Yvonne Puente started her own tax preparation business last year. The 38-year old Floridian didn’t plan for the dry spell that stretches from October through New Year’s, just before tax season.
As Christmas loomed, Puente needed to make payroll for her handful of employees. Her bank cut her credit card limit, and refused to extend her a loan. So she went to Advance America to get a payday loan.
Middle-income Americans like Puente are increasingly turning to alternative loans to make ends meet. Thanks to Dodd-Frank and other regulations, bankers say they can’t make a profit on lending to this group.
As a result, subprime credit cards could shrink by a third, sucking $80 billion of credit out of the system, according to research by the Federal Reserve and Goldman Sachs .
Disappearing credit is pushing borrowers with lower credit scores into the arms of alternative lenders such as pawn shops, Internet lenders and payday stores. Among the most controversial of these subprime substitutes are payday loans.
Payday lenders in stores and on the Internet supplied almost $40 billion of short-term credit to subprime borrowers in 2009. They’ve been accused of charging astronomical interest and fostering addiction to borrowing. But for middle-income borrowers, payday loans may be the lowest cost credit alternative available to them.
“It is responsive directly to a credit demand that they have,” says Billy Webster, chairman and co-founder of the biggest standalone payday lender, Advance America. “If you do it in a way that creates high customer satisfaction, we think the future for the product and our company is bright.”
That depends on what happens to the economy and the regulatory environment. Payday loans dry up when the economy is in a downturn. Loans through payday stores (excluding Internet loans) dropped to $30 billion in 2009 from $35 billion the year before, according to analyst David Burtzlaff at Arkansas investment bank Stephens Inc.
Payday stores’ revenue fell 13 percent to $4.8 billion, and 1,700 stores closed during that period.
Not all those closures happened because of the Great Recession. Payday lenders are under pressure from state banking regulators. States such as Arizona and Montana outlawed the business altogether.
Kentucky and others put in databases that track payday borrowers, preventing them from exceeding statutory borrowing limits. Since putting in its tracking system, Kentucky saw the average number of loans per borrower drop by 22 percent.
Consumer advocates say payday loans encourage pernicious repeat borrowing. All anyone needs to get a payday loan is a bank account and a steady source of income. A paystub and a bank check are the required proof. The borrower gives the payday lender a post-dated check, usually with a date of two weeks away.
Typically the fee is $15 per $100 of loan, so he or she leaves a $115 check, and walks out with $100 cash.
When the date on the check comes due, the borrower either comes in to redeem the face amount with cash, or the payday lender cashes the check.
“It sets borrowers up for failure to have the entire amount due in full in two weeks,” says Leslie Parrish of the Center for Responsible Lending.
“If you need $500 now what are chances the chances that in two weeks you will have that money?” That may be why the average payday customer takes out eight or nine loans a year.
Dee Litrell, head of investor relations for Cash America says payday lenders do not charge extra interest if a borrower repays late. “I’m not going to take you to court, it’s not worth it for $400,” says Litrell. Loss rates run around 20 to 30 percent of revenue, Litrell says.
The other criticism of payday loans is the outsized APR: $15 on $100 for two weeks equates to an annual interest rate of almost 400 percent. Compare that to overdraft fees, and it seems like a good deal. The average overdraft fee equates to a 1067 percent APR, according to an FDIC study from 2008.
Perhaps that’s why Elizabeth Warren, head of the Consumer Financial Protection Agency is not threatening to use her new regulatory authority to shut down payday lending. “This agency is not about banning things. This agency is about making price and risk clear to the consumer so markets can really work,” Warren said.
For borrowers like Yvonne Puente, the price is right and the risk is clear. She took out her second payday loan in January. She says she won’t need to borrow again once tax season gets under way.