Perhaps more than any other state, Virginia has been a cradle for the ideas of economic liberty. From the writings of Founding Fathers such as George Mason to the work of Nobel Prize-winning economists at the university that bears his name, freedom for entrepreneurs and consumers through choice and competition is almost a part of the state’s fabric.
So it’s surprising that anti-free market legislation that would institute the discredited concept of price controls is making its way through the Virginia legislature. Mimicking the practices of some other states and the District of Columbia, the bills now debated would cap interest rates on small consumer loans — effectively banning some types of loans by making them uneconomical for the lender. Other states with these rules are quickly learning that legislatures cannot outlaw the laws of economics, and when this is attempted, the law of unintended consequences ultimately passes.
The loans targeted by the bills in Virginia and other states are so-called payday loans, typically two-week loans ranging from $100 to $500 to tide a consumer over until the next paycheck. Often associated with the very poor, studies have shown they cross demographic lines.
They are utilized when there is a sudden need for cash due to unexpected economic circumstances such as a car breaking down or unplanned emergency travel. They are often used so a borrower in these circumstances can get money to pay other bills on time.
Anti-payday politicians, such as erstwhile Democratic presidential candidate John Edwards, say that these loans are “predatory” and take advantage of desperate borrowers. But the alternatives — such as bank “overdraft” fees for bounced checks and late payment charges on utility bills — can be even costlier. A November staff report of the Federal Reserve Bank of New York recently concluded that ” ‘payday credit,’ as expensive as it is, is still cheaper than the close substitute [of] bounced-check ‘protection.’ “
Evidence is already mounting from other states that caps on payday loans reduce choices for consumers and leave them financially worse off than before. Ironically, the main beneficiaries of laws pounding on payday lenders have been big banks and credit unions making millions from the overdraft fees that often serve the same purpose as a small loan for unexpected circumstances.
Proponents of the price controls throw out numbers designed to make interest on payday loans look astronomical. They correctly say the loans have an annual percentage rate of more than 300 percent, but fail to note very few borrowers actually pay this entire amount of interest. This figure is derived from a typical $15 interest payment for a two-week $100 loan multiplied by 26, the number of two-week periods in a year. While studies have shown many payday borrowers do borrow more than once during a year, very rarely, if ever, would someone pay 300 percent on a single loan.
In fact, many of the alternatives to payday lending — if classified as loans — would have a much higher effective interest rate than payday loans. A report by the Annie E. Casey Foundation, a left-of-center policy group, found that banks’ “fee-based bounce-protection programs are functionally equivalent to payday loans when used by customers as a form of credit.” The report concluded that “when used on a recurring basis for small amounts, the annualized percentage rate for fee-based bounce protection far exceeds the APRs associated with payday loans.”
Another study, by the National Association of Community Credit Unions, estimated that a $48 fee on a $100 bounced check has an annual percentage rate around 1,200 percent, more than 3 times that of a payday loan.
Yet by setting the interest rate on payday loans so low as to effectively ban them, the Virginia bills almost ensure that more costly alternatives like bounced-check “protection” may be consumers’ only recourse when they need cash quickly. The bills set the maximum annual percentage rate at 36 percent. Again, this number sounds high, but the key word is “annual.” Divided by 26 into a payday loan’s two-week duration, this means payday lenders could only charge $1.38 on a loan of $100.
“Payday advance lenders could not even meet employee payroll at that rate, let alone cover other fixed business expenses and make a profit,” according to the Community Financial Services Association, a trade group.
And when the government forces payday lenders out of a state, the lack of competition hurts the very consumers these laws claim to help. The New York Federal Reserve report found that when Georgia enacted laws similar to those proposed in Virginia, households in the state bounced more checks and filed for bankruptcy at a higher rate. The authors concluded that this “increase in bounced checks represents a potentially huge transfer from depositors to banks and credit unions.”
To be sure, some payday lenders haven’t been straight with their customers. But as we are seeing in the current mortgage mess, there are plenty of bad apples among major banks as well. The answer to problems with both types of lending is better disclosure and prosecution of fraud — not the banning of a free choice by consumers and lenders.
Payday loans, like all innovations, arose as a cheaper way to meet a need in the market. Now, with their growth, some banks and credit unions are offering small loans as well that potentially could be cheaper than payday loans. But these institutions may cease these offerings — and simply go back to “loans” in the form of expensive bounced-check fees — were the competition from payday lenders effectively banned.
If Virginia heeds the words of its founding citizens and Nobel-winning economic scholars, the free market will prevail and consumers will be the ultimate winners.