Legal and Ethical Issues Concerning Payday Loans

I. Introduction

II. Ethics of Payday Loans

III. Legal issues around Payday Loans

IV. Summary

There has been a great amount of deliberation regarding the ethics and

business practices of payday loan companies. On one side, the opponents of the payday

lending practice argue that the high interest rates, shady collection methods, and the

unseen snares of long-term payment arrangement scenarios lead to large, often times

astronomical, final payoff amounts for what would otherwise be a relatively small loan

amount. However, you also have the payday loan service providers and industry proponents

that bring valid arguments to support their views that payday loans provide valuable, important

services to a particular sector of society that would otherwise have no chance of obtaining

funds, in moments of dire economic needs. Payday loan providers have argued that the practice

of charging higher interest rates are a necessity to counter the amount of risk they are

undertaking by providing unsecured loans to those individuals with a questionable credit

history. These individuals (payday lenders) also argue that payday loans bring a balance to

business of lending funds, because the traditional lending practices unfairly rule out those

individuals who are frequently in need of the funding the most.

The basic premise behind the payday loans business is that they offer short-term loans,

intended to be used for critical emergencies usually because the individual in need has

no other immediate lending sources are available. The individuals that usually apply for

payday loans are people that have a poor to less-than-average credit history, or have

difficulty with securing other immediate financing, through the traditional lending

practices.

To this extent, the payday loan companies do provide a valuable service to those who

truly need them by offering immediate financing to a certain segment of the population

who would otherwise have no options available.

The Ethical Issue of Payday Loans

What terms would you be willing to agree to, if you needed to obtain emergency funds

for say unexpected auto repairs or to repair your furnace, in the dead of winter, maybe

300% interest for a $500 loan? Generally we would like to think, or at least hope, that

your average person would say “no thank you”. Surprisingly, there are many of our

neighbors saying “yes”. The industry of payday loans (or also known as cash advances)

has seen a growth of borrowers with needs, whether from bills or holiday shopping, for

small amounts of money and these people are willing to agree to outrageous terms.

Usually, these people have scenarios where their payday has just past, they do not

maintain any type of savings account, their credit history is less then perfect and due to

their credit history they are unable to secure a credit card either. Now enter the payday

lender that is offering to provide a solution. The payday lender lets the borrower write

them a check for a certain amount (usually $100 to $1000 depending on state laws), and

the borrower will get an immediate sum of cash. The payday lender withholds an

amount for the fee of the loan, which is included in the original amount of the check.

The payday lender will then give the loan for two (2) weeks or until the borrowers next

payday. After two weeks the borrower has several options available to them in order to

satisfy the payday loan. The borrower can do nothing and allow the payday lender to

deposit the previously written check for payment, or that individual may pay, the

payday lender, a cash amount equivalent to the original check. A third option is also

available and this is where the payday loan practices start down a path that many

believe is predatory in nature. The borrower may chose to provide the payday lender,

with another check and extend the loan or just pay the finance charge to roll the loan

over for another pay period. Since a majority of borrowers actually do end up extending

their original loan this single issue has become the primary case for the negative views

on the payday loan industry. This allows the person to extend the loan over and over

but the initial fee for the loan is just charged each time. The issue is that when a person

extends a loan over and over the fees initially incurred are charged again, with each

extension. Over the course of a year a person could accrue an enormous amount in fees

alone, and this doesn’t even take into account the extremely high interest rate. “Loans

typically cost 400% annual interest (APR) or more. The finance charge ranges from $15

to $30 to borrow $100. For two-week loans, these finance charges result in interest

rates from 390 to 780% APR. Shorter term loans have even higher APRs.”1

The main pitfall with payday loans is that they do not provide a solution to the real

problem for many of these people. If these individuals are already struggling with

financial adversity, then the payday loans are only going to make the problem worse.

1 Payday Loan Terms, http://www.paydayloaninfo.org/facts.asp

There is a common belief shared among many of those that opposed the payday loan

practice that the industry seeks to prey on the financially uneducated. As most of the

potential borrowers overlook the associate risk in accepting these loans and can only

see the small fee for the loan and/or the fact the company will just hold the check.

The industry of payday loans has prospered by successful marketing itself as a quick fix

or “short-term relief for a cash crunch” but in reality they are “designed to catch

working people – or those with a steady source of income such as Social Security or a

disability check – in a long-term debt trap.”2 This is highly evident since the terms of

these loans are normally such that the people have no way to pay back the loan, when it

is due, without destroying their already limited or fixed budget. Thus unfolds the

devastating trap these people became snared in as they are forced to immediately take

out a new loan after paying the first one back or extending the original loan (incurring

additional fees).

The payday loan industry has not shied away from justifying their services. They have

argued that their payday loan services can be less expensive than bounced check fees

and overdraft protection programs, by traditional banking institutions. As well as

contending that payday loans are the quickest and simplest manner for some people to

get necessary funds. However, there have been several studies that have negated these

statements. For instance, the Consumer Federation of America compiled the following

findings based off of studies performed by various educational institutions:

2 Payday Loans Put Families in the Red, Center for Responsible Lending, February 20, 2009

1. “Payday loan borrowers are worse off than consumers who have no access to payday

loans.”

2. “Using payday loans causes financial hardship for families.”

3. “Payday loans have a fifty-fifty chance of causing defaults in the first year of use.”

4. “Using payday loans causes borrowers to file for bankruptcy.”3

We noted earlier that the payday industry has a target audience of lower income,

financially uneducated individuals but it also has unfortunately taken a grave effect on

those individuals who are serving in our armed forces. We are all aware that serving in

the military is not going to shower abundant wealth on anyone, and that many of these

individuals with families have difficulty making ends-meat but for a long period of time it

was unnoticed that these families were becoming victims of these lending schemes until

the Pentagon reported that these predatory practices were weakening our military,

because debt issues were threatening the security clearances of military personnel.

This brought about the federal government implementing laws to assist in protecting

military families from the payday lending traps through the Military Lending Act, since

then States have also began looking into the legal status of these practices and the

negative economic impact on the communities.

The Legal Issues of Payday Loans

Since the basic function of law is to provide rules that govern our society as well as to

allow the individuals governed by those laws to live in a safe and pleasant environment,

and to have their lives and possessions be given consideration and respect by other

3 Research Findings Illustrate the High Risk of High-Cost Short-Term Loans for Consumers, Compiled by Jean Ann Fox, Consumer Federation of America, February 18, 2009

members of a society. Then we would expect that an industry such as that of the

payday loan would be drawing the attention of both federal and state legislative

members, looking to protect the residents being caught in the traps of quick fix

financing operations.

Across the country debates and argument play back and forth between the payday loan

industry and growing number of citizen groups, who are taking a stance in opposition

predatory lending practices plaguing their communities. The laws in particular that are

applicable to this situation are known as Usury laws. Usury is defined as the act of

lending money at an unreasonably high interest rate or “taking of more than the law

allows on a loan or for forbearance of a debt.” 4 Other than protecting military families

with a “36% APR cap on small predatory loans” 5 the federal government has yet to

move to expand legal reforms across the country, which has allowed some big national

banks to get into the short term loan business with lending products that are virtually

similar to the payday loans found at neighborhood locations across the country (i.e.;

Cash American, Payday Loans, etc). In the absence of the of the federal government

enforcing legislation to curb the use of the tactics employee by the payday lending

industry, several states have enacted usury laws to limit the maximum amount of loans

and/or fees and financing charges.

To date, fifteen different states, plus the District of Columbia, have made it illegal to

charge triple-digit interest. In addition, two states (Ohio and Arizona) held ballot

4 Business Law, The Ethical, Global, and E-Commerce Environment- Mallor, Barnes, Bowers & Langvardt, 4th Edition

5Military Lending Act to take effect October 1 , September 27, 2007, http://www.consumerfed.org

measures this past fall/winter on the topic of high interest rates charged on loans.

Arizona became the sixteenth state to put a stop to the predatory lending through an

interest rate cap which took effect as of July 2010. Many of the changes made on the

state level have made an effort to limit the risk associated with the payday loan

practices but in all there are thirty-four states which still authorize high-cost lending.

While regulation varies from state to state, there seems to be a fairly common

framework on which these laws have been established. Reviewing the current payday

lending states statues you can see the commonality, the maximum loan amount range

from $100 – 1000 with the majority of states establishing a $500 maximum. In addition,

many have made an attempt at controlling the interest amounts as well through various

limitation and calculation methods.

The State laws regulating payday loans have also established guidelines as to what

lenders must disclose to borrowers. Prior to enacted legislation of the short-term loan

laws; payday lenders were allowed to hide their fees in lengthy cash advance loan

agreements that were written in very vague language. These lenders are now required

to provide agreements written in a clear, understandable manner and that discloses

fees upfront in bold typeface print.

Now with the expansion of the internet into practically every aspect of our lives and

business, a new door has been opened up to the payday lending institution by allowing

borrowers to apply online or through faxed application forms. Loans are now direct

deposited into a borrower's bank account and then electronically withdrawn on the next

payday. In addition, most internet payday loan agreements are structured to

automatically renew every payday, with finance charges electronically withdrawn from

the borrower's bank account.

So, even though states either have or are working to enacted laws to curtail the actions

of the payday loan industry and protect the consumer, these laws have seemed to miss

the a major concern, of payday loans, by failing to limit the number of times an

individual may roll over or extend a loan.

Bringing it all together

It seems that society expects the government to protect us all, the consumer, from

practices, such as payday lending, by enacting legal measures or laws that would

prevent an organization from taking advantage of certain people. However, we also live

in a capitalistic society where if there is a demand someone is going to provide the

“supply” in hopes of making a buck or two. Unfortunately, we do live in a money

driven-get it now type of society which has set many people up for failure. Every day

you see a new gadget or gizmo come out or lately we see the cost of everything from

food to fuel on the rise. The average working person’s pay has not risen like the price of

gas, sales tax, or even milk and many have lost their job all together. So people do what

they feel they must do in order to keep up. Society shows them that they can have it,

but fails to show them what the cost of having it entails. Peoples demand for things can

out weigh any risks associated with obtaining the means to satisfy that demand. This

mentality is what has helped to create this niche for the payday loan industry. A

demand for small short term loans was created and they have filled it!!!

With that being said, it doesn’t mean that these organizations are not to be held

accountable. There is no questioning the fact that the current practices can and often

do leave individuals struggling to satisfy the requirements of these loan agreements or

in some cases worse off than when they started.

While we can read about the many myths surrounding payday loans and there are

actual horror stories which do exist but when taken as a whole the they are quite similar

to other industries aimed at the nation's lower wage earners (such as used car sales,

high interest rate credit cards, etc).

Personally, I feel that the use of these institutions should be a last resort. There will

always be emergencies that require special circumstances. However, if we as society

really want to help those individuals who are being swept up in the payday loan

schemes then maybe we should look at educating these individuals about alternatives

such as:

Build up an emergency cash fund in your savings account

Build credit so you can borrow from mainstream lenders (in moderation)

Get a signature loan from your bank or credit union

Negotiate a payment plan with your lenders (ask about loan modification)

Try peer to peer lending services for a better deal

At the end of the day, this heated debate is unlikely to end. We have seen more states

aim to pass stricter laws to help regulate the use of payday loans and the practices of

payday lenders. Views have been expressed as well, on both sides of the issue. For the

users of payday loans, it seems to be a love-hate relationship, but the overriding factor

here is that the decision is ultimately theirs!

Cited Sources:

1.Mallor, J.P., Barnes, J.A., Bowers, T, & Langvardt A.W., Business Law, The Ethical,

Global, and E-Commerce Environment; Irwin McGraw-Hill, 14th Ed., 2010

2. Baylor, Don, The Hidden Cost of Payday Lending, Texas Business Review, April 2008

3. Military Lending Act to take effect October 1 , September 27, 2007. Retrieved July 6, 2010

from http://www.consumerfed.org

4. Research Findings Illustrate the High Risk of High-Cost Short-Term Loans for Consumers,

Compiled by Jean Ann Fox, Consumer Federation of America, February 18, 2009

5. Payday Loans Put Families in the Red, Center for Responsible Lending, February 20, 2009

6. Payday Loan Terms, http://www.paydayloaninfo.org/facts.asp. Retrieved July 12, 2010