. “Payday-Loan Bans: Evidence of Indirect Effects on Supply.” Empirical Economics 56 (3): 1011–37.

Ramirez, Stefanie R. 2020. “Regulation and the Payday Lending Industry.” Contemporary Economic Policy 38 (4): 675–93.

Wang, Jialan, and Kathleen Burke. 2021. “The Effects of Disclosure and Enforcement on Payday Lending in Texas.” NBER working paper 28765.

Zinman, J. (2010). Restricting Consumer Credit Access: Household Survey Evidence on Effects around the Oregon Rate Cap. Journal of Banking and Finance, 34(3), 546–556.