Payday Lending

PAYDAY LENDING
Payday lending plays a vital role in the financial life of those who are underbanked or
unbanked. Many workers in low-paid or seasonal jobs have bad or no credit. They have
transactional needs that aren’t met by banking resources available to those in more fortunate
economic circumstances. Roughly 12 million Americans take out a payday loan each year.
Payday lending focuses on those who have either the worst credit rating, or no credit rating
history at all. While there is no set definition of a payday loan, the CFPB identifies some
common features (CFPB): The loans typically are for $500 or less with a term lasting only
until the next payday or receipt of funds from a source such as a pension or Social Security.
The term is most often 2 4 weeks. The borrower generally writes a post-dated check for the
full balance with funds to be drawn from a bank account, credit union, or a prepaid card
amount. The lender will ask for evidence of employment and an existing bank account, but
usually does not consider other obligations of the borrower in making the payday loan. Loan
proceeds may be provided by cash, check, or on a prepaid debit card. Some payday loan
terms provide for the loan to be rolled over when due and in some cases, they may be paid-
off over a longer period of time. These loans have fees of $10 30 per $100 and often roll
over. A new fee is assessed upon rolling over the loan. A $100 loan with a $15 fee with a
term of 2 weeks would equilibrate to an annual percentage rate (APR) of almost 400%. This
annualized rate is a bit misleading in that these loans are made for short-term temporary
needs and are not designed to roll forward for a full year. However, the annualized rates are
still staggeringly high, especially compared to credit card rates in the 15% 20% range.
Because of the high annualized rates, critics say payday loans are predatory and many states
have either set rate caps or banned payday loans outright. An act of Congress set a cap of
36% on loans to military personnel, effectively closing this market to most payday lenders.
On the other hand, other economists note the high default rate of the borrowers and believe
the high rates are justified, Also, the typical loan is for a small amount of money. The fee
charged to process the loan looks very large on a percentage basis, but if it were significantly
smaller, it would be more difficult to cover processing costs and at least some lenders would
exit the business. A key factor in excessive expense of these loans is that when borrowers roll
over the loan, a new fee is assessed. About 40% of borrowers roll over at least once
(DeYoung et al., 2015). One proposal is to require payday lenders to do more to assess the
likelihood that a borrower will roll over the loan. But the expense involved in that process
would also destroy the economics of the current payday lending model. Those supporting the
existence of these lenders point out that without payday loans, some people would be unable
to get cash through legal means and would be in a worse situation. They also point out that
while implied annual percentage interest rates on payday loans are very high compared to
credit cards and other loans, they are not as unreasonable when compared to other
alternatives such as late fees on phone company bills, and overdraft fees or bounced check
fees which can carry even higher implied rates of interest.
CREDIT SCORES : FICO
An important function of banking is the determination of creditworthiness of borrowers.

Banks will review detailed information on loan applicants. This provides banks an advantage
in gathering and interpreting data to lessen adverse selection. This information will include a
history of deposits and withdrawals, credit card purchase and payment records, employment
history, income, and other factors. They will also use information from credit reporting
agencies. The agencies commonly used are: Equifax, TransUnion, and Experian. These firms
sell credit information and payment history of individuals to potential grantors of credit. They
also provide similar information on credit history of businesses of all sizes. These agencies
sell businesses credit reports, analytics, demographic data, and software. Their credit reports
provide detailed information on the personal credit and payment history of individuals,
indicating how they have honored financial obligations such as paying bills or repaying a
loan. Credit grantors use this information to decide what sort of products or services to offer
their customers, and on what terms. Reports of businesses of all sizes are also available. The
amount of sensitive data and questionable policies and procedures of these agencies led to the
passage of the Fair Credit Reporting Act in 1970, which gave consumers new important
rights regarding their own credit information.
Another important company in credit reporting is FICO, formerly Fair Isaac and
Company. This company uses credit reports to construct an index representing the
creditworthiness of borrowers. There are many different pieces of data that go into the credit
report. These fall into five categories. The categories and their weighting for the general
population are as follows:
■ 35% of factors concern payment history.

■ 30% reflect amounts owed.
■ 15% involve length of credit history.
■ 10% new credit: A pattern of opening several new loans at the same time might signal
credit problems.
■ 10% credit mix: This is the kind of loans an applicant may have outstanding.
When making credit decisions, lenders might consider additional factors such as
income, employment, etc. Auto dealers, e.g., might look to weight more heavily any credit
information related to previous auto loans.
Scores range from 300 to 850 with higher scores representing better credit risks (An
alternative “NextGen” FICO score can go to 950.). These reports are used to assess the
financial status of borrowers in 90% of all credit decisions. The scores represent the
following categories of increasing riskiness to the lender:
■ 800 1 : This is the highest range of FICO Score. Loan applicants with scores in this
range will usually be approved. Approximately 1% of consumers in this category are likely to
become seriously delinquent in the future.
■ 740 to 799: This is a range of very good FICO Scores. Approximately 2% of
consumers with a credit score between 740 to 799 are likely to become seriously delinquent
in the future.
■ 670 to 739: This is the median range of FICO Scores and consumers in this range
are considered an “acceptable” borrowers. Approximately 8% of consumers in this range are
likely to become seriously delinquent in the future.
■ 580 to 669: These are below average or “fair” FICO Scores. Consumers in this
range are considered subprime borrowers and getting credit may be difficult with interest
rates that are likely to be much higher. Approximately 28% of consumers with a credit score
between 580 to 669 are likely to become seriously delinquent in the future.
■ 579 and lower: Consumers with FICO Scores are considered to be poor credit risks
and may be rejected for loans. Credit card providers and utilities may require a fee or a
deposit. A credit score this low could be a result from bankruptcy or other major credit
problems. Approximately 61% of consumers with a credit score under 579 are likely to
become seriously delinquent in the future.
A new competitor to FICO is VantageScore which was created in 2006 by Equifax,

Experian, and TransUnion. FICO is still used more frequently, but VantageScores are widely
offered to consumers for free.

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PAYDAY LENDING

An important function of banking is the determination of creditworthiness of borrowers.

■ 35% of factors concern payment history.

A new competitor to FICO is VantageScore which was created in 2006 by Equifax,

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