How do payday lenders get away with charging such high interest rates?

August 3, 2007 | By | 6 Replies More

The topic of usury laws and payday loans arises frequently these days. Payday lenders commonly charge interest rates of 300%, 400% or more on their loans to desperate consumers. Why do I suggest these consumers are desperate? It’s because they are writing postdated checks to payday lenders, agreeing to give up a large chunks of their next paychecks, and paying exorbitant interest rates in the process. How many people who are not financially desperate would be willing to sign away the proceeds of a future paycheck and pay 450% interest for this “privilege”? With repeated real-life scenario as the backdrop, the question often arises: do usury laws exist anymore? This topic has been addressed by Christopher Peterson in a comprehensive law review article entitled “Usury Law, Payday Loans, and Statutory Sleight-Of-Hand: an Empirical Analysis of American Credit Pricing Limits.”

It’s not hard to determine what motivates Peterson’s work. He writes that the American consumer is now dealing with “a new, largely unregulated credit marketplace.” The center of the storm is the payday lending industry which, “despite spending millions on lobbying and public relations, is at the center of an inferno of rage and public controversy.” Peterson takes time to discuss the history of usury laws throughout the history of the American republic. Usury laws, according to Peterson, have “historically been the foremost bulwark shielding consumers from harsh credit practices.” At the time our country declared its independence, no state had an interest of greater than 8%. Benjamin Franklin warned of the social and moral dangers of indebtedness:

The borrower is a slave to the lender, and the debtor to the creditor, disdained the chain, preserve your freedom; and maintain your independency: be industrious and free; be frugal and free.

Peterson writes of a “second phase” of the Republic, starting in the late 1800s, when groups of high-cost lenders known as “loan sharks” charged triple digit interest rates exceeding 500%. The did this through “salary-assignment” schemes that were so devastating to borrowers that the FTC eventually cracked down on them (see CFR 444.2(a)(3)). Another approach to social reform was to “raise the old traditional usury limits to a point where more mainstream financial institutions could profitably land of small amounts to working-class borrowers.” States follow the strategy, typically kept interest rates at between 24 and 42% per annum.

Competition among lenders and aggressive law enforcement worked reasonably well. Things changed again in 1978 with the Supreme Court decision of Marquette National Bank Versus First of Omaha Service Corp., 439 US 299 (1978). In Marquette, the Supreme Court ruled that a national bank lending money across state lines must apply the usury laws of the bank’s home state, rather than the usury laws of the borrower’s state. This decision was based upon the National Bank Act of 1864. The Marquette decision was an invitation for national banks to make a lot of money by relocating to South Dakota or Delaware, states that did not have meaningful usury laws. The result, according to Peterson was “a frenzied race to the bottom and American usury law.” State-chartered banks quickly pressured state legislatures to grant them the same power held by nationally chartered banks in the form of “parity laws.” When the dust settled, what remained was

a grand illusion. Every state in the union, save two, had a relatively aggressive usury law on the books. And yet, even though no legislature had ever passed a law saying as much, the new synthesized usury rule became: any bank can charge any interest rate it wants anywhere it wants.

Eventually, the assault on usury laws invited by Marquette crashed into what remained of the state usury laws pertaining to non-depository financial institutions. This gave birth to the payday lending industry. Payday lenders are careful to sidestep the FTC law that prohibited the issuance of loans based upon salary assignments, but payday lenders are, indeed, loan sharks re-incarnate. They sidestep the FTC rule mentioned above by requiring customers to postdate their personal checks for the amount due at the time of their next anticipated paycheck. The typical payday loan customer incurs a charge of $52 to have access to $325 for the period of one paycheck (typically 14 days). Doing the math, this comes out to an interest rate of approximately 417% interest. Peterson cites research showing that the average payday borrower pays $793 for a loan of only $325.

Payday lenders earn 90% of their revenue from “fees stripped from trapped borrowers.” Payday lenders have honed their business model well over the years. They figured out how to locate their businesses within poor and minority neighborhoods. They have also preyed on members of the military. This military strategy occurred to such a disturbing extent that Congress, flush with financial institution contributions, nonetheless passed a law, effective October 1, 2007, that limits interest rates that payday lenders can charge to military personnel to 36% annually. Payday lenders have indicated that they cannot make any money based upon this new rate cap of 36%. It’s not that payday lenders are going to disappear everywhere just because they disappear from military bases. As Peterson notes, between 2000 and 2004, the number of payday loan shops in America doubled from 10,000 to 22,000. In his article, Peterson conducts an elaborate analysis of usury laws across United States. Based upon Peterson’s calculations, nine states have no interest cap. Many states allow payday loans in excess of 400% APR. 36 states allow interest rates exceeding 300%. Some, like Missouri, allow an APR rate of 601%. In 1965, the median usury limit on a payday loan was about 36%. By 2007, the median state usury limit was ten times higher.

The irony is that many states, including Missouri, retain stringent usury caps on the books, and these caps apply to people like you and me who wish to make simple loans to each other. In Missouri, for example, 408.030 RSMo prohibits private individuals from making a loan at an interest rate exceeding 10% per annum. Payday lenders are more special than regular folks, of course, because they have lobbyists, so they can lend money at rates that are almost 200 times higher than the rest of us. Petersen concludes that, since 1965, usury law has become “much more lax, more polarized and more misleading.” In fact, he developed a “Mean Salience Distortion” measure to capture the degree to which the state legislators had obfuscated the true cost of taking out a payday loan.

Peterson’s analysis shows that a straight line could graphically portray the high interest and fees the state legislatures granted to payday lenders compared to the deceptive language used in the payday lending statutes. The higher the rate allowed by a state, the less straightforward the wording of that state’s statute. This situation is incredibly shameful. Peterson is scathing when he describes way all too many state legislatures have totally sold out to the payday lenders at the expense of their own constituents. His devastating statistics back him up fully. Peterson’s work is detailed, highly readable and depressing. His numbers don’t lie. Industry money has worked well on many state legislators, and they have thrown their poorest citizens to the financial wolves. It’s really a kick in the stomach to see this corrupt process detailed so precisely. This damage could be quickly undone if Congress or state legislators had the guts to banish payday industry lobbyists from the legislative process.

The silver lining to this sad story is that Peterson’s work might serve as the first step to addressing this distressing situation.


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Category: Consumerism, Corruption, Economy, Politics

About the Author ()

Erich Vieth is an attorney focusing on consumer law litigation and appellate practice. He is also a working musician and a writer, having founded Dangerous Intersection in 2006. Erich lives in the Shaw Neighborhood of St. Louis, Missouri, where he lives half-time with his two extraordinary daughters.

Comments (6)

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  1. Lynz says:

    First, the payday lending industry is regulated in the 38 states where storefront lenders exists. These regulation include maximum fees, maximum loan amounts, etc.

    The average cost of a payday loan is $16 per $100 borrowed. Compare that to the cost of bouncing a check, overdraft protection, paying a credit card bill late, etc…and it's very easy to determine why payday lending is a popular and growing industry. Payday loans are straight forward and cheaper than the other alternatives faced by people who have to pay a bill today, but don't get paid for another week. Eliminating payday loans doesn't help anyone, just takes away an option.

  2. Erich Vieth says:

    I'm curious, Lynz. Do you work in the payday loan industry?

  3. George Skakel says:

    The average cost of a bounced check in the US today is about $35.00. The amount of the bounced check does not matter it could be $2.00 or $2,000. The bank wants their money back, not in 2 weeks but IMMEDIATLY. You complain about the interest rates that payday lenders charge (in fact pay day lenders do not charge interst they charge a fixed fee, just like the bank does for a bounced check). So what do you think the APR (Annual Percentage Rate) on a $25.00 bounced check repaid in 2 days for which the check writer has to pay $35.00? Let's do the math. ($35/$25) / (2/365) = 2,550%

    It makes rational economic sense to borrow $100 for 2 weeks and repay $115 to avoid bounced check fees at banks.

  4. Thomas C. Lewis says:

    I just found your website and love it. Please keep it up and add me to your e-mailing list.

    Have you ever looked into eliminating the tip-credit minimum wage?

    Thanks, Tom

    • Erich Vieth says:

      Thomas: Glad you took the time to explore the site and that you're finding it worthwhile. We are proud that we have about 5,000 visitors in a typical day, and we'd appreciate it if you could spread the word.

      You can sign up for an RSS feed or you can subscribe by email on the home page.

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