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Financial Institutions and Payday Loans

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When looking across opinionated message boards strewn across the internet, a common train of thought held by many is that payday lending is simply a legal way for predatory loan sharks to operate. As legislation continuously tries to regulate this type of financing, and groups on both sides of the tracks emerge in support and in opposition, an ongoing cry has begun to ring once again: why do we, as a nation, allow such volatile loans to be legal?
 
Proponents of payday loans will immediately point to the fact that when people need money, they will get money—one way or another. These check advances allow borrowers to obtain money in a safe and secure manner, whereas without this type of financing, borrowers may very well resort to less-than-legal means of acquiring cash. They’ll turn to real loan sharks—the kind of lenders that don’t respond to default by rolling loans over, but instead with baseball bats or worse.
 
Setting that assumption aside though, few would argue that payday loans are perfect in their current form. But despite this recognition that there is room for improvement, little has been done. This then begs the next question: why don’t banks and credit unions offer a service similar to payday loans?
 
Some banks may claim they do, with direct deposit loans and other types with unique, branch-specific names, but they’re not quite the same. Rather, there are several prerequisites that many payday loan users, by definition, wouldn’t satisfy. Ranging from a minimum amount in one’s checking account to requiring direct deposit of a minimum amount, most check advance users simply don’t meet banks’ requirements; otherwise they wouldn’t be in the market for a payday loan to begin with.
 
Traditional banks of national or international stature simply don’t need to take the risk of issuing payday-like loans. There’s a reason an entire industry has been built behind this type of money issuance, and that’s because in order to make money on cash advances, it takes a lot of dedication, work, and specialization—all for not nearly as high a payout as the interest rates would leave outsiders to believe.
 
Consider this example posed by Felix Salmon, a finance blogger for Reuters:

“What happens when you lend 100 people $500 each, for one year, at 10 percent interest, with a 10 percent default rate? You start the year with $50,000. You end it with 90% of the loans paid back — that’s $45,000 — and another $4,500 in interest on those loans, for a total of $49,500. And you also have $5,000 of defaulted loans, which are worth say 25 cents on the dollar. Which means you make a total profit of $750.

On the other hand, what if the term of the loan is six months, but the 10 percent default rate stays the same? Then after six months you’ve got $45,000 back, plus $2,250 in interest, for a loss of $2,750. And if you run the same program again in the second half of the year, you’ll lose another $2,750. Instead of being down $500, you’re down $5,500. Yes, you’ve now got $10,000 in defaulted loans rather than $5,000. But even so, you end the year with a loss of $3,000.”

Banks are a business, and their business model revolves around retaining money and making secured loans. They needn’t issue quick, short-term money to high-risk borrowers with no collateral. They don’t need to stunt their employees’ time by having them make collections calls to around 10 percent of all payday loan borrowers who default. Banks, as apparent by the lack of an accessible payday loan alternative, have no desire to enter into this arena.
 
But What About Credit Unions?
 
However, Salmon, who, in addition to blogging, serves a board member of Lower East Side People’s Federal Credit Union, makes the argument that credit unions are different from banks, and that they should provide a payday loan alternative to its members. He points to the purpose of credit unions, which weren’t established solely for the reason of making money, but instead for the purpose of serving their members. If credit unions’ members seek out payday loan lenders on the street corner, then the credit unions aren’t doing their job.
 
“Credit unions exist to service their shareholder-members,” explains Salmon in his blog. “If those members need payday loans, then it behooves the credit union to find some way of giving them those loans, even if they’re not particularly profitable.”
 
He goes so far to say that credit unions may be prudent to offer payday loans at zero marginal profit—or even at a loss—if the unions’ members demand such a service. Adding a service such as this would not only serve a union’s members, but it would also help increase membership, as onlookers would see a credit union offering payday loans as a safe haven in the event the individual were to fall on hard times and need access to quick and safe cash.
 
Finally, Salmon explains that credit unions actually have the capability to issue such loans at significantly lower costs. Due to the fact that a credit union is a bank first and a lender second, they have access to deposits. As a result, they don’t need to have a wealthy group of investors providing money as overhead, nor do they have to borrow their money (in a traditional sense) from others and turn it around for profit. Instead, the stock of a credit union’s services is constantly supplied and replenished by their members.
 
Until Then!
 
But until financial institutions begin offering this service or legislation is passed promoting lower interest rates and fewer rollovers on payday loans, consumers in tight situations should be educated and encouraged to borrower responsibly.
 
This type of financing shouldn’t be used to acquire wants, but rather it should be saved for needs. Payday loans are perfect for groceries, rent, car payments, medical expenses, or satisfying a late bill that is increasing in size as time passes. When used properly, and under the assumption that a borrower will pay a cash advance off on their next paycheck, this type of financing is not as inherently predatory as many believe.
 
Rather, they are sometimes necessary when unexpected bills arise—and borrowers should have a legal means of satisfying those expenditures, regardless of their credit scores.