There are many credit products available for people in need of short or intermediate –term credit, but because the mainstream press doesn’t understand the demographics of the people who use these products, they rarely get the positive coverage they deserve. When the media does manage to do stories on credit, they often confuse the facts regarding each type of product. So for the benefit of the media and for consumers wondering what product might be right for them, this article will examine the differences between payday loans and installment loans.
The payday loan industry provides customers with small-denomination, short-term, and unsecured cash advances. The industry developed in the early 1990s in response to changes in the availability of short-term consumer credit alternatives from traditional banking institutions. The high charges associated with having insufficient funds in one’s bank account, as well as overdraft fees and other late/penalty fees charged by financial institutions and merchants, helped create customer demand for cash advance services.
Customers value cash advance services as a simple, quick, and confidential way to meet short-term cash needs between paydays while avoiding the potentially higher costs and negative credit consequences of other alternatives. Recent demographic trends show the following information concerning payday loan customers:
- Sixty-three percent (63%) have annual household incomes of more than $25,000, with 46% earning $25,000 to $50,000 a year.
- More than half (55%) have attended college, and nearly one in five (19%) has a bachelor’s degree or above.
- Thirty-eight percent (38%) own their own homes.
- Just under half (48%) of households have children under 18.
- Sixty-three percent (63%) of customers are under the age of 45.
People who use payday loans generally do so because they are in need of a short-term lifeline to meet an emergency expense, such as fixing a broken car. The average borrower takes out six to eight loans each year. This does not necessarily mean that they take out one loan and then flip it, rather that they take out that many separate loans.
One of the popular misconceptions about payday loan borrowers is that they do not have bank accounts. This is false. All payday loan customers must have a bank account, and they must be employed. Money is lent only because the borrower presents a pay stub, proving that they are employed and that their next paycheck will be used to pay off the loan. The customer is required to have a bank account because, if they default, the lender must have recourse to recover the money that was loaned. The borrower secures the loan by writing a post-dated check, which the lender can present to the borrower’s bank for payment.
The maximum fee that can be charged depends on which state the borrower resides in. Each state has its own laws. The average fee is $15 per hundred borrowed. Internet payday loans can cost between $10 and $30 per hundred.
Pretty simple, isn’t it? Makes you wonder how the media can make so many mistakes when doing stories on this loan product.
But how do payday loans differ from installment loans?
Installment loans have a history stretching back decades. Many independent finance companies existed in the mid-to-late 20th century, and borrowers could get a modest line of credit of $5,000 – $10,000 that was often unsecured, or secured with real estate. Names such as Beneficial, Household Finance, and Avco were the big players. Over the year, many of these companies were gobbled up by larger banks and finance companies. Many of them remained in operation as subsidiaries, while companies such as World Acceptance Corporation remained independent.
Installment loan consumer finance companies operate in a highly structured regulatory environment. Consumer loan offices are individually licensed under state laws, which, in many states, establish allowable interest rates, fees and other charges on small loans made to consumers and maximum principal amounts and maturities of these loans. Like payday loans, virtually all participants in the installment-loan consumer finance industry charge the maximum rates permitted under applicable state laws in those states with interest rate limitations.
Installment loan consumer finance companies generally make loans to individuals of up to $1,000 with maturities of one year or less. These companies approve loans on the basis of the personal creditworthiness of their customers and maintain close contact with borrowers to encourage the repayment or refinancing of loans. By contrast, commercial banks, savings and loans and other consumer finance businesses typically make loans of more than $5,000 with maturities of more than one year.
Those financial institutions generally approve consumer loans on the security of qualifying personal property pledged as collateral or impose more stringent credit requirements than those of installment loan consumer finance companies. As a result of their higher credit standards and specific collateral requirements, commercial banks, savings and loans and other consumer finance businesses typically charge lower interest rates and fees and experience lower delinquency and charge-off rates than do installment loan consumer finance companies. Installment loan consumer finance companies generally charge higher interest rates and fees to compensate for the greater credit risk of delinquencies and charge-offs and increased loan administration and collection costs.
Installment lenders require payments of equal amounts each month, with interest front-loaded under the “Rule of 78’s”. The first month of a 12-month loan is assigned interest equal to 12/78 of total interest due, in the second month it is 11/78 and so on. This reduces the overall risk to the installment lender by collecting more of the interest early I the loan. These days, installment loans are generally unsecured as lenders have little utility for seizing collateral such as furniture or televisions. Defaults are easily covered by cash flow.
Borrowers for this product are in need of larger amounts than they obtain via a payday loan and for a longer period. It is also much easier for the borrower to refinance the loan with a smaller principal and extend the maturity. Installment borrowers do not necessarily have to be employed or have a bank account, although generally at least one of these is required.
These products are easy to understand for consumers, so one must eye the media askance for so easily botching basic facts about them. It is this very ineptitude that should help legislators realize that if the public knows more than the media, perhaps the public should be allowed to choose among credit products, rather than eliminate them “for consumer protection”.
