payday loan business model

How fintech startups are disrupting the payday lending model

The pandemic has brought economic uncertainty for millions, and some fintechs claim they are increasing access to wages without exploiting consumers..

How fintech startups are disrupting the payday lending model

There are ways to get wages other than payday lending.

Mandi Trumpy, a 25-year-old hospitality worker based in Canton, Illinois, took out a $400 payday loan more than six months ago, and is still paying it off.

"I was in a super huge pinch with this coronavirus thing," she said. "I knew what I was getting myself into, but if I'm sitting here paying $82 or $83 every two weeks, I've already paid it off a few times."

Trumpy said she was about to get laid off from her previous job when she took out the loan for some unforeseen expenses. She's one of 12 million Americans who take out payday loans each year, spending $9 billion on loan fees. Payday loans usually charge a percentage or dollar amount per $100 borrowed. Maximum amounts vary by state, but a fee of $15 per $100 is common, which amounts to a 400% annual percentage rate for a two-week loan. Many payday loan borrowers cannot afford to pay their loan off in a couple of weeks, and are forced to borrow again.

Over the last five years, however, fintech companies have been disrupting the payday loan model, allowing workers to access portions of their paychecks prior to payday through a concept known as earned-wage access. These services are offered at either no cost to the consumer or for fees that are typically under $5. Challenger banks, or startups that offer banking services, also offer a range of low-cost or free tools aimed at boosting or rebuilding credit. With the proliferation of more affordable digital financial services, and a pandemic keeping many socially distanced, customers may have fewer reasons to go to payday lenders.

The growth of these new business models, however, still hasn't stamped out payday lending: There are an estimated 18,000 payday loan stores across the U.S. Between 2015 and 2019, though, the percentage of U.S. households that used payday loans did drop slightly, from 2.1% to 1.5%, according to the Federal Deposit Insurance Corporation.

Safely getting a portion, or all of, the paycheck early

Digital earned-wage access services are provided either directly to consumers or through employers. When they aren't integrated with employer payroll systems, consumers may need to prove that they're getting paid regularly, and some providers use technology to track or anticipate when incoming payments will hit a customer's bank account. They typically don't carry out a credit check.

The Dave app, for example, allows consumers to take out up to $75 prior to payday (up to $100 if they sign on to the free Dave bank account), and customers can choose to add on optional tips. Meanwhile, Earnin allows its customers to take out up to $100 of their accrued earnings per day up to $500 per pay period, and can also add an optional tip. The use of voluntary tips as a compensation vehicle; however, it has drawn scrutiny from governments and consumer advocates, prompting an investigation by state regulators as to whether these tips constitute "usurious or otherwise unlawful interest rates."

Companies in the space, including Dave and Earnin , say these tips are entirely voluntary, and that customers can access payroll advances services at no cost.

For an additional $1 per month, Dave customers get access to automated personal finance and budgeting tools, and access to Side Hustle, a job-finding platform. If customers use Dave as the direct deposit accounts for their paycheck, they are offered a free credit-building tool which reports their rent and utility payments to credit bureaus. Dave customers also get paycheck deposits two days prior to payday at no cost.

"Compared to a payday lender, Dave is a dream," Dave co-founder and CEO Jason Wilk said. Other earned-wage access providers integrate with employers' HR and payroll systems, including PayActiv, DailyPay and Clair.

PayActiv, which serves 2,000 businesses — from large chains like Walmart and Wendy's to small companies with under 100 workers — allows employees to take out a portion of their paycheck at no cost if they receive their wages through the PayActiv Visa debit card. It levies a $1 fee per day if customers choose to receive their wages in a different account, and it charges $1.99 for instant transfers.

Another major player in the employer-provided earned-wage access field is DailyPay, which serves more than 500 corporate clients, including fast food chains McDonald's, Taco Bell and Burger King. It charges customers $1.99 for withdrawals that are received the next day, and $2.99 for instant transfers. Clair, which connects with time and attendance and payroll systems, said all pay advances its users draw on are fee-free.

Both PayActiv and DailyPay said they've seen usage spike among certain categories of customers during the pandemic. Jeanniey Walden, chief innovation and marketing officer at DailyPay, said the platform saw a 400% spike in usage in mid-March, but it's since leveled off to 20% to 30% higher than use before the pandemic.

Both DailyPay and PayActiv contend that their offerings aren't loans, since they offer access to wages that are already earned. "We know the amount of time they've already worked on the hours that they have worked, so we are not underwriting them per se," Safwan Shah, CEO of PayActiv, said. "A payday lender gives money to the person and takes money back from the person, and in our case, monies are offered on behalf of the employer."

Some consumer advocates argue that repeat use of earned-wage access services can get expensive. A $5 fee on a $100 advance taken out five days before payday is equivalent to an annual percentage rate of 365%, Lauren Saunders, associate director of the National Consumer Law Center, recently told The New York Times.

As earned-wage access products are a relatively new category of financial services, regulators are beginning to offer some clarity on how they classify them. In November, the Consumer Financial Protection Bureau offered an advisory opinion on earned-wage access products.

It stated that a "covered" earned-wage access program does not involve the offering or extension of "credit" under Regulation Z, the Federal Reserve Board rule that implements the Truth in Lending Act. Among the characteristics of a "covered" earned-wage access program, the provider must contract with employers to offer services; the employee "makes no payment, voluntary or otherwise, to access earned-wage access funds" (though programs that charge nominal processing fees can seek clarification from the CFPB about a specific fee structure); and that recovery can only be done via payroll deduction.

Alex Horowitz, a senior research officer at Pew Charitable Trusts, said the advisory opinion draws a clearer line between earned-wage access providers that work with employers, and others that offer services directly to consumers. At the same time, it doesn't stipulate whether earned-wage access products offered directly to consumers are credit products. Credit products are subject to Regulation Z, and providers need to make certain disclosures, including the annual percentage rates, he added.

"They're just specifying which transactions are not considered credit," he said. "[Direct-to-consumer providers] are not legally in a different place than they were before."

PayActiv appeared to take a positive tone on the CFPB opinion. In late December, the CFPB issued a 24-month approval order clarifying that PayActiv's earned-wage access program is not credit and therefore not subject to the Truth in Lending Act and Regulation Z rules which govern creditors. Earnin, however, suggested that earned-wage access products offered directly to consumers should be viewed differently than loans. "We believe it is important to draw a bright line between services like Earnin, which allow workers to be paid for work they have completed, and other financial mechanisms that are based on debt and structured as loans," an Earnin spokesperson said.

Nico Simko, founder and CEO of Clair, suggested greater clarity on regulations will help providers evolve their product development journeys. "Regulatory uncertainty is one variable in product development that hinders innovation," he said.

The challenger bank playbook: Early paydays, credit building and small-dollar advances

Startups that offer banking services focus on day-to-day money management. San Francisco-based Chime, which has more than 8 million customers, provides users with a financial toolkit so they won't need to go to payday lenders.

"In extreme cases, maybe we're preventing some payday loan usage, but that's not really the impetus behind these products," said Zachary Smith, head of product at Chime. "Most of our members are coming from mainstream banks, where they had overdraft services that they could draw on. They're ridiculously expensive and predatory, and Chime has taken all those products and made them much more consumer friendly."

Chime, which partners with The Bancorp Bank, has three guardrails that could potentially reduce traffic toward payday loans: the ability to receive paycheck deposits two days early; a free credit-building product; and no-fee overdrafts up to $100. The company claims to have saved its clients $5 billion in overdraft fees.

Meanwhile, Varo Bank, a 5-year-old startup that obtained a national bank charter in July , said its tech stack allows it to offer low-cost credit products. The company launched a small-dollar loan product in October that allows qualified customers advances of up to $20 for free, with a maximum fee of $5 for a $100 advance. Customers have 30 days to repay the loan. Varo, which has 2 million customers, also offers its clients access to paychecks two days early and no-fee overdrafts up to $50. The company said it will continue to expand offerings to enhance financial security for its customers.

"The fact that we are a bank positions us to offer all of those products in a very unique way versus other fintechs that rely on sponsor banks," Wesley Wright, chief operating officer at Varo, told Protocol.

Varo and other fintechs, however, are facing competition from legacy banks following recent guidance from the Federal Reserve, the FDIC, the Office of the Comptroller of the Currency and the National Credit Union Administration aimed at encouraging banks to offer small-dollar loans. Earlier this month, Bank of America announced that it will soon offer loans of up to $500 for a flat $5 fee for customers who have had checking accounts with the bank for at least a year.

A new use case for peer-to-peer payment apps

While Square is probably best known for its payment infrastructure services and the peer-to-peer Cash App, it also offers payroll services. The company is using the Cash App as a way to distribute earned-wage access funds from employers to workers. Square launched on-demand pay for employees in September. Each pay period, eligible employees can transfer up to $200 of their earned wages to the Cash App for no charge or transfer the money to a linked debit card for a 1% fee that does not exceed $2.

"One of our key goals was making sure that these tools were affordable to employees," Caroline Hollis, general manager of Square Payroll, told Protocol. "Moving dollars from the seller ecosystem to the Cash App ecosystem, we can do that instantly at no cost."

Will fintech solutions ultimately displace payday loans?

Given the relatively recent rollout of lower-cost, digital alternatives, the impact on the market for payday loans is still unclear. A big question mark with earned-wage access products is whether they encourage good financial behavior or simply push consumers to habitually rely on them, Horowitz said.

"Whether earned-wage access is on net helpful or on net harmful is unknown," he said, and it's yet to be determined if these tools provide a pathway to a whole paycheck, or whether they will replace more expensive options.

Horowitz, however, is bullish on the prospects for two-day-early paycheck deposits. "It's easier to see how that is going to turn out well, because it doesn't have the trade-offs of not getting your whole paycheck," he said. "You don't lose that commitment device element of a full paycheck acting as a forced savings mechanism, and you don't have the fee."

Despite the risks, some consumers may still see earned-wage access as a ring-fenced alternative to payday loans because they have simpler fee structures, lower fees and shorter payback periods. Trumpy said she's relied on the occasional payday advance through Dave or Earnin since she started working again in July. She acknowledges that drawing on future paychecks can cause budgeting issues, but argues that easier user experiences and the transparency of repayment amounts make earned-wage access products safer alternatives to payday loans.

"With Earnin, I get a breakdown: The app says 'You've borrowed $100, this is your fee, this is how much you're tipping, and this is why we're charging you this much,'" she said. "With my payday loan, I log into the website and it won't let me go past the home screen — it wants me to call them."

As the pandemic pushes consumers to continue to look for ways to meet unforeseen expenses, the pie for digital solutions that offer access to earned-wage access solutions continues to expand. In November, ADP, one of the largest payroll providers in the U.S., began testing an earned-wage access tool. The company already offers its employer clients integrations with DailyPay and PayActiv. The same month, Immediate — a 2-year-old earned-wage access provider that works with employers — entered into a partnership with ScriptSave WellRx to offer users discounts on prescription drugs. Earned-wage access is part of a broader toolset to improve users' financial health, providers say.

"Maybe [users] got in a little bit of a bind during COVID, now they're actually taking money out early not because they need it, but because they're proactively paying down bills early to help improve their credit score and boost it back up to repair any damage that was done during COVID," Walden said.

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payday loan business model

Charging 589% Interest in the Pandemic Is a Booming Business

Story by Davide Scigliuzzo | Graphics by Christopher Cannon

The terms of the loans were frightening: $5,000 in principal, with payments due every couple weeks at annualized rates as high as 589%.

Interest charges would pile up at such a blindingly fast clip, Jamie Johnson told himself, that he’d have to prioritize debt repayment over everything else. And so he did. This was early April 2020, just as the pandemic was breaking out, and Johnson, a 44-year-old metals worker, had suddenly found himself out of a job and in desperate need of cash. When beefed-up unemployment insurance checks started arriving in his mailbox in Detroit a month later—$965 each week—he set aside big chunks of them to pay back the debt.

This is money, Johnson says, that he would have used to help support his disabled mother and buy food for his girlfriend’s four kids—the kind of essential spending the government had envisioned when it funded a $2.2 trillion relief package for American workers and companies. Instead, it ended up juicing the profits of one of the most controversial corners of the financial industry.

“I can’t even think about how much money I just paid in interest,” Johnson says. “It was just a big mess.”

Jamie Johnson in Detroit, Michigan.

So good was 2020, in fact, for certain providers of payday and other high-interest loans that they’re emerging from the pandemic stronger than perhaps ever before, a development that’s encouraging them to aggressively ratchet up lending now as the economy rebounds.

It is one of the cruel ironies of the pandemic: At a time of great suffering for millions of working-class Americans, the odd financial rhythms of the past year—with its waves of job layoffs, followed by unprecedented government stimulus and a sharp economic rebound—have helped some of these high-interest lenders rake in record earnings. That the windfall for these companies came just as the Federal Reserve was making near zero-rate loans available for corporate America and the wealthy only further riles up the industry’s biggest critics.

“Debt collectors had a big year, and so did predatory lenders,” said Lauren Saunders, associate director at the National Consumer Law Center, a non-profit that advocates for low-income borrowers. “The idea that any company could keep charging 100% or 200% interest or more during this time of crisis is really outrageous.”

What’s more, consumer advocates point to studies that show Black and Latino communities are disproportionately targeted by providers of high-cost loans.

In Johnson’s home state of Michigan, areas that are more than a quarter Black and Latino have 7.6 payday stores for every 100,000 people, or about 50% more than elsewhere, according to data collected by the Center for Responsible Lending. A forthcoming study from the University of Houston that was provided to Bloomberg shows similar disparities when it comes to online advertising.

Record Profits

The Covid-19 outbreak and the economic fallout from efforts to contain it had the potential to be a major blow for consumer finance companies that cater to the 160 million Americans who don’t have good credit scores. They tightened lending standards in preparation for a surge in delinquencies as the unemployment rate rocketed past 14% last year.

But this crisis proved to be different.

Trillions of dollars in government stimulus, largely in the form of direct payments to low- and middle-income earners, helped countless people keep their heads above water financially. Many borrowers—facing the prospect of being chased by debt collectors and seeing their wages garnished—chose to spend at least some of the cash repaying their most expensive obligations.

According to data collected by the Federal Reserve Bank of New York through March, U.S. households had used or planned to use about a third of the cash they received via stimulus checks to pay down debt. For families earning less than $40,000 a year or without a college degree, the share was closer to 40%.

Chart

It’s proven a boon for some of the largest players in the industry. Enova International Inc. and Elevate Credit Inc., two publicly traded companies that provide high-cost loans to non-prime consumers online, reported record profits in 2020, even as overall revenue declined.

“Earnings were definitely higher than we would have expected because they benefited from an improvement in the credit environment,” said Moshe Orenbuch, an analyst at Credit Suisse Group AG who covers the sector. “Consumers tended to pay back debt with funds they were given by the government.”

Debt Spiral

Providers of high-cost loans say they offer credit to communities that are under-served by traditional banks, and that high interest rates are necessary because those borrowers are more likely to default. But according to consumer advocates, the loans often cause families to fall into debt traps built on exorbitant fees and endless renewals.

That’s the situation Kimberly Richardson found herself in late last year.

Her hours got cut following an outbreak at the factory where she works. Before long, the Tennessee resident began to struggle making payments on a $1,500 loan she had taken from CashNetUSA, a subsidiary of Enova, on which interest was accumulating at a rate of 276%.

As the coronavirus ravaged the U.S., CashNetUSA encouraged Richardson, who like Johnson is Black, to borrow even more on her credit line. She’d get prompts by email anytime her account had available credit. Little by little, she was digging herself deeper into debt.

Richardson filed for bankruptcy last month, but not before paying CashNetUSA nearly $10,000 all-told.

Out of Control

How Richardson went from borrowing $1,500 to bankruptcy

Chart

Through a spokesperson, Enova said its policy is to provide customers with flexibility and to help them be successful with their loan. The company said it plays a critical role serving people who need short-term financing to make repairs or avoid even costlier expenses such as bounced checks or late fees on bills.

In an emailed statement, Elevate said it is committed to serving those with non-prime credit scores who are locked out of traditional financial products. The company added that many of its customers are eligible for payment deferrals as a result of the pandemic.

Regulatory Rollback

A few months after Covid-19 was officially declared a pandemic, the National Consumer Law Center and other advocacy groups urged Congress to mandate a cap on the interest rates that could be charged on consumer loans. The idea, in part, was to provide desperate borrowers some relief, much like deferral programs put in place to help homeowners and students.

The provision never made it into law. Instead, policy making in Washington largely went in the opposite direction.

In July, the Consumer Financial Protection Bureau repealed substantial portions of a 2017 rule that would have required lenders to determine consumers’ ability to repay loans. The scrapped provision—which applied only to some types of high-cost loans—could have wiped out as much as 68% of the industry’s revenue from traditional payday loans, according to the agency.

In announcing its decision, the CFPB said its actions would ensure “the continued availability of small-dollar lending products for consumers who demand them, including those who may have a particular need for such products as a result of the current pandemic.”

A separate rule issued by the Office of the Comptroller of the Currency in October made it easier for lenders like Enova and Elevate to partner with national banks to originate high-cost loans. Consumer advocates have denounced such arrangements as “rent-a-bank schemes” designed to circumvent state-level interest-rate caps.

Over a dozen states and the District of Columbia have caps limiting the rate that can be charged on payday loans to 36% or less, but Michigan and Tennessee aren’t among them.

Annual Rates Can Top 600% in Some States

Payday interest rates, based on a $300 loan

Chart

Source: Center for Responsible Lending

At the federal level, there are early signs that President Joe Biden’s administration and Congressional Democrats plans to reverse course.

Just last week, the Senate voted to overturn the controversial OCC rule. CFPB Acting Director Dave Uejio wrote in a blog post in March that the agency is concerned “with any lender’s business model that is dependent on consumers’ inability to repay their loans,” and that it believes the harms identified by the 2017 regulation still exist.

Even if restored, however, the CFPB regulations are unlikely to cover the type of credit line Richardson received.

Nor would they cover the loan that JoAn Cumbie, a retired truck driver who lives in an RV Park near West Columbia, South Carolina, also took from CashNetUSA.

JoAn Cumbie in West Columbia, South Carolina.

The 52-year-old, who is disabled and was recently treated for cancer, borrowed $650 in August. In just a few weeks, she saw her balance top $900 as interest started accumulating at a rate of 325%.

She managed to pay off the loan in October, but only after selling her six-month-old power generator for about half of what she’d paid for it.

“I sold it so cheap, someone got a real good deal,” said Cumbie, who estimates she paid over $1,500 to CashNetUSA all-told. “I just needed to pay them off as fast as I could.”

Lending Boom

Even though scrutiny of the industry may intensify, executives are confident demand for high-cost loans will grow in the coming years.

U.S. households expect to increase their spending by 4.6% over the next year, according to latest New York Fed survey of consumer expectations, only slightly below the 4.7% reading recorded in March, which was the highest since December 2014.

“As the economy opens back up, we believe that consumers will raise their spending potentially to elevated levels due to increased activity and pent-up demand,” Enova Chief Executive Officer David Fisher told Wall Street analysts during a conference call in April. “We saw the same dynamic following the financial crisis, which led to strong origination growth in 2010 and 2011.”

Anticipating a boom in demand from struggling borrowers, Enova last year acquired OnDeck, a lender that specializes in small-business loans that have an average interest rate of 49%. The opportunity, as the company puts it, is to capitalize on the hair salons, gyms, local retailers and restaurants that have struggled over the past year.

“Many of these businesses have used up their savings trying to survive the pandemic,” Fisher said on the April call. “This could lead to a large surge in demand that we are ready to fill.”

Back in Detroit, Johnson, the metals worker, is slowly digging out of debt.

He got his factory job back last summer and was able to pay off his most expensive obligations—two payday loans he had been juggling for months. “I was lucky,” he says. “I was able to get some overtime.” Every two weeks, though, he still sends $241 to Rise, a unit of Elevate, to service a separate $4,500 loan that won’t mature until October.

The rate on that? Just 125%.

Source: Data compiled by Bloomberg

Editors: Boris Korby and David Papadopoulos

Assistance from: Paula Seligson

More On Bloomberg

clock This article was published more than  9 years ago

Is the CFPB about to break the payday lending business model?

payday loan business model

Whenever governments start thinking about cracking down on small-dollar, high-interest financial products like payday loans and check cashing services, a shrill cry goes up from the businesses that offer them:  You're just going to hurt the poor folks who need the money! What do you want them to do, start bouncing checks? 

A field hearing held by the Consumer Financial Protection Bureau today was no exception. The young agency has been studying how the industry functions for a couple years and is now very close to issuing new rules to govern it. To start setting the scene, CFPB Director Richard Cordray came to Nashville — the locus of intense payday lending activity recently — to release a report and take testimony from the public.

The report , building on a previous white paper , is fairly damning: It makes the case that "short term" loans are usually not short term at all, but more often renewed again and again as consumers dig themselves into deeper sinkholes of debt. Half of all loans, for example, come as part of sequences of 10 or more renewed loans — and in one out of five loans, borrowers end up paying more in fees than the initial amount they borrowed.

Faced with a barrage of data, the industry defended their products as an essential option for people living paycheck to paycheck. Many in the hearing audience at the Country Music Hall of Fame wore yellow stickers with the slogan "I choose payday advance."

"You see so many different stories that come through, and you're able to help people in a time of need," said Heath Cloud, who said he'd been in the payday loan business for 13 years. "I'm so grateful to then see that smile, that relief on their face when they leave my office, because I was able to help them. That's why I enjoy what I'm doing."

The message: Destroying this form of credit will mean more late mortgage payments, more foregone medical procedures, more missed days of work when someone couldn't pay for gas. But here's the thing. Cordray doesn't want to get rid of payday loans either — he said they "can be helpful for the consumers who use them on an occasional basis and can manage to repay them" — and he doesn't have to in order to make them safer for consumers. 

Based on advocates' positions and previous regulatory actions, like provisions of the Military Lending Act for servicemembers, the industry's greatest fear is that the CFPB's rule will include a strict interest rate cap of 36 percent APR — dramatically less than the 400 percent they usually charge, amounting to just a few dollars on top of a $100 loan.

"The truth of the matter is that no lender can operate in a market with those aggressive price caps or restrictions," said Amy Cantu, a spokeswoman for the Consumer Financial Services Association of America, which represents a majority of payday lenders. "We can't pay our employees, we can't pay our utilities, we can't pay our rent. Regulated, licensed entities are effectively banned." (The Association also protested that the CFPB had not waited to incorporate its members' data into its report.)

Passing a rate cap, however, is not the only remedy. In fact, it's not even possible: The CFPB is barred by statute from doing so.* And actually, the Pew Charitable Trusts — which has been tracking payday lending for years — doesn't even think it's the best approach.

"The core problem here is this lump-sum payday loan that takes 36 percent of their paycheck," says Pew's Nick Bourke, referring to the average $430 loan size. "T he policy response now has to be either eliminate that product altogether, or require it to be a more affordable installment loans." 

Bourke favors the latter option: Require lenders to take into account a borrower's ability to repay the loan over a longer period of time, with monthly payments not to exceed 5 percent of a customer's income. That, along with other fixes like making sure that fees are assessed across the life of the loan rather than up front, would decrease the likelihood that borrowers would need to take out new loans just to pay off the old ones.

Now, the installment loan plan wouldn't leave the industry untouched. When Colorado mandated something similar, Pew found that half of the storefront payday lenders closed up shop. But actual lending didn't decrease that much, since most people found alternative locations. That illustrates a really important point about the small dollar loan industry: As a Fed study last year showed, barriers to entry have been so low that new shops have flooded the market, scraping by issuing an average of 15 loans per day. They have to charge high interest rates because they have to maintain the high fixed costs of brick and mortar locations -- according to Pew, 60 percent of their revenue goes into overhead, and only 16 percent to profit (still quite a healthy margin). If they were forced to consolidate, they could offer safer products and still make tons of money.

Meanwhile, there's another player in the mix here: Regular banks, which  got out of the payday lending business  a few months ago in response to guidance from other regulators. With the benefits of diversification and scale, they're able to offer small-dollar loans at lower rates, and so are better equipped to compete in the market under whatever conditions the CFPB might impose.

It's true, these changes could result in a serious retrenchment for storefront payday lenders. Many, many small businesses would not survive, which is why groups like the CFSAA have instead asked the CFPB to simply codify its best practices into law — they prevent the worst abuses, but still allow a fairly inefficient industry to maintain the status quo.

If Cordray's remarks are any indication, that's not in the cards.  "The business model of the payday industry depends on people becoming stuck in these loans for the long term, since almost half their business comes from people who are basically paying high-cost rent on the amount of their original loan," he said. "Loan products which routinely lead consumers into debt traps should have no place in their lives." 

* Updated to reflect that the Dodd-Frank Act prohibits the CFPB from imposing usury caps. 

payday loan business model

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What Is a Payday Loan?

Understanding a payday loan, how payday loans work, how to get a payday loan, payday loan interest rates, are payday loans legal.

  • Frequently Asked Questions (FAQs)

The Bottom Line

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What Is a Payday Loan? How It Works, How to Get One, and Legality

Matt Webber is an experienced personal finance writer, researcher, and editor. He has published widely on personal finance, marketing, and the impact of technology on contemporary arts and culture.

payday loan business model

Investopedia / Theresa Chiechi

Payday loans are short-term, high-interest loans based on your income. The principal of the loan is generally equal to a part of your upcoming paycheck. Payday loans take advantage of the borrower's need for immediate credit by charging a higher-than-normal interest rate.

Key Takeaways

  • Payday loans are short-term, very-high-interest loans available to consumers.
  • Payday loans are typically based on how much you earn, and you usually have to provide a pay stub when applying for one.
  • Payday loans are not available in all states. Sixteen states—Arizona, Arkansas, Colorado, Connecticut, Georgia, Maryland, Massachusetts, Montana, New Hampshire, New Jersey, New York, North Carolina, Pennsylvania, South Dakota, Vermont, and West Virginia—and the District of Columbia outlaw payday loans of any kind.
  • A number of laws have been put in place over the years to regulate the high fees and interest rates of payday loans.

Investopedia / Michela Buttignol

Payday loans function as unsecured credit as they do not require any collateral. They are often considered a form of predatory lending due to their extremely high interest rates, hidden fees, and the lack of concern on the lender's part regarding whether the borrower can pay back the loan or not.

Because of these high costs, payday loans often end up being a debt trap for many consumers who find it impossible to claw back out of the burden of debt they've accumulated from these loans. Before taking out a payday loan, consider other options, such as safer personal loan alternatives .

Payday loan providers will normally require you to show proof of your income—usually your pay stubs from your employer. They will then lend you a portion of the money that you will be paid. You will have to pay the loan back within a short time, generally 30 days or less.

Payday lenders take on a lot of risk because they don’t check your ability to pay back the loan. Because of this, they normally charge very high interest rates for payday loans, and they may also charge high fees if you miss your repayments. This can be dangerous for borrowers because it can mean that you’ll need to borrow more money to cover the cost of the first loan.

You can apply for payday loans online at various loan providers. You can also apply for payday loans at local providers who are generally small lenders with physical stores.

For a payday loan application , you will need a bank account and government ID. You will also need to provide proof of income, which can be done through your work pay stubs. The principal of a payday loan is typically a percentage of your income.

Additionally, your wages may function as collateral where the lender can automatically receive a portion of your wages in order for the loan to be paid back. A credit check and your ability to pay back the loan are not usually considered when applying.

Payday lenders charge very high levels of interest: as much as 780% in annual percentage rate (APR) , with an average loan running at nearly 400%. Most states have usury laws that limit interest charges to anywhere from 5% to 30%. However, payday lenders fall under exemptions that allow for their high interest.

As these loans qualify for many state lending loopholes, borrowers should be wary. Regulations on these loans are governed by the individual states, with 16 states—Arizona, Arkansas, Colorado, Connecticut, Georgia, Maryland, Massachusetts, Montana, New Hampshire, New Jersey, New York, North Carolina, Pennsylvania, South Dakota, Vermont, and West Virginia—and the District of Columbia outlawing payday loans of any kind.

In California, for example, a payday lender can only lend up to $300 at a time. They can also charge a fee of up to 15% of the loan amount, with a maximum fee total of $45. Although 15% doesn't seem exceptionally high, on a 14-day loan, it becomes the equivalent of an APR of 460% for a $300 loan.

Although the federal Truth in Lending Act requires payday lenders to disclose their finance charges, many people overlook the costs. Most loans are for 30 days or less and help borrowers to meet short-term liabilities. The loans usually can be rolled over for additional finance charges, and many borrowers—as high as 80% of them—end up as repeat customers.

A number of court cases have been filed against payday lenders as lending laws have been enacted since the 2008 financial crisis to create a more transparent and fair lending market for consumers. If you’re considering taking out a payday loan, then a personal loan calculator can be a vital tool for determining what kind of interest rate you can afford.

Efforts to regulate payday lenders were proposed in 2016 under the Obama administration and put in place in 2017, when the Consumer Financial Protection Bureau (CFPB) , under then-Director Richard Cordray, passed rules to protect consumers from what Cordray referred to as “debt traps.”

The rules included a mandatory underwriting provision requiring lenders to assess a borrower’s ability to repay a loan and still meet everyday living expenses before the loan is made. The rules also required lenders to provide written notice before trying to collect from a borrower’s bank account and further required that after two unsuccessful attempts to debit an account, the lender could not try again without the permission of the borrower.

These rules were first proposed in 2016, and under the Biden administration, the new leadership at the CFPB established stricter rules for payday lending, which became mandatory on June 13, 2022.

In Feb. 2019, the CFPB—then under the Trump Administration and Director Kathleen L. Kraninger—issued proposed rules to revoke the mandatory underwriting provision and delay implementation of the 2017 rules.

In June 2019, the CFPB issued a final rule delaying the Aug. 2019 compliance date, and on July 7, 2020, it issued a final rule revoking the mandatory underwriting provision but leaving in place the limitation of repeated attempts by payday lenders to collect from a borrower’s bank account.

Are Payday Loans Fixed or Variable?

Payday loans are usually meant to be paid off in one lump-sum payment when you get your paycheck. Because of this, the interest rate on these loans is fixed. In fact, many payday lenders don’t even express their charges as an interest rate, but they instead charge a fixed flat fee that can be anywhere from $10 to $30 per $100 borrowed.

Is a Payday Loan Secured or Unsecured?

Most payday loans are unsecured. This means that you do not have to give the lender any collateral or borrow against a valuable item as you do in a pawn shop.

Instead, the lender will normally ask you for permission to electronically take money from your bank, credit union, or prepaid card account. Alternatively, the lender may ask you to write a check for the repayment amount, which the lender will cash when the loan is due. Under federal law, lenders cannot condition a payday loan on obtaining authorization from the consumer for “preauthorized” (recurring) electronic fund transfers.

How Long Do Payday Loans Stay in the System?

The records of traditional loans may be kept for six to 10 years by credit bureaus —the companies that calculate credit scores —which in turn may affect your ability to borrow money in the future. Payday lenders do not usually report to the credit bureaus, even in case of overdue repayments; however, the payday loan may be filed once it is passed to the collectors after the lender sells the debts.

If you repay your payday loan on time, then your credit score shouldn’t be affected. On the other hand, if you default on your loan and your debt is placed in the hands of a collection agency, then you will see a dip in your score.

Can Payday Loan Debt Be Forgiven?

In practice, it’s very rare for payday loan debt to be written off. This is because payday lenders make significant sums from the interest that they charge on these loans.

This means that you should try and pay off payday loans as soon as you possibly can. If you can’t pay back a payday loan, the account may be sent to a collection agency, which will pursue you for the money and interest that you owe. This is not only unpleasant but also can add money to your overall debt—and it will damage your credit.

Can You Get a Payday Loan Without a Bank Account?

Yes. Having a bank account isn’t universally required to borrow money, but lenders that don’t require it generally charge high interest rates. This includes many payday lenders. Payday lenders may ask for a bank account, but sometimes a prepaid card account may be enough to qualify.

Because these loans cost so much and may be difficult to repay, it’s almost always best to avoid them. If you can’t pay back the loan promptly, fees can add up, leading to a debt trap that’s hard to get out of. Because of this, you should only take out a payday loan if you are absolutely sure that you can pay it back.

Payday loans are designed to cover short-term expenses, and they can be taken out without collateral or even a bank account. The catch is that these loans charge very high fees and interest rates.

Borrowers should be wary of these loans. They may be considered predatory lending, as they have extremely high interest, don’t consider a borrower’s ability to repay, and have hidden provisions that charge borrowers added fees. As a result, they can create a debt trap for consumers. If you’re considering a payday loan, then you may want to first take a look at alternative emergency loans for bad credit .

Consumer Financial Protection Bureau. “ What Is a Payday Loan? ”

Consumer Financial Protection Bureau. “ What Are the Costs and Fees for a Payday Loan? ”

Payday Loan Information for Consumers. “ Legal Status of Payday Loans by State .”

Payday Loan Information for Consumers. “ How Payday Loans Work .”

California Department of Financial Protection and Innovation. “ Consumer Financial Education: Other Loans .”

Code of Federal Regulations. “ Title 12, Chapter X, Part 1026 — Truth in Lending (Regulation Z) .”

Consumer Financial Protection Bureau. “ CFPB Data Point: Payday Lending ,” Page 4.

Consumer Financial Protection Bureau. “ CFPB Finalizes Rule to Stop Payday Debt Traps .”

Consumer Financial Protection Bureau. “ Statement by CFPB Acting Director Uejio on CFPB Victory in Legal Challenge to Payday Lending Rule Protections .”

Consumer Financial Protection Bureau, via Federal Register. “ Payday, Vehicle Title, and Certain High-Cost Installment Loans: A Proposed Rule by the Consumer Financial Protection Bureau on 02/14/2019 .”

Consumer Financial Protection Bureau, via Federal Register. “ Payday, Vehicle Title, and Certain High-Cost Installment Loans; Delay of Compliance Date; Correcting Amendments: A Rule by the Consumer Financial Protection Bureau on 06/17/2019 .”

Consumer Financial Protection Bureau. “ Payday Loan Protections .”

Consumer Financial Protection Bureau. “ Docket No. CFPB-2019-0006 ,” Page 218.

Consumer Financial Protection Bureau. “ Do I Have to Put Up Something as Collateral for a Payday Loan? ”

Consumer Financial Protection Bureau. “ I Heard That Taking Out a Payday Loan Can Help Rebuild My Credit or Improve My Credit Score. Is This True? ”

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Payday Lending in Canada in a Global Context pp 83–127 Cite as

A Business Analysis of the Payday Loan Industry

  • Chris Robinson 4  
  • First Online: 30 March 2018

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In this chapter, we focus on how the industry functions in Canada: industrial organization, revenues, costs, profitability, and the effects of regulation up to this date. We focus primarily on the storefront operations of the larger payday lending chains and internet payday lending. We present a financial analysis that shows the maximum fee allowed should be 15% of the principal of a loan, assuming that payday lending is allowed to continue in Canada. We consider as well the economics of both the installment loan—as a close alternative to the payday loan—and setting a limit on the loan size.

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http://canadiancfa.com/ccfa-members/ , accessed July 29, 2017.

Another method that one payday lender tried for a while in Ontario was to charge 59% interest plus a large insurance fee to cover the risk of non-payment. These are examples of opportunistic compliance—creating the appearance of compliance while violating the intent of a law—as noted in Chap. 6 .

Private conversation between an Ontario government employee involved with the issue and Chris Robinson.

We call it Money Mart throughout because that is the name the public sees. The legal name is National Money Mart Company.

ROA = (Net income + Interest expense after tax)/total assets. An approximate calculation to convert ROA to ROE is to deduct current liabilities from total assets and divide that total by shareholders’ equity at market value. An estimate of market value at March 31, 2014, is the agreed valuation for the merger of $9.50 per share.

10K is the required annual financial report that all SEC registrants must file and which then is posted on https://www.sec.gov/edgar.shtml .

The BC reporting date is October 31, but the date for the individual companies reporting will vary depending on their financial reporting systems. Small companies that prepare only annual financial statements could be reporting values almost a year old each Oct. 31.

$1.8 million ÷ 360 = $5000 volume per day. $384,000 ÷ 360 = $1067 revenue per day. $5000 ÷ $460 average loan size = 10.9 loans per day.

See https://www.canada.ca/en/financial-consumer-agency/services/rights-responsibilities/rights-banking/cheque-hold-access-funds.html#toc0

The main product categories they will accept as security, buy for resale, or take on consignment are jewelry, high-quality watches, gold and silverware, electronics, bicycles, and chinaware.

https://www.moneymart.ca/loans/installment-loans/installment-loans-faq , accessed July 22, 2017. Less than a year earlier, Money Mart was advertising a more limited version of installment loans, $1500–3000 with a term of 12–24 months and an APR of 59.9%. These loans were offered at that time in Manitoba, Ontario, and Newfoundland and Labrador.

http://coag.gov/uccc/info , Comparison Table of Deferred/Payday Lenders, 2005–2014, accessed March 6, 2016.

This data is a bit older than the Canadian figures we provide by province in Table 4.1 , but regulation has not changed much in the US in recent years and so the table is still valid. Much of the data is for 2014. I do not specify the currency, because rate caps are always in the same currency as the loan; that is, they are a percentage of the loan. The dollar value of the rate cap conventionally is always applied to a loan of $100, and hence the dollar values are equal to a flat percentage of the fee. The convention of “x dollars per hundred” is commonly used to distinguish the fee charged on the loan from an interest rate of x% per annum.

In 2008 I looked at the rates on the internet for a number of Missouri lenders, both chains and independent stores. I did not keep the links, only the general observation on the average rate.

Contribution margin for a line of business, a segment of a business, or a specific product line is revenue directly attributable to the line or segment minus costs directly attributable to it.

I developed this model in successive research engagements for Industry Canada (2004–2005), Association of Community Organizations for Reform Now (2006) and the Public Interest Law Centre and Public Utilities Board of Manitoba (2007–2016).

The base model in a financial modeling is the best single estimate of the relevant parameters. We know that there is variation in what will happen, but the base model is my best estimate of current and future results.

Business Practices and Consumer Protection Act: Payday Loans Regulation Section 23, at http://www.bclaws.ca/EPLibraries/bclaws_new/document/ID/freeside/16_57_2009 , accessed July 22, 2017.

Without going into a lot of detail about deductions from gross pay like income tax, employment insurance premiums, and Canada Pension Plan, we cannot compare net income very precisely with any benchmark.

Carlstrom, Steven (Affidavit sworn April 14, 2014). Application Record for Ontario Superior Court of Justice (Commercial List) . Court File No. CV-14-10518-00CL [online]. http://cfcanada.fticonsulting.com/cashstorefinancial/docs/Application%20Record.pdf

DFC Global Corp. 2013. Form 10-K for the Year Ended June 30, 2013 . Berwyn, US: DFC Global Corp. https://www.sec.gov/Archives/edgar/data/1271625/000119312513352311/d590562d10k.htm

———. 2014. Form 10-Q, for the Nine Months Ended March 31, 2014 . Berwyn, US: DFC Global Corp. https://www.sec.gov/Archives/edgar/data/1271625/000119312514195203/d724100d10q.htm

Dijkema, Brian, and Rhys McKendry. 2016. Banking on the Margins: Finding Ways to Build and Enabling Small-Dollar Credit Market . Hamilton: Cardus.

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Ernst & Young. 2004. The Cost of Providing Payday Loans in Canada . Ernst & Young, Tax Policy Services Group.

Pew Charitable Trusts. 2013. Payday Lending in America: Policy Solutions . Pew Charitable Trusts.

Pinto, Jerald, Elaine Henry, Thomas Robinson, and John Stowe. 2015. Equity Asset Valuation . 3rd ed. CFA Institute and John Wiley and Sons.

Robinson, Chris. 2016. An Economic Analysis of the Payday Loan Industry and Recommendations for Regulation in Manitoba . http://www.pubmanitoba.ca/v1/payday_loan_review2016/cac_5_tab_3_economic_analysis_c_robinson.pdf

Robinson, C., and M. Schwartz. 2017. A Corporate Social Responsibility Analysis of Payday Lending. http://ssrn.com/abstract=3044087 ; forthcoming in Business and Society Review , 2018.

The Washington State Department of Financial Institutions. 2014. 2014 Payday Lending Report . http://dfi.wa.gov/sites/default/files/reports/2014-payday-lending-report.pdf

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Chris Robinson

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Menno Simons College, Canadian Mennonite University Affiliated with the University of Winnipeg, Winnipeg, MB, Canada

Jerry Buckland

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Brenda Spotton Visano

Appendix 1: Segment Results of DFC Global Corp

  • This table is extracted from the DFC Global Corp. 10Q report , March 31, 2014, pg. 43 (Total assets line) and pg. 44

Appendix 2: DFC Global Corp

Interim Unaudited Consolidated Statements of Operations

Three months and nine months ended March 31, 2014

(In US$ millions, except share and per share amounts)

  • This table is extracted from the DFC Global Corp. 10Q report , March 31, 2014, pg. 4

Appendix 3: BC Aggregate Payday Loan Data

Source: Consumer Protection BC. 2016. BC Aggregated Payday Loan Data – Self-Reported for License Years Ending on October 31 . https://www.consumerprotectionbc.ca/images/content/licensing/payday_lenders/2016%20Payday%20Aggregate%20Loan%20Data%20Table%20for%20Web.pdf

Appendix 4: US Payday Loan Data by State

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Robinson, C. (2018). A Business Analysis of the Payday Loan Industry. In: Buckland, J., Robinson, C., Spotton Visano, B. (eds) Payday Lending in Canada in a Global Context. Palgrave Macmillan, Cham. https://doi.org/10.1007/978-3-319-71213-0_4

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Student Essay: My Summer Working for a Payday Lender

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Payday lending has grabbed headlines in the past several years for its danger to vulnerable borrowers who can’t pay back the principal, plus high interest rates packaged in these “fast cash” loans. In 2017, the U.S. Consumer Financial Protection Bureau passed new rules requiring payday and other similar lenders to make sure borrowers could pay back their obligations in a reasonable amount of time so they wouldn’t fall into a debt trap, and then gave the industry two years to prepare. These payday loan safeguards were set to take effect this Monday, August 19, 2019 — but have been delayed by the Trump administration for at least another 15 months. 

Given the news swirling around the payday lending industry, KWHS thought the timing couldn’t be better when high school student Ari Berke reached out to us with an idea to write about his unique summer job experience. Ari is a senior at Yavneh Academy of Dallas in Texas, U.S. He is a repeat KWHS contributor, previously submitting an essay about his passion for investing and providing some analysis for this year’s spate of tech IPOs. He is especially interested in finance.  

In this, his latest first-person essay, Ari takes us inside the controversial payday lending industry, where he worked this summer. He presents a somewhat unexpected perspective on why he believes laws restricting the payday lending business have resulted in  “unintended consequences.” 

Did you know that 40% of Americans can’t cover an unexpected $400 expense? That means tens of millions of American adults literally can’t afford to have a flat tire or a broken arm. A report published in 2018 by the Federal Reserve Board pointed out that those who don’t have access to emergency cash would have to borrow or sell something to get the money. Some 10 million Americans take out what’s called a payday loan, a loan marketed as a way to access cash until the next time you get your paycheck.

I’m really interested in finance, and payday loans have always intrigued me. They are small loans that allow you to borrow against a future paycheck. That option comes with a high price, however, because the interest rates associated with these loans are incredibly high. Payday loans are prevalent in low-income communities, and these lenders have received lots of criticism for their treatment of low-income borrowers. Borrowers might need extra cash to meet their monthly expenses, but at the same time are not able to pay back the payday loans on time, which puts them into a growing debt with payday lenders. Or, they get into a vicious cycle. They take out a payday loan for, say, $700, to pay their bills. When their paycheck comes, they pay off the loan and then have no money for bills. So, they take out another payday loan. Each loan results in more debt, more fees, that they struggle to repay. Often, they don’t have access to other kinds of credit .

A few months ago, I decided to get a summer job, and I ended up working for a payday lender. Here’s my experience.

Junie B. Jones and Payday Loans

As I was finishing up my junior year of high school this spring, I went into job-seeker mode to find summer employment. I’m an Orthodox Jew and therefore couldn’t work on Saturdays, so my choices were limited. After a few failed attempts at getting retail jobs, I ended up driving around town filling out job applications for any storefront that would be closed on Saturday. With some reservations — due to the negative reputation of the payday loan industry — and a great deal of curiosity, I accepted a job with a payday loan company to help manage a storefront in Carrollton, Texas. Texas has a crowded payday-lending industry, with lots of “fast cash” signs in low-income neighborhoods. Like banks, these tend to be closed on the weekends. In addition to a job, this would be a really hands-on way for me to better understand payday lenders. My summer work journey had begun.

When I arrived on the first day, I had no idea what to expect, but was up for the learning experience. The company had two locations and was opening a third. My first day was spent installing a security camera in the soon-to-be opened store. From then on, however, I sat in the store waiting for walk-ins and analyzing customer data to improve the stores’ Google ranking. Turns out, very few people actually walked in. The vast majority of customers found my employer and did their loan transactions entirely online. They used Google to find the store, applied on the website, got approved for the loan, and received funds via direct deposit, which is also how they paid off their debts for the loans. All electronic! In fact, customer walk-ins were encouraged to leave the store and apply online.

This lack of foot traffic made the few customers I did meet especially memorable. I was seated behind my desk when a fairly young woman came in with her daughter, whose nose was buried in the book Junie B. Jones Has a Peep in Her Pocket . The owner went to the back to find some paperwork and I tried striking up a conversation with the woman. She told me about her childhood and how she was left to fend for herself from a young age, and how she knows she can do more for her daughter than what was done for her. In fact, she was taking out the payday loan to cover a down payment for her daughter’s school.

“I was even more shocked to learn that despite charging such exorbitant interest rates to its customers, the company I worked for had pretty narrow margins.” — Ari Berke

According to Forbes , some 10 million people take out payday loans each year. The customers I met used these loans to fund what I’d define as daily expenses, like paying bills. Some customers clearly were looking to access cash on the down low. One of my employer’s favorite customers was a well-off professional who made hundreds of thousands of dollars a year. The owner told me that this customer valued the privacy of the loans, whatever that meant. Most of the time, however, I got to ‘know’ clients by analyzing spreadsheets or Google searches, and the results were surprising. Almost all the customers had jobs, bank accounts and were paid by their employers via direct deposit. Google analytics cited my employer’s repeat business as a key reason for giving the company a high ranking amongst the competition .

Throughout the summer, I began to explore how to make these loans more affordable to people like the woman and her daughter, especially as I came to better understand the structure of these loans. Someone taking out a loan, and following a six-month payment schedule, ends up paying interest and fees of 120% or more! That’s on top of the repayment of the original loan principal. It’s no wonder that many payday loan recipients get locked into a cycle of debt.

I was even more shocked to learn that despite charging such exorbitant interest rates to its customers, the company I worked for had pretty narrow margins, meaning not much profit. I studied its overhead to see what was costing so much that it almost canceled out the revenue brought in from these high-interest loans. Possibly if the company could bring its costs down, it wouldn’t have to charge its customers such high fees and interest. When I looked at the numbers, one thing stood out: two massive interest payments made every few months to outside vendors. With time on my hands, I decided to do more research into how the payday loan industry works.

Enter the Third Party

The payday loan business model is actually much more complicated than I ever realized. It’s not just one company lending its money to a customer for those high interest rates and fees. In fact, that model is essentially illegal in many states (including my home state of Texas) due to usury laws, which prohibit personal loans from having usuriously high interest rates (in Texas, the limit is 10%).

Payday loans are personal loans, so payday lenders got around these laws by acting as a brokers or middlemen between lenders and customers. Here’s an example. Say a payday loan company wants to lend out $100,000. They can’t do it directly because they’ll violate those usury laws. So, they become a sort of middleman between the customer and another lender, rather than servicing the customer directly. They take out a $100,000 loan from another lender and then use that money to extend multiple smaller loans to their loan applicants at higher rates and additional fees. This way, they can be considered loan brokers, as they are facilitating a loan from one party to another. They then charge high brokerage fees, normally of 120% or more.

But it’s not that easy. Normally, a business in need of a loan would go to a bank, which offers pretty reasonable loan terms. But, many payday lenders won’t be approved for a bank loan because no bank wants to be associated with payday lending due to its toxic public profile. Instead, they are forced to take out loans from different, less generous third-party lenders. The business loan they take out from the “third-party lender” obviously has interest, typically around 15%. And it doesn’t end there. These third-party lenders require the payday lenders to keep between 50% and 100% of the loan principal stored away in a bank account, so they feel comfortable that they can be paid back. That’s called collateral. To get that collateral, the payday lenders have to take out another loan (unless they have 75 grand sitting around), which is another 15% interest owed.

All of these costs are what allow a payday lender to qualify as a loan broker between the third-party lender and the customer. Right off the bat, this payday loan company has incurred 30% in recurring overhead expenses before it can even start lending. What kind of effect do you think this high cost will have on their payday lending? It dramatically raises the cost of a loan for the consumer , because the payday lenders then tack on the huge brokerage fees to compensate for the costs of becoming a broker.

If payday lenders were legally allowed to operate as lenders and not brokers, they wouldn’t need to add on those massive fees. The usury legislation, which was passed in an attempt to help low-income consumers from getting ripped off by payday lenders, has actually cost consumers more!

I’m not saying I agree with the practices of payday lenders. I understand that many of these lenders are taking advantage of people who have limited means. I think it’s interesting, though, that payday lenders became so universally repugnant that society tried outlawing their practices outright. And following the law of unintended consequences, this legal protection (through usury laws put in place many years ago) has resulted in significantly raising the costs of the loans for the millions of Americans who need them.

Working at the company this summer, I saw the human side of a socially complicated business. It gave me a new perspective. I don’t have all the answers to address the complex questions of high-interest-rate payday lending. But after my office experience, I feel strongly that regulators should be even more cautious about the effects that restrictive laws can have on industries and society.

payday loan business model

Related Links

  • CNN Money: 40% of Americans Can’t Cover Emergency Expenses
  • Forbes: 10 Million Americans Want Payday Loans This Year
  • Equal Voice News: Payday Loans
  • LA Times: Payday Lenders Faced Tough New Rules Protecting Consumers. Then Trump Took Office.

Conversation Starters

It’s no secret that the payday lending industry is considered toxic and even abusive to consumers who don’t often have the means to repay these loans. How do you feel about the payday loan industry? Did Ari’s essay change or reinforce your perspective? Why or why not?

Do you have a personal experience with payday loans? Share your story in the comment section of this article.

Do you have specific questions or feedback for Ari Berke after reading his essay? Ask him in the comment section of this article and he will respond!

2 comments on “ Student Essay: My Summer Working for a Payday Lender ”

“I saw the human side of a socially complicated business. It gave me a new perspective…I feel strongly that regulators should be even more cautious about the effects that restrictive laws can have on industries and society.”

It is true that restrictive laws could have many unintended negative consequences on businesses and consumers. The payday loan industry is a very interesting example of how when government legislation tries to protect consumers from being charged high interest rates, it could backfire, causing the many ordinary Americans in need of loans being pulled into deeper debt by the even higher rates the payday ‘brokers’ have to charge. It seems that strict legislation could lead to reduced consumer welfare instead of preventing debt, especially for low-income borrowers. This might even make loan sharks a more attractive option. Not only is borrowing from loan sharks illegal, borrowers and their family/friends are also vulnerable to harassment, threats and violence. This is a problem that is often reported in the news in Singapore, where I live. The Singapore government is very strict in cracking down on loan sharks and other unlicensed moneylenders.

While tough legislation on the money-lending practices could definitely establish credibility for licensed money-lenders and increase their demand, regulators cannot overlook the significant proportion of lower income groups that need access to small, fast-cash loans. Putting restrictions on the payday loan industry may not reduce the demand for such loans. Hence, to reduce the negative impact of unintended consequences, these restrictive laws could be accompanied with other legislation and schemes that target the root cause of why “40% of Americans can’t cover an unexpected $400 expense”. It is important for government agencies to take a closer examination of the socio-economic issues that have resulted in their cash-strapped, paycheck-to-paycheck situation. More extensive safety-nets, employment schemes, financial aid schemes and financial support structures could be employed to lessen the financial crunch that low-income groups face. Subsidizing big-ticket purchases such as property, cars, and college education is also a possible consideration to reduce the demand for fast loans. In addition, I strongly believe that educating all young students about how to properly manage their personal finances is one of the best possible measures to improve both the household and national financial health of a country in the long term.

Restrictive laws is just one tool to address the complex issue of consumer debt. Let’s use our creativity and work together to come up with effective and comprehensive solutions! 

Did you know that this “36% APR theme” began in 1915? That a $300 loan principal in 1915 is equivalent to $7000 today; it’s called inflation.

Smart young man! I hope he goes to Washington D.C. Certainly has more common sense than the majority of our elected legislators and their sycophant lobbyists.

Lenders cannot offer small-dollar loans [think $4K – $5K at a minimum] and pay their bills when a 36% APR is rammed down their throats.

So nearly half of all US households in 2020 cannot access $400 cash when faced with a financial emergency according to PEW and the FED. Thus, a $300 loan at 36% yields a gross $9/month. From this $9, a Lender must pay rent, taxes, employees, customer acquisition costs, cost of capital. loan production and servicing costs, bank fees, ACH/processing fees, phone, utilities, legal, insurance, licensing…

Even we non-deplorable “get’ it. Small-dollar loans will simply be made unavailable. If the loan principal is anything less than $5K at a MINIMUM it is not worth a Lender’s effort to underwrite much less fund!.

The result? When 40% of a population cannot pay for their child’s medicine, keep the lights on, fix their car to keep their job… they are going to find alternatives. Alternatives that will not appeal to the 1%.

I’m biased and I FULLY admit it. I once used payday loans to save my butt and now I own payday, installment, personal loan stores & internet portfolios. I talk to REAL folks everyday. This young man did the same. I wish I could hire him but he’s destined for bigger better things. Maybe he can help fix this mess! Jer Ayles; Trihouse Consulting

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Payday Loan Business Plan Sample

OCT.12, 2016

payday business plan

The loaning business is one of the most lucrative in the world today mainly due to the large number of people who take loans for various reasons such as purchasing a property or starting a business. That said; there are some challenges that one has to be prepared to face to succeed. Having a comprehensive bank loan business plan will help to identify the problems and plausible solutions.

Essentials of a Payday Loan Business Plan

Executive summary.

The executive summary is used to give the investors a glimpse of the loan business that you intend to start even before they start going through the other dense materials such as the financial statement. It should be as brief as possible and give a positive impression of the business. Here, you should include the business name, mission statement, objectives, and vision. Without a vision, you will not succeed in getting your business to where you want it to be.

Overview of the Industry

An overview of the industry refers to clear-cut details about the loan rendering industry. The investors need to know that you have what it takes to start and learn a financial institution that specialize in offering payday loans or unsecured loans. Therefore, it is imperative to do an intensive study of this industry. As you carry out the research, take note of the following.

  • Opportunities that you can exploit to give your business a higher cutting edge in the market

Financial Model

To offer loans to clients, you need to have enough capital. Your business should also be able to provide a broad range of loans to your customers without getting into financial turmoil. This fact makes it paramount for entrepreneurs who want to venture into this industry to seek investors to stay afloat especially once the business is up and running.

The financial model should give precise details about how you will get financing, how you will spend the money, and how you intend to repay the investors. You need vast hands-on financial experience to come up with an accurate model. To be on the safe side, hire a financial expert who is reliable and capable of creating the model for you. Rest assured that the investors will go through this section of the business plan thoroughly because they need to be sure that your business will manage to repay them.

Evaluation of Challenges and Solutions

Just like in any other form of business, there are challenges that one should be prepared to tackle along the way such as clients who fail to honor the loan repayment agreement and volatile economy. The feasibility study will give you all this information. It is wise to have a section in your business plan loan script that highlights these challenges and the solutions to help the investors make informed decisions. After launching the business, you can infer to this section to get insights on how to resolve a challenge.

Sales and Marketing

A loan officer business plan is not complete if it does not indicate how the company will market its financial services and generate revenue. The sales and marketing techniques that you highlight in this section have to implementable and in line with the current market. Using traditional marketing methods could be your undoing, as other businesses are using the advanced marketing strategies such as social media marketing and SEO.

Clearly, a loan originator business plan is crucial to the success of any start-up in the financial industry that wants to focus on providing loans. Do not second-guess or leave anything to chance when coming up with the business plan. Get in touch with us, OGS Capital, for a detailed and professional business plan writing services by filling the contact form.

Download Payday Loan Business Plan Sample in pdf

OGS capital professional writers specialized also in themes such as  business plan for an insurance agenc y, start a holdings company business plan , business plan for a financial adviso r, starting finance business plan , business plan for a credit repair and many others.

OGSCapital’s team has assisted thousands of entrepreneurs with top-rate business plan development, consultancy and analysis. They’ve helped thousands of SME owners secure more than $1.5 billion in funding, and they can do the same for you.

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CFPB data point: Payday lending

Our data point reports are prepared by our Office of Research to provide an evidence-based perspective on consumer financial markets, consumer behavior, and regulations to inform the public discourse. This first data point provides detailed analysis of consumers’ use of payday loans with a focus on loan sequences, the series of loans borrowers often take out following a new loan.

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Workers are paying to get part of their paychecks early. It's 'payday lending on steroids,' one expert says

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  • So-called "earned wage access" programs allow workers to take a portion of their paychecks before payday, often for a fee.
  • They've grown rapidly: $9.5 billion in wages was accessed early during 2020, triple the $3.2 billion accessed in 2018, according to the latest data by Datos Insights.
  • However, in some cases, high fees and frequent use can translate to an annual interest rate of more than 330%, according to experts, regulators and consumer advocates.
  • EWA programs are also known as daily pay, instant pay, accrued wage access, same-day pay and on-demand pay.

Millions of American workers are paying for early access to their paychecks . In some cases, it can come with a steep price.

So-called "earned wage access" programs, which operate either directly to the consumer or through employers, let workers tap a portion of their wages before payday, often for a fee. The services have ballooned in popularity.

While there can be various benefits for consumers — like quick access to funds in the event of an emergency — some services share characteristics of high-cost debt such as payday loans that can cause financial harm, according to some experts and consumer advocates.

"When used properly ... it's great," said Marshall Lux, a banking and technology expert and former senior fellow at Harvard University.

However, Lux said overuse by consumers and high fees that can translate to interest rates up to roughly 400% can turn the services into "payday lending on steroids," especially since the industry has grown so quickly.

Earned wage access has gotten more popular

Earned wage access goes by various names: daily pay, instant pay, accrued wage access, same-day pay and on-demand pay, for example.

The programs fall into two general camps: business-to-business models offered through an employer and direct-to-consumer versions.

The B2B model uses employers' payroll and time-sheet records to track the users' accrued earnings. When payday arrives, the employee receives the portion of pay that hasn't been tapped early.

Third-party apps are similar but instead issue funds based on estimated or historical earnings and then automatically debit a user's bank account on payday, experts said.

More from Personal Finance: Many Americans can't pay an unexpected $1,000 expense Why the 'last mile' of the inflation fight may be hard Paying rent usually won't boost your credit score

Such programs aren't new.

Fintech companies debuted the earliest iterations more than 15 years ago. But business has boomed in recent years, accelerated by household financial burdens imposed by the Covid-19 pandemic and high inflation , experts said.

In the employer-sponsored market, $9.5 billion in wages was accessed early during 2020, triple the $3.2 billion in 2018, according to the latest data from Datos Insights, a consulting firm. The number of transactions also increased threefold over that period, to 55.8 million transactions from 18.6 million, it found.

Survey finds most Americans are living 'paycheck to paycheck'

Branch, DailyPay and Payactiv are among the "most significant" B2B companies, according to a recent paper published by the Harvard Kennedy School and co-authored by Lux and research assistant Cherie Chung.

There are fewer players in the direct-to-consumer market, but the most popular apps "have increasingly large and prominent userbases," the Harvard paper said. For example, three companies, Dave, EarnIn and Brigit, report a "highly significant" user base of about 14 million combined, it said. MoneyLion is another market leader, according to Datos Insights.

'It's another version of payday loans'

Big companies such as Dollar Tree, Kroger, Hilton, McDonald's, Target, Uber and Walmart now also offer employees early access to paychecks.

Companies in the B2B market often tout themselves as a win-win for employers and for their employees who use the services.

High worker demand for such programs makes them a cost-effective way for businesses to retain and recruit employees, according to consultants and academics. Employees can cover any short-term expenses that might arise before payday — maybe an unexpected car repair or medical bill — perhaps for lower fees than they would incur using credit cards, bank overdrafts or other ways to access quick cash.

The idea that these advances are not loans is a legal fiction. Monica Burks policy counsel at the Center for Responsible Lending

Some programs, depending on how consumers use them, may grant that early paycheck access free of charge. Further, 28% of users — who tend to be lower earners, hourly workers and subprime borrowers — said they turned to alternative financial services such as payday loans less frequently than before using earned wage access, according to the Harvard paper.

Meanwhile, 80% of consumer program transactions are between $40 and $100, on average, according to a 2023 analysis by the California Department of Financial Protection and Innovation. Amounts generally range from 6% to 50% of a worker's paycheck.

"We as human beings incur expenses every day," said Thad Peterson, strategic advisor at Datos Insights. "But we're only paid on a periodic basis. That's a massive inconsistency, especially when there's technology that allows it to go away."

However, data suggests the average user can accrue significant costs.

Total fees translate to an annual percentage rate of more than 330% for the average earned wage access user — a rate comparable to payday lenders, according to the California report. It analyzed data from seven anonymous companies across business models and fee structures.

"It's another version of payday loans," Monica Burks, policy counsel at the Center for Responsible Lending, a consumer advocacy group, said of earned wage access. "There's really no meaningful difference."

However, a recent study by the U.S. Government Accountability Office found that earned wage access products "generally cost less than typical costs associated with payday loans."

That said, the products pose a few consumer risks, including lack of cost transparency, the study found.

Fees can add up for frequent users

Fees can add up, particularly for users who frequently access their paychecks early, experts said.

The average user did so nine times a quarter, according to California regulators.

Additionally, 40% of people with employer-sponsored EWA access use the service at least once a week, and more than 75% used money for regular bills instead of emergency expenses, according to the Harvard paper. Liquidity issues most often affect low-income households, which have less savings and less access to traditional credit, it said.

The typical user earns less than $50,000 a year, according to the GAO.

High fees and user dependency "are kind of the darker side of the business," said Peterson of Datos Insights.

However, it's "the exception, certainly not the rule," he added.

Consumer risks are generally greater in the direct-to-consumer rather than the business-to-business market, according to both Peterson and Harvard's Lux.

We as human beings incur expenses every day. But we're only paid on a periodic basis. That's a massive inconsistency. Thad Peterson strategic advisor at Datos Insights

A chief concern is that consumers can use multiple apps concurrently and take on more debt than they can handle, according to Datos Insights. Among direct-to-consumer app users, 8% had five or more such apps currently on their phone, according to the Harvard paper.

Consumers who overextend themselves "can end up in the black hole of payday lending," Peterson said.

"You can't get out of it," he said.

Since direct-to-consumer companies generally automatically debit user bank accounts, consumers without sufficient funds may also pay unexpected overdraft fees, the GAO said.

Unlike direct-to-consumer apps, the B2B model allows "full transparency" into how much employees have worked and earned, said Stacy Greiner, COO of DailyPay, which has more than 1,000 employer clients.

A MoneyLion spokesperson said direct-to-consumer providers help gig and freelance workers, small business employees, union and public-sector workers and others "smooth out cash flows between pay cycles to gain better control over their finances."

An EarnIn spokesperson called EWA a "no risk option" that avoids a negative impact to credit scores since it doesn't require credit checks or credit reporting.

Representatives for Brigit and Dave declined to comment.

There are many types of fees, including tipping

Consumer fees for EWA use can take many forms.

Employer models may charge per transaction, or for "expedited" delivery whereby users get their money faster — maybe $2 for receipt within a day or $10 within an hour, instead of for free within a few days, according to the Harvard paper.

Direct-to-consumer models may also charge subscription fees, which can range from perhaps $5 to $10 a month, the paper said. Users can also tip. While tips are voluntary, apps may default consumers to tip a certain percentage per transaction, it said. 

Among tip-based providers, consumers tipped on 73% of transactions, California regulators found. The average was $4.09.

Those tips can start to add up. For example, about 40% of EarnIn's annual revenue comes from tips, Ben LaRocco, the company's senior director of government relations, said in testimony before the Vermont House Committee on Commerce and Economic Development.

An EarnIn spokesperson said its average "voluntary payment" is $1.47.

Some models may be 'closer to an ATM'

The earned wage access industry doesn't think it's fair to use APRs and interest rate proxies to describe their fee structures.

"It is inaccurate to compare an optional $1 or $2 fee — whether that's a voluntary tip or fee to expedite a transaction — to mandatory fees and compounding interest rates charged by other short-term lenders," said Miranda Margowsky, a spokeswoman for the Financial Technology Association, a trade group.

And while companies monetize their businesses in various ways, they always offer a free option to consumers, Margowsky said.

Branch, a B2B company, for example, makes most of its money from an optional debit card. The card is free for consumers but levies a transaction, or "interchange," fee on businesses when consumers make purchases, said CEO Atif Siddiqi.

In addition, workers may pay a $2.99 to $4.99 fee if they opt to more quickly transfer cash to a debit card from a digital wallet that stores their early accessed wages, Siddiqi said. They may also pay to access cash from out-of-network ATMs.

Here's why Americans can't keep money in their pockets — even when they get a raise

Similarly, Payactiv, another B2B firm, makes a "significant portion" of revenue from interchange fees, said CEO Safwan Shah.

Users who opt not to use Payactiv's debit card pay a $1.99 or $2.99 flat fee per transaction. Since the worker is tapping wages they've technically already earned, such a transaction fee is akin to an ATM fee, Shah said.

"We feel we are closer to an ATM. You deposited money in the bank and are taking it out," Shah said.

Broadly, the EWA industry doesn't publicly share the percentage of paid transactions relative to those that are free — "but I suspect it's a lot" that are incurring a charge, said Harvard's Chung.

"If someone signs up in an emergency, they might not be able to wait and would want to get the money instantly," she said. "That would typically cost a fee."

Are they loans and why does it matter?

The industry is also loath to refer to early paycheck access as a "loan" or "credit."

"It's a common misconception," said Phil Goldfeder, CEO of the American Fintech Council, a trade group. "EWA is not a loan or an advance. It's access to the money you've already earned," not future earnings, he said.

There also aren't credit checks, accrued interest, late fees or debt collection associated with such programs, for example, Goldfeder said.

However, some consumer advocates and state regulators have the opposite view.

While such a distinction may seem like unimportant minutiae, the label could have a significant consumer impact. For example, being regulated as a loan would mean being subject to caps on interest rates and more fee transparency via disclosure of how consumer costs translate into an annual interest rate, or APR, experts said.

"The idea that these advances are not loans is a legal fiction," said Burks, of the Center for Responsible Lending.

"[These] are agreements to receive money now and pay it back in the future, either without — or much more frequently with — an additional fee paid to the lender," she added. "In every other context, we call such an agreement a loan, and fintech cash advances are no different."

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Payday Lending

Many consumers who need cash quickly turn to payday loans – short-term, high interest loans that are generally due on the consumer’s next payday after the loan is taken out. The annual percentage rate of these loans is usually very high – i.e., 390% or more. In recent years, the availability of payday loans via the Internet has markedly increased. Unfortunately, some payday lending operations have employed deception and other illegal conduct to take advantage of financially distressed consumers seeking these loans.

The FTC enforces a variety of laws to protect consumers in this area. The agency has filed many law enforcement actions against payday lenders for, among other things, engaging in deceptive or unfair advertising and billing practices in violation of Section 5 of the FTC Act; failing to comply with the disclosure requirements of the Truth In Lending Act; violating the Credit Practices Rule’s prohibition against wage assignment clauses in contracts; conditioning credit on the preauthorization of electronic fund transfers in violation of the Electronic Fund Transfer Act; and employing unfair, deceptive, and abusive debt collection practices. The FTC has also filed recent actions against scammers that contact consumers in an attempt to collect fake “phantom” payday loan debts that consumers do not owe. Further, the FTC has filed actions against companies that locate themselves on Native American reservations in an attempt to evade state and federal consumer protection laws.

  • FloatMe ( January 24, 2024 )

Press Releases

  • FTC Acts to Stop FloatMe’s Deceptive ‘Free Money’ Promises, Discriminatory Cash Advance Practices, and Baseless Claims around Algorithmic Underwriting ( January 24, 2024 )
  • FTC Action Leads to $18 Million in Refunds for Brigit Consumers Harmed by Deceptive Promises About Cash Advances, Hidden Fees, and Blocked Cancellation ( November 2, 2023 )
  • Federal Trade Commission Returns More Than $970,000 To Consumers Harmed by Deceptive Payday Lending Operation ( June 14, 2022 )
  • Federal Trade Commission Sends out Second Round of Redress Checks in Payday Lending Scheme Operated by AMG Services ( May 19, 2022 )
  • Payment Processor that Helped Bogus Discount Clubs Bilk Consumers Will Pay $2.3 Million as a Result of FTC Case ( March 10, 2022 )
  • Statement by FTC Acting Chairwoman Rebecca Kelly Slaughter on the U.S. Supreme Court Ruling in AMG Capital Management LLC v. FTC ( April 22, 2021 )
  • FTC Acts to Ban Payday Lender From Industry, Forgive Illegal Debt ( February 11, 2021 )
  • FTC Halts Deceptive Payday Lender That Took Millions From Consumers’ Accounts Without Authorization ( May 22, 2020 )
  • FTC and DOJ Return a Record $505 Million to Consumers Harmed by Massive Payday Lending Scheme ( September 27, 2018 )
  • FTC Charges Debt Collection Operation Took Consumers’ Money for Phantom Debts ( August 29, 2017 )
  • FTC Charges Defendants with Selling Fake Payday Loan Debt Portfolios ( January 9, 2017 )
  • U.S. Court Finds in FTC’s Favor and Imposes Record $1.3 Billion Judgment Against Defendants Behind AMG Payday Lending Scheme ( October 4, 2016 )
  • FTC Action: Payday Debt Relief Operation Banned from Debt Relief Business ( September 8, 2016 )
  • FTC Returns Money to Consumers Harmed by Scam That Collected Millions in Phantom Payday Loan Debts ( April 6, 2016 )
  • FTC and Illinois Attorney General Halt Chicago-Area Operation Charged with Collecting and Selling Phantom Payday Loan Debts ( March 30, 2016 )
  • Data Broker Defendants Settle FTC Charges They Sold Sensitive Personal Information to Scammers ( February 18, 2016 )
  • FTC Returns Money to Consumers Harmed in Payday Loan Ploy ( February 17, 2016 )
  • FTC Secures $4.4 Million From Online Payday Lenders to Settle Deception Charges ( January 5, 2016 )
  • FTC, Illinois Attorney General Halt Chicago Area Operation Charged With Illegally Pressuring Consumers to Pay ‘Phantom’ Debts ( April 10, 2015 )
  • FTC Sues to Stop Deceptive Debt Relief Operation ( February 24, 2015 )

Public Statements

  • Prepared Statement of the Federal Trade Commission On Consumer Protection In Financial Services: Subprime Lending and Other Financial Services ( February 28, 2008 )

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Payday lending: Wonga's business model is slick despite moral qualms

Bad news for the Archbishop of Canterbury: competing Wonga out of existence, which is Justin Welby's declared ambition for credit unions, ain't going to be easy.

The payday lender's financial results for 2012 confirmed how far Wonga has come in six years. Post-tax profits rose 36% to £62.5m and four million loans totalling £1.2bn were advanced to more than one million customers. The company is on a roll.

How has it been done? Wonga's business model seems to have four key elements. First, the company rejects two-thirds of applicants as bad credit risks. Efficient assessment of credit risk kept default rates last year to 7.4% – a rate that would disgrace a mainstream lender but is easily tolerable for Wonga at its astronomical rates of interest. It is also why chief executive Errol Damelin can breezily offer to help Welby give credit unions a leg-up. Damelin, you can be sure, will not be offering to hand over the algorithms that are central to Wonga's system.

Second, Wonga is, one must admit, a slick operation that gives its customers what they want. Processing loans rapidly is not a trick mainstream banks have mastered. Whether you regard many of Wonga's customers as desperate or misguided, the company has clearly identified an appetite for instant loans.

Third, Wonga is an extraordinarily capital-efficient business. Damelin boasts that the company makes only £15 net profit per loan. That sounds low but the point to remember is that the company is turning over its capital several times each year. Thus the "same" £200 might earn £15 six or seven times in the space of 12 months. That is what produces financial statistics that leave mainstream lenders in the shade. Wonga's return on shareholders' equity is about 30% and after-tax profit margins are 20%.

The fourth characteristic is the one that – rightly – enrages Wonga's critics. It is the company's presentation of borrowing at high interest rates, even for a short period, as a fun-filled everyday activity undertaken by aspirational folk. The adverts are humorous and Damelin reports that his typical customers are "young, urban, digital, and with a very strong proportion of smartphone ownership".

There will, of course, sometimes be sensible economic reasons for some borrowers to take out a short-term loan at high interest rates – avoiding overdraft charges, for example. But, on Damelin's description of his customers as members of the "Facebook generation", most would be better off curtailing their spending or joining the world of mainstream finance.

More fool them, one might say. Well, yes, but society should also protect the interests of the victims of the growth of payday lending – the already over-indebted who are dragged deeper into trouble by becoming hooked on short-term loans. There is a clear case for placing caps on how much payday lenders can charge. A limit of 50%-60% rates of interest sounds reasonable to curb rollover lending.

Certainly somebody in the financial or government establishment should take an interest in the rise of easy-access payday lending. At the very least, Wonga and its ilk, via their cheery adverts, are undermining everything the new regulator says about the importance of financial education in avoiding the next crisis.

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Knowledge at Wharton Podcast

How new rules could reshape the payday loan industry, august 2, 2016 • 25 min listen.

The Consumer Financial Protection Bureau has proposed regulations to tighten several loopholes that are exploited by payday lenders and to curb some the issues with repayment of the loans.

payday loan business model

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  • Public Policy

Wharton's Jeremy Tobacman and Ohio State's Creola Johnson discuss proposed changes to the rules governing payday loans.

The payday loan industry, long criticized for its predatory tactics targeting desperate consumers, is under new scrutiny by the federal government. The Consumer Financial Protection Bureau has proposed regulations to tighten several loopholes that are exploited by payday lenders and to curb some the issues with repayment of the loans.

In many cases, consumers are borrowing money against their paychecks and expected to pay back the loan within two weeks, along with a hefty interest payment. Jeremy Tobacman, a Wharton professor of business economics and public policy, and Creola Johnson, a law professor at The Ohio State University, take a look at the proposed changes and discuss whether they will have a lasting impact. They discussed the topic recently on the Knowledge at Wharton show  on Wharton Business Radio on SiriusXM channel 111 . (Listen to the podcast at the top of this page.)

An edited transcript of the conversation follows.

Knowledge at Wharton: What’s the most importance piece of these new rules?

Jeremy Tobacman: The central feature of the new rules is an ability to repay requirement. The typical model in the past for the industry has been to earn a lot of money off a sequence of finance charges. As a result, the underwriting procedures that they used were not geared towards trying to detect which borrowers would be likely to be able to repay the loans in full at their first due date.

Creola Johnson: There’s a section in the proposed rules that deals with attempts by payday lenders to change what they’re doing — what I call the chameleon. For example, in Ohio, a payday lending statute was passed to curb payday lending. Ohio has a Second Mortgage Loan Act that payday lenders got licenses to operate under. Most payday lending customers don’t own their home, but because Ohio law didn’t specifically require a mortgage under the Second Mortgage Loan Act, payday lenders started getting licenses to operate under that pre-existing law so that they could continue to issue triple-digit interest rate loans.

The Consumer Financial Protection Bureau’s new rule would then say any artifice, device, shenanigans to evade the rules, you would still be covered. In other words, the CFPB is saying we’re looking to the substance of what’s going on, not to some way that you’ve tweaked the transaction to try to pretend like you’re not issuing payday loans.

“Among the various payday lenders, some are trying to skirt the rules and some aren’t. Some are just trying to offer products that they think are useful.” –Jeremy Tobacman

Knowledge at Wharton: The state rules versus what the federal government is talking about is an interesting point because there are 12 or 13 states that do have rules for payday lending.

Johnson: That’s correct. There are several states besides Ohio that have passed legislation to curb payday lending. So, for example, in Ohio, a payday loan interest rate is supposed to be capped at 28%. There are limits on how much can be lent, how often a person can obtain a loan. Yet what payday lenders started doing was creating contracts that created a longer long-term loan, so they could say, “Well, it’s not a payday loan because a long-term is more than two weeks. It’s not a payday loan because we’ve decided now we’re going to operate under this act.” Or there’s a current problem of what we call “rent to tribe.” That is payday lenders partnering with someone who lives on a Native American reservation, having an agreement to allow those loans to be technically issued from the reservation, so that the payday lender could argue that they don’t have to abide by the state law where the consumer resides. Again, this provision would deal with attempts to get around these new rules.

Knowledge at Wharton: Obviously, these companies are looking at any way they can skirt the rules, whether at the federal or state level.

Tobacman: It’s certainly true that there are a variety of related products. There have also been a variety of illegal behaviors that have been subject to enforcement actions by the CFPB and the Department of Commerce. I think that among the various payday lenders, some are trying to skirt the rules and some aren’t. Some are just trying to offer products that they think are useful. One of the things that is impressive and sensible about the new rules that were issued is that the rules are designed to encompass many of these possible substitutes and to provide a clear, new framework for everything that might be an alternative to a payday loan.

Knowledge at Wharton: The rules are also trying to address car title loans and high-interest installment loans, right?

Johnson: That’s correct. To get a car title loan, sometimes called auto title loan, the consumer has to own the car outright. So, if you’ve got a 2010 Ford Explorer that you’ve paid the loan off, you could take that car and go to a car title lender. They will lend you a fraction of the amount of what that car is worth. The car is worth $10,000; they will lend you $3,000. Then you have to pay that amount back usually by the end of 30 days. It doesn’t take a rocket scientist to figure out that that’s a lot of money to have to come up with in 30 days.

Payday lenders and car title lenders are considered cousins. That is to say, the transactions are similar in the sense that the consumer’s being asked to spend a large amount of money in a short period of time. And whatever you pay normally does not reduce the principal. For consumers who understand home mortgages, every month you make a payment there is so much interest and so much principal that is being paid. With car title loans and payday loans, if you pay an amount to extend the due date of the loan, that amount does not count towards reducing the principal that is owed.

That is problematic because people keep paying fees to extend the due date because they cannot pay that large amount of money in a short period of time. With car title lending, the CFPB has passed regulations to try to deal with that so that people can actually wind up with a loan they can pay back. The real problem with car title lending is that if you default and they can’t get you to come in and make a partial payment, they can repossess your car. Just imagine if you lost your transportation how difficult it would be to get to work and, therefore, keep a job.

Knowledge at Wharton: Do you think these changes address enough of the problem, or is this just the first step?

Johnson: I don’t know if the CFPB is calling this a first step, but there are issues with payday lending that are not covered by these proposed rules. For example, payday lenders are notoriously known for threatening people with arrest if they defaulted on a loan. That’s because when payday loans first came on the scene, a person had to give a postdated check in return for getting the loan. You give them a postdated check for $350, they give you $300 cash, and in two weeks you’re supposed to come back and pay the $350. If you don’t pay it, the check gets dishonored. What was happening was that payday lenders were threatening people and filing criminal complaints to have people arrested for passing a bad check. Over time, a lot of actual arrests went down.

“Just imagine if you lost your transportation how difficult it would be to get to work and, therefore, keep a job.” –Creola Johnson

It has come to light in the last three, four years that some payday lenders, particularly in Texas, were still getting people arrested by filing criminal complaints with the local district attorney that they had passed a bad check. The rules don’t specifically get into dealing with this issue of threatening people with arrests, and that’s really problematic because a lot of people are paying debts they don’t even owe or debts that they have paid off because of the threats of arrest. Payday lenders are often able to extract a lot more money out of them because of that.

An enforcement action was brought by the CFPB a couple years ago against Ace Cash Express, which is the second-largest payday lender in the United States. One of the allegations against them was threatening people with arrest, having people fear being arrested to get them to pay amounts they didn’t owe or get them to pay amounts in excess of what they owed.

Tobacman: I’ll say that I think the new rules have been carefully crafted in the sense that the CFPB has done a lot of very careful data analysis to document the patterns. They have tried to collect extensive information from consumer groups, from industry and from other people working in this area, including the research community. I think that this imposition of the ability to repay underwriting standard is one that is easily articulated and relatively easily to implement by the lenders that choose to try to keep operating it. That simplicity is probably deliberate on the CFPB’s side. It’s also a pretty straightforward step from the central finding in CFPB’s empirical work, that the fault rates are incredibly high on all of the covered products addressed by this regulation.

The high default rates have all of these consequences, including collections, behavior, which is at the very least problematic for the delinquent borrowers and often times illegal in the sense of violating the Fair Debt Collection Practices Act. There are all these other follow-ons that tend to be commonly associated with these types of products, especially when the loans become delinquent. One way to reduce the harms to consumers associated with those follow-on behaviors by the lenders and collection agencies is by imposing this new standard that the loans can’t be made unless there’s an expectation that the borrowers will be able to repay. In that sense, I think it’s very deliberately crafted.

Knowledge at Wharton: What are some of the states where this is a significant problem that needs to be addressed immediately?

Johnson: In 2006, Congress passed the Military Lending Act to deal with payday loans, rent-to-own transactions and other credit transactions considered problematic for people in the military. With respect to payday loans, they capped the interest rate to active duty military personnel at 36% and did some other things to try to curb it.

What happened after that was payday lenders were just basically tweaking what they did to get around the Military Lending Act. They would make the loan term longer, make the finance amount different. In 2015, the Department of Defense expanded the definition of what we call payday loans so that we could try to curb it. The payday loan rules under the Military Lending Act, however, don’t go into effect until October 2016. Right now, we don’t know what the payday lenders are going to do in response to this to see if these new rules by the Department of Defense will actually make the loans that are being issued to military personnel comply with these new regulations.

In Arizona, payday lending was effectively prohibited by statewide referendum in 2015. Yet you’ve got regulators finding out that they have done things to get around that. For example, instead of calling them payday loans, they’ll call them installment loans or something else. Virginia is another place. In 2009, they amended their payday lending act, adding a 45-day cooling off period between when you can get the next loan.

“Payday lenders are notoriously known for threatening people with arrest if they defaulted on a loan.” –Creola Johnson

Part of what I would like to see is a national database. I know when we hear database, it’s like, Uncle Sam is watching you. But if you think about it, if you say the consumer is not supposed to be able to get so many loans within a year, then how can you track if that’s happening? It’s only through a database you can figure out if payday lenders are complying because they would have to submit the names or account numbers of folks who are getting the loans.

One of the things that has not gotten enough media attention is that there’s a carve-out for credit unions that give these payday alternative loans. They’re called PALS, payday alternative loans. I don’t want people to listen to the mantra of the industry saying, “If you do this, then there won’t be any short-term affordable loans to consumers.” That is not the case. Two national credit union associations have supported and pushed for the CFPB to do a carve-out. They wanted a carve-out for credit unions in general, but that’s not what the CFPB did. Instead, there’s a carve-out for these payday alternative loans.

Notably, these loans have an interest rate capped at 28%, application fees cannot be greater than $20. There can’t be more than three PALS within a six-month period. This is a good thing because this is the chance for the credit unions to have the opportunity to go out and market these PALS in a way that consumers will realize that they still have access to more affordable short-term credit.

Knowledge at Wharton: What do you think is the impact on the industry with these specific changes the CFPB is bringing forward?

Tobacman: I think there’s a consensus that lots of payday lenders are going to exit if this rule goes into force. I haven’t heard a dissenting comment from that view. But there’s also a question about what structure the lenders have now. Over the last decade, we’ve seen an enormous portion of the payday lending business go online. If somebody is running an online payday lender now, then probably they’ve paid a lot of fixed costs in order to get their algorithms set up. They might still be able to keep going, just at lower volumes and tighter underwriting standards. In terms of the number of operators, my guess is that we might not see that big a reduction online. In terms of the bricks-and-mortar stores that have higher marginal costs of staying in business and continuing to operate, I bet a lot of them are going to close.

Johnson: I’m not so sure that’s true. The national Consumer Law Center has come out with a step-by-step of the loopholes they think still exist within these new rules. For example, the rules say you’re supposed to assess the ability of the borrower to repay — but that’s not all loans. There are certain loans where, if you meet certain requirements, the payday lender doesn’t have to do an assessment of the person’s ability to repay. And that’s problematic if you think about the CFPB research that has found consumers tend to be overly optimistic about good things happening to them and minimizing bad things happening to them.

Knowledge at Wharton: Part of this would also go to the changes that the CFPB is trying to bring forward, the fact that some states have rules in place and whether we will see a continued push to protect the consumer and maybe even have tougher rules down the road.

Tobacman: It’s not impossible. The CFPB has been working on these rules for a long time and my guess is that they are unlikely to revisit the issue after the final rule is rolled out in the near future. There’s also certainly a question about what may change in Washington after this November.

Johnson:   It’s possible that they could revisit. Assuming that the election results are lined up with an action plan to hobble the CFPB, which there have been numerous bills over the last few years to try to limit the CFPB’s authority. If that doesn’t happen, then the CFPB can do just like the Department of Defense has done. It’s been 10 years since the Military Lending Act was passed by Congress, and last year the Department of Defense said, “OK, now that we see the loopholes and how they’ve figure how to get around those, we’ve got these new rules.”

I think the CFPB has been very good at doing research and documenting data. If a few years from now we see that their loophole is actually being exploited to get around these payday lending rules, then I think that we can expect the CFPB to close those loopholes. What they’re thinking now is they’ve come up with a strong set of rules that they think may work. And remember, we’ve got that carve-out for PALS. Therefore, if there’s no need to tighten the rules further because we’ve got this push towards consumers getting PALS, then we have consumers doing what we want all along, which is to seek out and obtain loans that are safer.

Knowledge at Wharton: When is the expectation that these rules would be put in place?

Tobacman:   I think the comment period ends September 14 and then the comments get reviewed. I don’t know exactly the time frame after that.

Johnson: I would imagine that the new rules will not go into effect until 2017.

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