Cashless at payday: financial and ethical dilemmas of cash advances.

Macy, Anne

THE FOOTBALL GAME

The phone rings. Steve fumbles for the phone. He is greeted by a gruff voice. It is his brother Scott. Scott wants to know where the pizza is. Steve mumbles back that he is still asleep. Scott tells him that he as already missed the kickoff. Steve didn't realize it was so late. He drags himself out of bed. Steve quickly dresses, calls for carryout, and gets on his way. He makes it to Scott's house by the second quarter. The two brothers sit on the couch and discuss the team's chances for the playoffs. The first half ends well. There are no injuries.

During the game, Scott tells Steve that the transmission on his car is not working again. It is going to cost over $300 to get it fixed. Scott asks Steve if he would be willing to drive him to and from work for the next week or two.

QUICK CASH

Steve picks up his brother after work. Scott gives Steve directions to a payday loan store. Steve has never been here so he follows Scott inside. Scott tells the clerk that he needs $400. He gives the clerk his pay stub and employer's phone number. The clerk disappears into the back room. He reappears a minute later and tells Scott that he can have the $400. He needs to write a check for $480. The payday loan store will cash his check in fourteen days. The clerk hands Scott the $400.

Once in the car, Steve asks Scott about the loan. He remarks that eighty dollars seems like a lot of interest. Plus, the amount is more than the $300 Scott needs for the car. Scott replies that he thinks the car will cost more to fix and that he needs some cash for gas and food. Scott knows that it is expensive but it is better than an overdraft on his checking account. The money in the checking account needs to go for his utility and telephone bills. Besides, he doesn't have anywhere else to turn. He tried to go to the bank but they were not helpful and made him feel uncomfortable. He has already borrowed money from his friends and their mom and can't ask for more. Scott already owns Steve a $100. Steve wonders aloud if their mom would give Scott a little bit more. Scott replies that he already owes her $1,000 from when he had to go to the emergency room last year. Scott tells Steve that he knows the payday loan is expensive but he doesn't have any other option.

After dropping off Scott, Steve decides to investigate whether his brother has any options or not.

BANKING ON CASH

Steve stops off at the bank to see what the options are. He knows Mrs. Talbot from when they lived on the same street. He asks if she can give him some alternatives to a payday loan. Steve questions whether a payday loan is less expensive than an overdraft on a checking account.

Mrs. Talbot invites Steve into her office so they can talk more privately. She doesn't like to talk about overdrafts and payday loans in the bank lobby. She begins to go over the costs of an overdraft. An overdraft has several costs. First, there is the explicit cost from the bank. This bank charges $30 per overdraft, which is the average nationwide charge. Mrs. Talbot points out that many banks will lower the cost of the first overdraft to $20 but raise the cost on subsequent overdrafts to $35 each. The lower cost on the first draft is because some people just make errors and this a way to not offend a normally good customer.

The merchant will also charge an overdraft amount. It varies widely among merchants but most fall into the range of $25 to $35. If the merchant turns the overdraft over to a collection agency, they also charge a fee, usually around $35.

Steve is surprised to learn that the fees are charged no matter the amount of the overdraft. It doesn't matter if the debit is for $15 or $115, the fees are the same. Mrs. Talbot also reveals that most banks clear charges based on size. Thus, the largest debit is cleared first followed by the second largest and all the way down to the smallest. For a person who overdrafts, this can cause fees to increase because the person may overdraft on more than one debit. For example, a customer has $100 in his account and he has two debits, one for $15 and one for $125. The bank will clear the $125 debit first. Because the account does not have enough to cover the larger debit, the account is overdraft on both debits. If the bank had instead posted the smaller debit first, the customer would only have an overdraft on the larger debit. The $15 debit will cost over $50 in fees and more likely $60 in fees.

Mrs. Talbot said that it is not unusual for someone to not realize that they are low on their account and overdraft several times in one day. Now that people use debit cards, it is a $30 charge for each swipe. A person might be out and get a soda at McDonald's for a $1 and get a $30 charge for that swipe. Later the individual might get some food, another $30 charge. This will go on all day until the person checks the account balance. Thus, some people will run errands and end up with several hundred dollars in overdraft charges for that one day. The bank won't remove them or consolidate them. It can really add up.

Steve is shocked at how the penalties for a mistake and asks about overdraft protection, which he has on his checking account. Overdraft protection means that the bank pays the merchant for the customer but the bank still charges the customer the insufficient funds charge. In addition, banks will charge a daily amount until the funds are replaced. The usual daily amount is $5. The benefit is that the customer avoids the merchant charge and basically has a few extra days to come up with the amount. Plus, he avoids the stigma of insufficient funds with the merchant. However, he still owes the bank the charges.

Mrs. Talbot points out that some people became lazy with the overdraft protection and overused it. Most banks have a limit of overdraft protection, usually around $300 to $500, so a person can run into that limit as well. If the customer goes over the limit, the customer has to pay the fees to the merchants on those overdrafts.

Because so many customers have insufficient funds, banks have added other alternatives. The alternatives only exist for customers who have the funds to pay off the overdraft or who have an established banking relationship. For a $5 transfer fee, a customer can link the checking account to a savings account. When there is an overdraft, the bank just pulls the money out of the savings account and puts it in the checking account.

Customers with good credit can get a line of credit approved. When there is an insufficient charge, the bank covers the amount with a draw on the line of credit. A link to a line of credit usually costs around $15 for the annual fee and interest of 12%. The line of credit can be used throughout the year for the same $15 fee, not a $15 fee each time it is used. Plus, there are no overdraft charges. The customer pays off the line when he has the money. Mrs. Talbot says that many small businesses use this as do families where several people are using the same account and may not be aware of each other's payments.

For those customers with a credit card from the bank, the bank can pay the insufficient charge with a cash advance on the credit card. The usual cost is $3 plus the interest cost at 18% for the cash advance and the insufficient funds charges are avoided. The minimum total fee for the cash advance is $15.

He thanks Mrs. Talbot for her help. While he is surprised at all the fees associated with insufficient funds but it is an alternative to a payday loan. Some of the other choices from the bank might be cheaper. Steve uses that bank because it has free checking. But now he wonders how free it really is.

CASH AND CREDIT

As Steve heads home, he sees a billboard for a credit card. He wonders if a credit card would be a better choice. At his house, he hunts around for his last credit card bill. He could get a cash advance at 22% a year annual percentage rate. He also notices that if his payment is late, like it might be for Scott, he is charged a late fee on top of the interest. For $400, the late fee is $50.

Then it dawns on Steve. Why doesn't his brother just use the credit card to pay the bills? The rate must be lower. Steve quickly calls Scott and asks about using a credit card. Steve tells Scott that the credit card rates start at 15% and 22% on a cash advance and go up. It is still expensive but a lot cheaper than the payday loan.

Scott informs Steve that he doesn't have a credit card. He did have one but he got behind in the payments he almost had to declare bankruptcy. He was finally able to pay if off by working a couple of extra jobs and living at home for a year. After that experience, Scott decided to stay on an all cash basis. If he declared bankruptcy, he could lose his job as security at the government facility. He didn't want to lose that job because of the health care benefits.

Scott asks Steve if he would be willing to put the charge on his credit card. Steve hesitates but declines. If Steve really is having this much of a cash flow problem, he wonders how he will be repaid. Besides, Steve has to pay tuition and fees along with buying books for the upcoming semester. He doesn't have any extra money.

CREDIT UNIONS

After Steve drops off Scott at his job the next day, Steve notices that there is a credit union across the street from the government facility where Scott works. Steve decides to stop by and see what alternatives it has for Scott.

Steve asks to see a new customer representative. He inquires if it is possible to get a small loan. The representative replies that it depends upon your credit rating. Steve asks if there are any options for people without a good rating as he explains the situation.

The credit union officer points out that credit unions operate a lot like banks. However, because it is a cooperative agreement among the members instead of a for-profit venture like a bank, the credit union can offer lower rates on loans than banks. The loans are good alternatives to using a credit card. However, the person has to have the ability to pay back the loan. Credit unions do not have the resources to have large loan write offs.

While the credit union doesn't seem to be a good choice for Scott right now, the officer does point out that if Scott were able to get save $400 dollars, the credit union could loan him that amount. Because the loan is fully collateralized, the rate is can be about two percent less than a credit card rate. The more collateral and better credit rating the customer has, the lower the rate will be. The customer makes a monthly payment and the loan is usually for several months to a year. The loan is for people who have an income but can't always meet their bills.

Because of the increase in payday lending, some credit unions are not offering their own version of a payday loan but at a lower interest rate and with 50 days to repay.

VISIT TO SCHOOL

Steve stops by his advisor's office to finalize his schedule. He tells the professor about his brother's situation and about all of the places Steve has visited trying to find options for his brother.

After reassuring the professor that he wouldn't lend his brother the money, Steve was surprised to learn that his advisor knew all about payday loans. The professor is on a university committee that looks at the financial stresses on its students. Many students quit school because of financial pressures. It is not uncommon for undergraduate students to have a credit card balance and overdraft on their checking account in addition to having car and education loans. Now that a payday loan store has opened across the street from the student union, the university is worried that even more students will get into financial distress.

The professor shares some statistics that he has gathered from the Center for Responsible Lending (2008). Payday loans are a $45 billion business. The average loan ranges from $300 to $400 dollars and the average loan is rolled over four times. Actually, sixty percent of loans go to borrowers who will do more than twelve loans in a year while twenty-four percent of loans are to borrowers who will do over twenty loans in a year. It is not uncommon for a payday loan to have an annual percentage rate of over 1000%.

Steve is astonished at these figures. He asks how a person can pay off the loan. The professor responds that this is why so many are rolled over. If the borrower doesn't roll the loan over, the payday loan store turns the check over to the district attorney's office to collect because the person passed a bad check. The customer has to pay the insufficient funds fees on top of the interest and fees for the payday loan.

Because repayment is such a problem, the payday loans store are now having customers give the store the right to draft from the bank account directly. There are no checks. The payday loan store drafts the amount out at the end of the loan, which has increased the loan stores loan recovery rate. Because the store wants you to be debt, it encourages its customers to continually roll over the loans, with added fees. If the person isn't able to even make the interest payment, usually about $20 per $100 borrowed, the interest is added into the payday loan. Thus, the amount of the loan is continually increasing. The borrowers can be pulled into a spiral of debt.

The professor asks Steve if he can remember his time value of money from finance. Steve smiles and hesitates. The professor asks what happens to the amount that the borrower owes if the loan amount increases, the repayment period is short and compounding on the loan increases. Steve replies that the debt and interest owed increase and would continue to increase until the loan is paid. The professor answers that this is the business model of payday loan stores. Many payday loans stores are now targeting those people with steady checks from the government such as senior citizens. It is not uncommon to see payday loan stores right across the street from a retirement village. Some stores are even getting the elderly to give the right to draft the Social Security check each month to the store.

The professor asks Steve if he can tell him where many of the payday loan stores are. Steve replies that they are in the lower socioeconomic areas of town and near the factories. They tend to be in strip malls on major roads. Near the university, there is the payday loan store by the student union, one by the dorms and another by the group of apartment complexes just off of campus.

The professor is nodding his head. Payday loan stores are also called cash advance stores. They are located near where people live and work who are more likely to run out of cash and need some quickly. It doesn't take much capital for a store. The lease and operating costs for the small square footage in a strip mall runs about $50,000 on average nationwide. If the store starts with loanable funds of $50,000, the total initial investment is $100,000 (Lauder, 2008). If the store charges $20 per $100 loaned, it doesn't take long to earn a profit.

The loans are so expensive that the U.S. government has limited the annual interest rate that can be charged to members of the military to 36%. States have even limited the interest rate and many payday loan stores have left those states. The top rate varies by state but Arkansas, New Hampshire, Oregon, Connecticut, Georgia, Maine, Maryland, Massachusetts, New Jersey, new York, North Carolina, Ohio, Pennsylvania, Vermont, West Virginia and the District of Columbia have all sent two-digit interest rate caps. The typical cap is between 28% and 36% for the annual percentage rate.

The professor points out that for many of the borrowers, they needed cash quickly and didn't have the credit rating to get a short-term loan. Thus, they had to turn to something more expensive. Two other alternatives are pawn shops and car title lenders. With pawn shops, the person has to have something of value while with car title lenders, the person must give up the car. For people needing cash advance, they have already sold everything that has value and they need their car for work so they can try to pay off the loan. Payday loan stores are used after all other avenues have been exhausted. Friends and family won't loan any more money.

Steve asks why the government doesn't do anything about it. The professor points out that many states have put in interest rate caps. However, there is a belief that the people who get into debt and have problems are in this situation because of poor decisions and poor money management skills. This might be the case or it might be that the people have had a bad run of luck. Additionally, because the amount of the loan is usually only a few hundred dollars, many middleclass people have a hard time believing that someone would go into debt over that amount. It just seems too small for them. However, since the payday loan industry is over $45 billion in size, there certainly is a demand for quick cash.

The professor encourages Steve to check his credit history and make sure that he is doing everything he can for a good rating. Steve asks what he can do to get a good score. While there are various credit scoring companies and each have their own method, the average weightings are as follows:

1. 35% based on payment history

2. 30% based on amounts owed and the balance to credit limit ratio

3. 15% based on length of credit history

4. 10% based on type of credit used

5. 10% based on new credit

Steve leaves the professor's office feeling a bit worried. He seems to have more questions than answers. Payday loans are so expensive but does his brother have a better option?

Anne Macy, West Texas A&M University