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Federal Reserve Study Reveals Cost of Denying Options to Consumers

By Niger Innis

January 2, 2008

It's one of the cornerstones of our free-market system: Choice benefits consumers. A recent staff report from the Federal Reserve Bank of New York confirms it in regards to "payday" loans, those small short-term cash advances that politicians love to bash.

There's no doubt that a huge market exists for payday loans. According to the industry, there are more than 22,000 retail payday locations across the country offering about $40 billion in short-term credit to consumers. The main beneficiaries of payday loans are working households in minority communities, which have been traditionally underserved by banks and other financial institutions.

Payday lenders have helped to improve the situation from a generation ago, when many working families were locked out of critical parts of the financial marketplace. With few, if any, legitimate options available to them for financial emergencies, they were easy prey for loan sharks and other underground operators.

The report, "Payday Holiday: How Households Fare after Payday Credit Bans," looks at the financial fates of families in North Carolina and Georgia after those states outlawed payday loans. (The study is online at www.newyorkfed.org/research/staff_reports/sr309.html.)

"Payday loans are widely condemned as a 'predatory debt trap,'" says the report. "Most of our findings contradict the debt trap hypothesis." The authors looked at three financial problems "that seem endemic to payday borrowers": complaints against lenders and debt collectors; bankruptcy; and bounced checks. The last item might seem trivial, but the authors point out that bounced checks can "cascade into problems with debt collectors, or even bankruptcy."

The authors' research revealed the following: "Compared with households in all other states, households in Georgia have bounced more checks, complained more ... about lenders and debt collectors, and filed for Chapter 7 bankruptcy protection at a higher rate. North Carolina households have fared about the same." The report concludes that payday loans are "preferable to substitutes such as the bounced-check 'protection' sold by credit unions and banks or loans from pawnshops."

The authors' discussion of bounced-check protection in Chicago is especially telling. The report notes that even the head of the Federal Deposit Insurance Corp., Sheila Bair, "observed that the 'enormous' fees earned on bounced protection programs discouraged credit unions and banks from offering payday loans. She warned that customers were 'catching on' and turning to payday credit for their 'cheaper product.'"

Californians have also benefited from the availability of payday loans. The report cites findings that "California households weather floods, fires and other natural disasters with less suffering (foreclosures, illness, and death) if they happen to live closer to the types of places where payday lenders tend to congregate.... payday credit can be profoundly beneficial, even lifesaving, in extraordinary events." The Federal Reserve study stresses, however, that payday loans are just as useful for avoiding more routine problems, "like bouncing a mess of checks, or getting hassled at work by debt collectors."

The report is a serious blow to the credibility of the Center for Responsible Lending, a leading critic of payday loans: "Banning payday loans did not save Georgian households $154 million per year, as the CRL projected; it cost them millions per year in returned check fees."

The report raises serious questions about the implications of cutting off access to payday loans. New York, New Jersey and most New England states have always banned payday lenders. Oregon and Pennsylvania recently outlawed them.

Regardless of their intentions, policymakers who seek to deny payday loans to struggling households are helping to undermine minority communities that are already reeling from a lack of financial services. Banks don't want to do business in these neighborhoods. A bank manager recently told me that he was offered a raise to work in a branch in a minority community. But he declined because he knew the branch was slated to be shut down soon.

Financial Literacy Whether you use a payday loan or other legitimate option to make ends meet, one thing is essential: You need to educate yourself about the costs and benefits of your choice. The Congress of Racial Equality, one of America's oldest civil rights organizations, views the issue of financial literacy as one of empowering communities. In recent years, CORE has expanded its activities from traditional civil-rights concerns like discrimination in the political arena to ensuring that historically disenfranchised groups have full participation in the nation's economy. A lack of information can be just as hobbling as physically preventing someone from entering a financial institution.

To remedy this situation, CORE created a "Financial Literacy, Choice & Awareness Campaign" to work with policymakers, legislators and the financial-services industry in a comprehensive effort to educate communities about their options in the financial marketplace. Central to our campaign is the belief that consumers have just as much responsibility for informing themselves about these programs and services as the financial-services industry has for providing accurate, up-to-date information that's presented in a way that members of the general public can understand.

The old Roman proverb "Caveat emptor"-Let the buyer beware-may be more relevant today than it was two thousand years ago. Financial assistance, whether in the form of a payday loan, credit card, or other product, can help you get through a tough time. But before signing up for any of these, you need to acquire at least a basic understanding of how the product works. It's like getting a car, an indispensable tool in modern life. Before you turn the key, make sure you know enough about the vehicle so that you're the one in control.