Is Colorado Paving the Way for Payday Loan Reform?

A few years ago, I found myself in a small claims courtroom in downtown Seattle. I was there to sue my landlord. (I lost.)

Before the judge heard my case, however, the court had some routine business to take care of: a representative from a chain of payday lending shops had a list of delinquent customers, and he was asking the court for permission to take money out of their paychecks.

The judge said yes, yes, yes, to the whole list, and the man smiled.

This was disturbing, but it didn’t tell me anything about whether payday lending is actually a problem. You hang around a courtroom, you see the worst side of everything.

Beyond good and evil

The payday lending industry argues that they’re providing a valuable product that people want.

“There is clear evidence of demand for short-term credit in today’s economy,” says the website of the Community Financial Services Association (CFSA), the lobbying arm of the payday loan industry.

“Nearly 15 million Americans use payday loans to manage their financial obligations,” it adds.

The Pew Charitable Trusts have been studying payday lending under their Safe Small-Dollar Loans Project for several years.

“We saw that there was a big gap between the way the product was promoted, as a short-term loan for emergency expenses, and the way that it’s experienced,” says research director Nick Bourke.

You probably already have an opinion on payday loans. May I ask you to put it aside for a few minutes?

The debate over whether payday loans are good or bad is tiresome and surprisingly difficult to resolve.

The industry would like payday lending to continue in its current form and expand to the states that currently ban it; most critics would like to get rid of it altogether.

Meanwhile, as described in a new report from Pew, one state has embarked on an experiment to keep payday loans around but make them safer.

The Colorado experiment

Conventional payday loans are short-term lump sum loans.

You borrow $500 against your next paycheck and collect cash today. On your next payday, you repay the $500 in full plus a $75 fee.

If you can’t pay the $500, you can pay just the $75 and roll the $500 loan over for another two weeks, at which time you’ll still owe $575. (The average payday loan is for $375.)

Even the payday industry agrees that rolling over loans in this way is common.

“Most borrowers fully plan and expect their payday loans to be outstanding for more than one pay cycle at the time of initial borrowing,” says Amy Cantu, communications director for the CFSA.

Critics, including Pew, argue that this loan structure is inherently unaffordable for most borrowers.

“A typical payday loan advances $375 for a fee of $55 and requires payment in full — $430 — on the borrower’s next payday,” says Bourke.

He continues, “That equals 36 percent of the borrower’s paycheck before taxes. Few people can afford to sacrifice one-third of their paycheck to repay a loan, while still being able to pay rent or mortgage, utilities, credit card or student loan bills, and basic living expenses.”

The industry argues that this is irrelevant, because borrowers understand the fees and repayment schedule, and those who are unable to pay out of their next paycheck can simply save money up toward future repayment while rolling over the loan.

In other words, they convert a lump sum loan into something more like an installment loan.

That’s where Colorado’s experiment comes in.

Colorado banned lump-sum payday loans in 2010 and replaced them with six-month installment loans.

Interest rates are still high, but borrowers have six months to repay the loan instead of the two weeks or so until their next paycheck.

Here are some results in the three years since Colorado changed the game:

• The typical payment on a payday loan dropped from one-third of the borrower’s next paycheck to 4%.
• The average loan size remained the same.
• Fees and interest payments over the course of a loan have dropped by 42%.
• There’s no evidence that borrowers are turning to online payday lenders (which tend to offer lump sum loans, legal or otherwise) any more often than in other states.

Unsurprisingly, these changes have made payday lending in Colorado less profitable, but they haven’t eliminated it.

“Access to credit in Colorado is almost unchanged,” says Bourke. “Nearly everywhere in the state where people had access to a payday loan store before, they continue to have access today.”

The number of loans originated has dropped by about 15%.

CFSA’s Cantu responds that Colorado’s reform is unnecessary and doesn’t reflect what customers want.

“CFSA’s members do offer installment options across the country in the states where they are permitted,” says Cantu, “and we continue to work with lawmakers and regulators to extend those credit products to consumers in additional states.”

Where installment loans are offered alongside lump-sum payday loans, they’re generally less popular.

That may be because customers prefer lump-sum loans, but it could also be because lump-sum loans are less risky and more profitable for lenders, and lenders therefore have an incentive to push lump-sum loans.

CFSA also argues that Pew’s conclusions are based on anecdotes told at focus groups, rather than actual data.

It’s true that Pew convened focus groups and relied on them for quotes in its report, and it’s true that you can find anyone saying anything at a focus group.

But the key points in the report are based on hard data from the Federal Reserve and the Colorado Attorney General’s office.

A valuable experiment

The payday industry argues that the point of regulation is to improve outcomes for consumers, and none of the data presented by Pew is proof that borrowers in Colorado are any better off now than they were when they could get lump-sum payday loans.

This gets to the question of whether you believe financial products can be unsafe. The terms of a lump-sum payday loan are clear, and people take them out voluntarily.

If people misuse them, is that the fault of the product or the users?

To Pew’s Bourke, the answer is obvious. “Lenders know that repeat borrowing is likely to occur because of the payday loan’s unaffordable loan structure,” he says.

“In fact, the conventional payday loan business model would completely fall apart if just half of all payday borrowers repaid the loans after just one or two pay periods,” he adds.

Colorado, he says, is proof that if you believe access to credit for subprime borrowers is important, there’s a way to do it that puts some seat belts and airbags on the product without taking it off the road:

“The Colorado example shows us that a safer and more affordable alternative to payday loans is viable for both consumers and for lenders, and it can be done in a way that is much more transparent about the costs and how long the loans will take to repay.”

The payday lending laws vary widely from state to state. Some states ban payday lending. Some allow lump-sum lending, but with restrictions on loan size, interest rate, and other factors.

Colorado is unique in requiring installment loans.

Payday loans to military families are illegal nationwide. And online payday loans, legal and otherwise, are growing in popularity, amounting to over 40% of the market, according to the Wall Street Journal.

In other words, a national experiment is underway.

My bias is clear, I hope: most payday borrowers are already in debt and having trouble paying their bills, and I suspect that extending additional high-interest credit to people in that situation is more likely to harm than to help.

“On the whole, are people better off getting a high-interest-rate installment loan or not having access to that high-interest-rate installment loan?” says Bourke. “We don’t really know that.”

Producing good data on this question should be a national priority, because it could provide actionable information on how to use policy to help people in poverty or a personal financial crisis.

And experiments like Colorado’s help generate the data we need to construct a national policy on subprime lending.

In the meantime, the Consumer Financial Protection Bureau (CFPB) is getting in on the payday action. If you have a payday loan complaint, as of this month you can submit it to the CFPB.

Matthew Amster-Burton is a personal finance columnist at Mint.com. Find him on Twitter @Mint_Mamster.