Payday lending has grabbed headlines in the past several years for its danger to vulnerable borrowers who can’t pay back the principal, plus high interest rates packaged in these “fast cash” loans. In 2017, the U.S. Consumer Financial Protection Bureau passed new rules requiring payday and other similar lenders to make sure borrowers could pay back their obligations in a reasonable amount of time so they wouldn’t fall into a debt trap, and then gave the industry two years to prepare. These payday loan safeguards were set to take effect this Monday, August 19, 2019 — but have been delayed by the Trump administration for at least another 15 months.
Given the news swirling around the payday lending industry, KWHS thought the timing couldn’t be better when high school student Ari Berke reached out to us with an idea to write about his unique summer job experience. Ari is a senior at Yavneh Academy of Dallas in Texas, U.S. He is a repeat KWHS contributor, previously submitting an essay about his passion for investing and providing some analysis for this year’s spate of tech IPOs. He is especially interested in finance.
In this, his latest first-person essay, Ari takes us inside the controversial payday lending industry, where he worked this summer. He presents a somewhat unexpected perspective on why he believes laws restricting the payday lending business have resulted in “unintended consequences.”
Did you know that 40% of Americans can’t cover an unexpected $400 expense? That means tens of millions of American adults literally can’t afford to have a flat tire or a broken arm. A report published in 2018 by the Federal Reserve Board pointed out that those who don’t have access to emergency cash would have to borrow or sell something to get the money. Some 10 million Americans take out what’s called a payday loan, a loan marketed as a way to access cash until the next time you get your paycheck.
I’m really interested in finance, and payday loans have always intrigued me. They are small loans that allow you to borrow against a future paycheck. That option comes with a high price, however, because the interest rates associated with these loans are incredibly high. Payday loans are prevalent in low-income communities, and these lenders have received lots of criticism for their treatment of low-income borrowers. Borrowers might need extra cash to meet their monthly expenses, but at the same time are not able to pay back the payday loans on time, which puts them into a growing debt with payday lenders. Or, they get into a vicious cycle. They take out a payday loan for, say, $700, to pay their bills. When their paycheck comes, they pay off the loan and then have no money for bills. So, they take out another payday loan. Each loan results in more debt, more fees, that they struggle to repay. Often, they don’t have access to other kinds of credit.
A few months ago, I decided to get a summer job, and I ended up working for a payday lender. Here’s my experience.
Junie B. Jones and Payday Loans
As I was finishing up my junior year of high school this spring, I went into job-seeker mode to find summer employment. I’m an Orthodox Jew and therefore couldn’t work on Saturdays, so my choices were limited. After a few failed attempts at getting retail jobs, I ended up driving around town filling out job applications for any storefront that would be closed on Saturday. With some reservations — due to the negative reputation of the payday loan industry — and a great deal of curiosity, I accepted a job with a payday loan company to help manage a storefront in Carrollton, Texas. Texas has a crowded payday-lending industry, with lots of “fast cash” signs in low-income neighborhoods. Like banks, these tend to be closed on the weekends. In addition to a job, this would be a really hands-on way for me to better understand payday lenders. My summer work journey had begun.
When I arrived on the first day, I had no idea what to expect, but was up for the learning experience. The company had two locations and was opening a third. My first day was spent installing a security camera in the soon-to-be opened store. From then on, however, I sat in the store waiting for walk-ins and analyzing customer data to improve the stores’ Google ranking. Turns out, very few people actually walked in. The vast majority of customers found my employer and did their loan transactions entirely online. They used Google to find the store, applied on the website, got approved for the loan, and received funds via direct deposit, which is also how they paid off their debts for the loans. All electronic! In fact, customer walk-ins were encouraged to leave the store and apply online.
This lack of foot traffic made the few customers I did meet especially memorable. I was seated behind my desk when a fairly young woman came in with her daughter, whose nose was buried in the book Junie B. Jones Has a Peep in Her Pocket. The owner went to the back to find some paperwork and I tried striking up a conversation with the woman. She told me about her childhood and how she was left to fend for herself from a young age, and how she knows she can do more for her daughter than what was done for her. In fact, she was taking out the payday loan to cover a down payment for her daughter’s school.
“I was even more shocked to learn that despite charging such exorbitant interest rates to its customers, the company I worked for had pretty narrow margins.” — Ari Berke
According to Forbes, some 10 million people take out payday loans each year. The customers I met used these loans to fund what I’d define as daily expenses, like paying bills. Some customers clearly were looking to access cash on the down low. One of my employer’s favorite customers was a well-off professional who made hundreds of thousands of dollars a year. The owner told me that this customer valued the privacy of the loans, whatever that meant. Most of the time, however, I got to ‘know’ clients by analyzing spreadsheets or Google searches, and the results were surprising. Almost all the customers had jobs, bank accounts and were paid by their employers via direct deposit. Google analytics cited my employer’s repeat business as a key reason for giving the company a high ranking amongst the competition.
Throughout the summer, I began to explore how to make these loans more affordable to people like the woman and her daughter, especially as I came to better understand the structure of these loans. Someone taking out a loan, and following a six-month payment schedule, ends up paying interest and fees of 120% or more! That’s on top of the repayment of the original loan principal. It’s no wonder that many payday loan recipients get locked into a cycle of debt.
I was even more shocked to learn that despite charging such exorbitant interest rates to its customers, the company I worked for had pretty narrow margins, meaning not much profit. I studied its overhead to see what was costing so much that it almost canceled out the revenue brought in from these high-interest loans. Possibly if the company could bring its costs down, it wouldn’t have to charge its customers such high fees and interest. When I looked at the numbers, one thing stood out: two massive interest payments made every few months to outside vendors. With time on my hands, I decided to do more research into how the payday loan industry works.
Enter the Third Party
The payday loan business model is actually much more complicated than I ever realized. It’s not just one company lending its money to a customer for those high interest rates and fees. In fact, that model is essentially illegal in many states (including my home state of Texas) due to usury laws, which prohibit personal loans from having usuriously high interest rates (in Texas, the limit is 10%).
Payday loans are personal loans, so payday lenders got around these laws by acting as a brokers or middlemen between lenders and customers. Here’s an example. Say a payday loan company wants to lend out $100,000. They can’t do it directly because they’ll violate those usury laws. So, they become a sort of middleman between the customer and another lender, rather than servicing the customer directly. They take out a $100,000 loan from another lender and then use that money to extend multiple smaller loans to their loan applicants at higher rates and additional fees. This way, they can be considered loan brokers, as they are facilitating a loan from one party to another. They then charge high brokerage fees, normally of 120% or more.
But it’s not that easy. Normally, a business in need of a loan would go to a bank, which offers pretty reasonable loan terms. But, many payday lenders won’t be approved for a bank loan because no bank wants to be associated with payday lending due to its toxic public profile. Instead, they are forced to take out loans from different, less generous third-party lenders. The business loan they take out from the “third-party lender” obviously has interest, typically around 15%. And it doesn’t end there. These third-party lenders require the payday lenders to keep between 50% and 100% of the loan principal stored away in a bank account, so they feel comfortable that they can be paid back. That’s called collateral. To get that collateral, the payday lenders have to take out another loan (unless they have 75 grand sitting around), which is another 15% interest owed.
All of these costs are what allow a payday lender to qualify as a loan broker between the third-party lender and the customer. Right off the bat, this payday loan company has incurred 30% in recurring overhead expenses before it can even start lending. What kind of effect do you think this high cost will have on their payday lending? It dramatically raises the cost of a loan for the consumer, because the payday lenders then tack on the huge brokerage fees to compensate for the costs of becoming a broker.
If payday lenders were legally allowed to operate as lenders and not brokers, they wouldn’t need to add on those massive fees. The usury legislation, which was passed in an attempt to help low-income consumers from getting ripped off by payday lenders, has actually cost consumers more!
I’m not saying I agree with the practices of payday lenders. I understand that many of these lenders are taking advantage of people who have limited means. I think it’s interesting, though, that payday lenders became so universally repugnant that society tried outlawing their practices outright. And following the law of unintended consequences, this legal protection (through usury laws put in place many years ago) has resulted in significantly raising the costs of the loans for the millions of Americans who need them.
Working at the company this summer, I saw the human side of a socially complicated business. It gave me a new perspective. I don’t have all the answers to address the complex questions of high-interest-rate payday lending. But after my office experience, I feel strongly that regulators should be even more cautious about the effects that restrictive laws can have on industries and society.
- CNN Money: 40% of Americans Can’t Cover Emergency Expenses
- Forbes: 10 Million Americans Want Payday Loans This Year
- Equal Voice News: Payday Loans
- LA Times: Payday Lenders Faced Tough New Rules Protecting Consumers. Then Trump Took Office.
It’s no secret that the payday lending industry is considered toxic and even abusive to consumers who don’t often have the means to repay these loans. How do you feel about the payday loan industry? Did Ari’s essay change or reinforce your perspective? Why or why not?
Do you have a personal experience with payday loans? Share your story in the comment section of this article.
Do you have specific questions or feedback for Ari Berke after reading his essay? Ask him in the comment section of this article and he will respond!
“I saw the human side of a socially complicated business. It gave me a new perspective…I feel strongly that regulators should be even more cautious about the effects that restrictive laws can have on industries and society.”
It is true that restrictive laws could have many unintended negative consequences on businesses and consumers. The payday loan industry is a very interesting example of how when government legislation tries to protect consumers from being charged high interest rates, it could backfire, causing the many ordinary Americans in need of loans being pulled into deeper debt by the even higher rates the payday ‘brokers’ have to charge. It seems that strict legislation could lead to reduced consumer welfare instead of preventing debt, especially for low-income borrowers. This might even make loan sharks a more attractive option. Not only is borrowing from loan sharks illegal, borrowers and their family/friends are also vulnerable to harassment, threats and violence. This is a problem that is often reported in the news in Singapore, where I live. The Singapore government is very strict in cracking down on loan sharks and other unlicensed moneylenders.
While tough legislation on the money-lending practices could definitely establish credibility for licensed money-lenders and increase their demand, regulators cannot overlook the significant proportion of lower income groups that need access to small, fast-cash loans. Putting restrictions on the payday loan industry may not reduce the demand for such loans. Hence, to reduce the negative impact of unintended consequences, these restrictive laws could be accompanied with other legislation and schemes that target the root cause of why “40% of Americans can’t cover an unexpected $400 expense”. It is important for government agencies to take a closer examination of the socio-economic issues that have resulted in their cash-strapped, paycheck-to-paycheck situation. More extensive safety-nets, employment schemes, financial aid schemes and financial support structures could be employed to lessen the financial crunch that low-income groups face. Subsidizing big-ticket purchases such as property, cars, and college education is also a possible consideration to reduce the demand for fast loans. In addition, I strongly believe that educating all young students about how to properly manage their personal finances is one of the best possible measures to improve both the household and national financial health of a country in the long term.
Restrictive laws is just one tool to address the complex issue of consumer debt. Let’s use our creativity and work together to come up with effective and comprehensive solutions!
Did you know that this “36% APR theme” began in 1915? That a $300 loan principal in 1915 is equivalent to $7000 today; it’s called inflation.
Smart young man! I hope he goes to Washington D.C. Certainly has more common sense than the majority of our elected legislators and their sycophant lobbyists.
Lenders cannot offer small-dollar loans [think $4K – $5K at a minimum] and pay their bills when a 36% APR is rammed down their throats.
So nearly half of all US households in 2020 cannot access $400 cash when faced with a financial emergency according to PEW and the FED. Thus, a $300 loan at 36% yields a gross $9/month. From this $9, a Lender must pay rent, taxes, employees, customer acquisition costs, cost of capital. loan production and servicing costs, bank fees, ACH/processing fees, phone, utilities, legal, insurance, licensing…
Even we non-deplorable “get’ it. Small-dollar loans will simply be made unavailable. If the loan principal is anything less than $5K at a MINIMUM it is not worth a Lender’s effort to underwrite much less fund!.
The result? When 40% of a population cannot pay for their child’s medicine, keep the lights on, fix their car to keep their job… they are going to find alternatives. Alternatives that will not appeal to the 1%.
I’m biased and I FULLY admit it. I once used payday loans to save my butt and now I own payday, installment, personal loan stores & internet portfolios. I talk to REAL folks everyday. This young man did the same. I wish I could hire him but he’s destined for bigger better things. Maybe he can help fix this mess! Jer Ayles; Trihouse Consulting