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Payday Loans: Resources for Underbanked Consumers

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In recent years, payday loans have received a significant amount of media attention, much of it negative. These small personal loans have been criticized for their high-interest rates, which have the potential to contribute to long-term debt. Some critics claim that payday advances are "predatory" because of their high APRs, especially since so many people who use them are already at risk for debt. Pundits argue that check advances are a financial detriment to consumers because they have the potential to result in an unmanageable downward spiral of debt for borrowers.

In reality, much of the criticism of paycheck advances fails to place these useful short-term loans in the proper perspective. All too often, critics fail to acknowledge that payday advances are a valuable business resource for the underbanked. For the many people who do not use mainstream banks--usually due to low credit scores and an unsatisfactory financial history—a check advance is a useful financial tool. In many cases, a payday loan is the only legitimate way someone with poor credit can borrow money without risking valuable personal property such as a car, TV or jewelry to secure a loan. The underbanked community uses a variety of alternative financial services (AFS) such as cash advances as an alternative to mainstream financial services that are usually out of reach. According to the Federal Deposit Insurance Corporation (FDIC), 20% of US households are underbanked. In other words, one out of five US households or approximately 51 million adults do not make use of the mainstream banking system. Many underbanked individuals rely upon cash advances as a convenient way to borrow money. In fact, more than ten million Americans use payday advances every year. Therefore, the consequences of restricting or ending these small credit loans must be considered before knee-jerk legislation is passed that would rob a significant percentage of Americans of their ability to access short-term credit.

Critics of paycheck advances often operate on the flawed assumption that the underbanked will make poor financial choices that will lead them into debt. Instead of allowing consumers to make their own financial decisions, these pundits would rather remove these short-term loans as an option altogether. This view is both patronizing and dangerous. The truth is that the majority of the people who use payday advances are hard workers who have no other option way borrow money. These underbanked consumers understand the costs associated with an unsecured loan, and they are making an informed decision that is designed to provide short-term financial relief in an emergency. In the current economy, millions of Americans lack the means to handle a financial emergency through a traditional bank loan, credit card or personal savings. These consumers benefit from paycheck advances and consider them to be a valuable financial tool. 

Although lobbyists and legislators who push for restrictions on payday lending might think that they are advocating on behalf of the underbanked, these restrictions merely disregard their needs and limit their financial options. Cash advances are a proven asset for people who cannot get credit elsewhere due to poor credit or low income. The Federal Reserve Bank of New York has conducted studies demonstrating that when payday loans become unavailable, consumers pay more overdraft fees and are more likely to file for bankruptcy because they often have no other legitimate options to borrow money. According to a 2007 Federal Reserve Bank of New York study, the argument that paycheck advances contribute to long-term debt is flawed. Instead, the study found, households tend to fare worse when they are banned: 

This negative correlation—reduced payday credit supply, increased credit problems—contradicts the debt trap critique of payday lending, but is consistent with the hypothesis that payday credit is preferable to substitutes such as the bounced-check “protection” sold by credit unions and banks or loans from pawnshops.

When the underbanked lose access to short-term credit, they suffer in a variety of ways. For instance, if they are unable to borrow money for car repairs, they could lose their jobs due to transportation problems. In addition, they could face high NSF fees that are far more costly than the interest on a two-week cash advance. Other unintended consequences of banning payday loans are that the underbanked have no way to borrow money for utility bills, which can lead to service interruptions and high reconnection fees, and can also result in a decreased credit score. When used responsibly, paycheck advances--which are intended to be paid back at the next payday--can help the underbanked handle a variety of financial emergencies and avoid costly NSF and late fees, reconnection fees, and other negative consequences of being unable to pay for unexpected expenses between pay periods. As the Federal Reserve Bank of New York study indicates, a cash advance is a better alternative to a pawn shop loan, which not only comes with a high interest rate but also requires collateral. Unlike pawn loans, payday advances remove the risk of losing valuable personal property to secure a loan. And unlike expensive bounced-check protection, which is often unavailable to the underbanked due to poor credit or low income, a payday loan offers a one-time solution to prevent expensive overdraft or NSF fees, which can cost between $30 to $40 per transaction when an account is overdrawn.

Research shows that regulations against payday lending do more harm than good. The underbanked do not need protection from cash advances. In fact, the opposite is true: payday loans offer protection for the millions of individuals who opt out of mainstream banking services or are not able to use them. Legislation that restricts or bans payday lending leaves the most vulnerable members of our society without the means to borrow money. Instead of forcing payday lenders to close their doors, legislators should promote innovation in the short-term credit market. The underbanked need more affordable short-term loan options, not fewer.  

Payday lenders offer beneficial financial resources to underbanked consumers. Mainstream banks should follow their lead and offer more innovative products. Not only would this benefit the underbanked, it would also be profitable for banks. The underbanked community would be a valuable market for mainstream banks to tap into. If banks offered more short-term credit options to the 51 million American adults who are underbanked, it would be a win-win situation for both groups; however, to date, banks have been reluctant to take advantage of this opportunity. Payday lenders have faced criticism for marketing their products to the underbanked when they are actually providing them with quick, reliable financial services. Payday advances are an invaluable resource to underbanked individuals who have no other viable way to borrow money.