Lending money to people without money is a risky business, and people who use payday loans likely have burned through the other relationships that could have provided less expensive alternatives – friends and family, credit cards, their own savings, or whatever.
As a lender of last resort, payday lenders represent a lifeline to these people at the end of their rope. Because of the risk involved (read: the probability that the borrower will not repay), payday lenders need to charge higher interest rates and fees than traditional lenders. If they did not – they would go out of business because of the high rate of default.
Colorado Democrats want to effectively eliminate this option for the poor. The Center for Responsible Lending is sponsoring a ballot measure this fall to restrict the all-in annual interest rate of payday loans to 36%. The headlines are eye-popping: 129% interest rates according to a recent Denver Post article. But what does this number really mean? First, the length of a payday loan is much shorter than a traditional loan – just weeks or months on average. Second, the amounts of payday loans are tiny – normally just a few hundred dollars.
When you think about the operations, logistics, employee expense, real estate, and marketing required just to open the doors of a payday lending shop, it is uneconomical to charge traditional lending interest rates on these loans. For example, if a lender charged just ten percent annual interest on a $200 loan that was outstanding for two months, they would only be making about $3.33 in interest for the term of the loan. Obviously, no business can sustain itself on three dollars at a time serving this niche market of borrowers. This does not even begin to account for the borrowers who will never pay them back.
Without payday lenders, do-gooders who propose restrictive legislation and ballot measures may (or may not) have the best of intentions, but they end up harming those they are trying to help – the poorest in Colorado.