No credit? No collateral? No problem

As the American financial crisis deepens, blame is circulating faster than money.

While congressional fingers wag at Wall Street, and watchdog groups indict sleeping government regulators, pundits lament a culture of consumption that has traded old-fashioned American thrift for a low down-payment and no interest for 16 months.

A shop window in Falls Church, Virginia advertises payday loans. (Source: Wikipedia)

With markets in turmoil, money is staying put. Borrowers — from businesses looking to expand, to homeowners hoping to refinance mortgages — are finding it difficult to secure a loan.

But in strip malls across the country, under signs with phrases like “Fast Cash” and “EZ Money,” nearly anyone with a pay stub, a bank statement and a photo ID can take out a high-interest cash loan in a matter of minutes, without collateral and with few questions asked.

Called payday loans, these small cash payments made in anticipation of a payday have spawned a $59 billion-a-year industry nationwide. Driven by booming demand, the number of payday lending locations in Iowa ballooned from 17 in 1996 to over 270 a decade later.

Working on the frontiers of finance where traditional banks won’t go, the payday lending industry offers a consumer credit option to people who — because of poor credit or sudden financial need — have few others.

As a lender of last resort to often-desperate clients, the industry operates in an ethical wilderness. Although many customers defend them, payday loans come with finance charges high enough that a typical loan in Iowa effectively has a 300-percent annual interest rate. On most loans, charging interest rates that high would be illegal. But in Iowa, payday loans are exempt from the provisions of the Iowa Consumer Credit Code that otherwise cap rates.

Though payday loans push the limits of legal lending, with 24,000 stores in 37 states and nearly $60 billion a year in net revenue, the industry is increasingly in the mainstream of American finance.

And as policymakers attempt to clean up the nation’s credit mess, they will confront many of the same questions raised by the explosive growth of payday lending. At what point is an interest rate too high? When is a convenient loan too convenient? And how should governments balance regulation with respect for private enterprise and individual choice?

While the industry continues to grow at breakneck speed in many parts of the country, six states and the District of Columbia have decided that payday lending goes too far. Just this year, Ohio became the most recent state to pass legislation effectively eliminating the loans by imposing a cap on interest rates of 28 percent. At that rate, say payday lenders, their businesses have no choice but to close.

‘They’ve saved my life’

But Tammy, a mother and part-time employee at a nursing home in Newton, Iowa, believes that an Iowa ban on payday loans would be a disaster. “They’ve saved my life quite a few times,” she said on a recent afternoon, as she stood in the parking lot of a Newton strip mall after paying off a loan for $125 along with its finance charge of $19.44, which amounted to a 405.46 percent annual interest rate.

She accepts the steep finance charges because, for people like Tammy and her husband, there aren’t many other options. For those who have already exhausted their credit cards, it’s difficult to find another way to borrow money in the short term. And traditional banks, even for customers with stellar credit, rarely deal in loans as small as Tammy takes out on a regular basis.

As she reflected, “There have been times when I had to come here just to get food to feed my family.”

Steven Schlein, a spokesman for the Consumer Financial Services Association, a national trade association that represents the vast majority of Iowa payday lenders, said that payday loans are designed for just those kinds of sudden, critical family needs. “The idea is, if you’re going through a period in your life when you need a payday loan, you have emergencies, immediate expenses — but you don’t stay in payday loans,” he said.

Indeed, pamphlets stating plainly that “payday advances are designed for short-term use only” can be found in the stores of CFSA members across Iowa.

Victor Elias, a senior associate at Iowa’s Child and Family Policy Center who also staffs the Coalition Against Abusive Lending, a network of about 30 organizations from community action agencies to church groups, dismissed the idea that payday loans help people out of sudden financial binds.

“If you don’t have the $200 this paycheck, what makes you think you’re going to have the $200 plus the 300-percent interest next week to pay it off?” he asked. “It’s the same kind of help that you’ll find if I fall out of a canoe and you throw me an anchor rather than a life preserver.”

By paying back loans on time and never taking out more than $200 or $300, Tammy avoids the worst excesses of the industry, such as when customers take out multiple loans from different vendors and use one loan to pay off the fees on another, in a cycle that one employee at an Iowa lender said in an interview with the Iowa Independent was common among customers.

Still, if Tammy once used payday loans to get out of short-term financial fixes, as the industry advocates, today she relies on them year round, taking out 25 loans a year — almost one for every paycheck.

Tammy isn’t unique. An assessment by the Iowa Division of Banking that opened up payday lenders’ books estimated that, while almost 50 percent of Iowa customers took out 12 loans or fewer from the same location in 2007, nearly 30 percent of customers took out between 13 and 15 loans, and over 16 percent of customers borrowed between 16 and 20 times. Moreover, an alarming 7.6 percent of borrowers were in Tammy’s boat, taking out more than 21 loans from the same lender per year. As those statistics only track the number of times customers took out loans from the same retailer, they fail to account for those Iowans who drew loans from multiple sources in 2007. That means it’s likely that even higher percentages of Iowa customers are taking out one or more loans for every paycheck.

At those rates, which, according to both the industry and its critics, exceed the national average, it’s clear that many Iowa customers have made payday loans a permanent source of credit — a practice that even industry literature warns is “the wrong way” to use the service and “can create new financial challenges.”

‘It’s basically a loan shark model’

Confronted with the results of the Iowa Division of Banking’s study, industry spokesman Schlein was taken aback. “That sounds extraordinary to me,” he said. “I’ve never heard that anywhere.”

When asked whether taking out 25 loans a year is irresponsible, he punted. “If they’re taking them out every two weeks, they’re paying them back every two weeks; they’re paying them back right away,” he said.

For his part, Elias believes that customers who continually rely on payday loans are at the heart of the industry’s business strategy. “In general,” he said, “the industry makes most of its money on people who keep rolling over their loans. It’s basically — and they hate me for saying this — I grew up in New York — it’s basically a loan shark model. They’re better off if you keep paying off the interest on a loan for a long time.”

It’s that belief — that lenders prey upon customers with few options, fostering long-term dependence on a product with exorbitant interest rates — that has led many around the country to say payday lending should be banned altogether.

Legislature weighs options

To stem the tide of regulation, payday lenders have stepped up contributions to elected officials and increased the number of lobbyists they employ in state legislatures, while at the same time mounting aggressive public relations campaigns to defend the loans and push back against critics.

Iowa is one of many states where the battle between critics and defenders of the payday lending industry is raging. But in Iowa, the industry appears to be winning.

It was in 1995, during the long period of conservative dominance of state government, that payday loans were first made legal in Iowa. And as long as Republican majorities held in the state House, there was little chance that new regulations would pass.

Democrats took control of the Iowa Legislature in 2006, many of them vowing to curb predatory lending. But the legislature has not yet taken action against payday lenders.

Elias explained that many of the legislators and interest groups that support regulating Iowa’s payday lenders chose to first focus their energies on eliminating car-title lending, an industry that charged interest rates similar to those of payday loans but also repossessed customers’ cars if they failed to make payments. After eliminating that industry in 2007, many of those same groups worked to create a private cause of action for certain fraud violations, an effort that failed to succeed in this year’s session. As those other priorities took precedence, bills to regulate payday lending fell by the wayside.

According to Sen. Steve Warnstadt, chairman of the Senate Commerce Committee, there is also reluctance among many legislators to ban payday loans without providing for an alternative short-term credit option. “Every policy decision has unintended consequences,” he said. “Until you just take something away, you want to know that there are other options for those individuals. Obviously there are people out there who want that type of short-term product.”

Elias, on the other hand, argues that if payday loans were banned, Iowans in a financial fix would do what they used to do — borrow from friends and family.

And Elias attributes more cynical motives to legislators than a fear of unintended consequences. As opposed to the car-title industry, he said, “The payday lenders have more lobbyists and have been more ecumenical in spreading out their lobbying dollars and their campaign finance contributions. The car-title loan industry gave primarily to Republicans. The payday lenders have spread their money to both parties.”

In fact the payday lending industry has dramatically increased its donations to Iowa legislators since the Democratic takeover of the Capitol in 2006. Likely out of a fear that progressive legislators are more inclined to impose new regulations on payday lenders, the vast majority of the industry’s donations have gone to Democrats.

It remains to be seen whether the industry’s strategy will successfully derail attempts to limit payday lending next legislative session.

For now, Tammy will continue to borrow from strip malls.

And, as the average American’s debt soars under pressure from the prices of gas and food, mortgage rates and health care costs, it’s likely that more Iowans will join her.