Cashless at payday: financial and ethical dilemmas of cash advances.(Instructor's Note)

Macy, Anne

CASE DESCRIPTION

The primary subject matter of this case is payday loans, which are cash advances on a customer's next paycheck. Payday loans are a large segment of the subprime lending industry. Students examine the industry model, characteristics of payday loans and the people who use them, along with alternatives to payday loans while they calculate the benefits and costs of the various options. Secondary issues include the effect of a bad credit score on a person's ability to obtain credit and employment and along with reasons why people don't use banks. Finally, students discuss the ethical nature of bank fees and payday loan charges. The case has a difficulty level of three and is designed to be taught in one class period. The case should require one to two hours of outside preparation by students.

CASE SYNOPSIS

This case examines the process, costs and alternatives of payday loans. Payday loans are cash advances against the next paycheck. Payday loans constitute a $45 billion business and cater to individuals who are temporarily short on cash, such as college students. Many college students do not understand the true cost of payday loans while others believe it is their only option. The customer must have a checking account and a steady job. Typically, the individual does not have access to a credit card or other means for a cash advance. Students, in the role of Steve, examine the payday loan taken by Scott, Steve's brother. Steve also investigates the industry to learn how payday loans work along with an examination of the viability and cost of alternative sources of cash. During the evaluation process, students calculate the annual percentage rate of the loan and of alternative sources for the money. Furthermore, students discuss the ethical issues regarding payday loans and other alternative sources of quick cash including bank fees and credit cards.

INSTRUCTORS' NOTES

Recommendations for Teaching Approaches

1. What is the interest cost of Scott's payday loan, especially if he rolls it over for the entire year?

Scott pays $80 to borrow $400 for fourteen days. This is an interest cost of 20% ($80/$400) for the fourteen days. There are approximately 26.07 fourteen day time periods in a year (365/14). Thus, the loan could be rolled over 26.07 times in a year. The annual percentage rate is 20% times 26.07 or 521.43%. The 521.43% interest cost assumes that the borrower pays off the $80 in interest and any new rollover fees after each fourteen day period.

If the interest cost is also rolled over, the annual effective interest rate is 11,484.75%.

Effective interest rate = {[[1+ (5.2143/26)].sup.26]} - 1 = 11,484.75%

2: What are the dollar and interest rate costs of an overdraft on a checking account? Are there any ethical issues with the fees that banks charge for overdrafts?

There are two main costs to insufficient funds on a checking account. First, one's credit rating is damaged by the overdraft, which will affect one's ability to obtain future credit. The second cost of the insufficient funds is the cost of the various charges and fees associated with the overdraft.

For Scott, each overdraft costs $30 from the bank fee and another $25 to $35 from the merchant. The average would be $60 per overdraft. It the merchant turns the charge over to a collection agency, the additional fee of $35 would be added. The $60 charge is 15% interest ($60/$400).

Scott could have three overdrafts, the utilities bill, the telephone bill, and the car repair bill. This could add to $180 in fees, much larger than the payday loan charge.

Because the charge is the same whether the overdraft is $1 or $100, people who intentionally overdraft will overdraft one large amount instead of several small amounts to save on the fees. The students may find it unfair that a $1 Coke is charged a $60 insufficient funds charge. This allows for a discussion on whether the bank is actually doing its own version of a payday loan. It allows you to overdraft but at a charge of $30. By calling it a fee, the bank is avoiding the regulations of a loan but for a habitual overdrafter, the fees certainly add up and it takes on the appearance of a loan.

Many students will have a free checking account. However, they may not be aware of the fees associated with insufficient funds. A free checking account might not be free in the way that the students are thinking of it. Overdraft charges are a large part of bank profitability, which is why they charge fees for each overdraft and not based on the dollar amount of the overdraft. After this discussion, most students will realize that banks use free checking as a way to get customers, like a grocery store that has a low price on milk. For customers will good credit or income, the bank will sell the customer mortgages, car loans, certificates of deposits, etc. just like a grocery store will sell meat, vegetables and soda. For the customer just able to stay above the account limit, the bank will charge fees including overdraft fees for those customers with insufficient funds.

Scott could utilize the overdraft protection feature of his checking account. Each bad check would cost $100. The bank charges its insufficient funds charge of $30 plus $5 a day until the balance is paid. For fourteen days, this charge becomes $70. Three bad checks would cost Scott $300. However, Scott does not have a bad check on his credit rating unless he doesn't deposit the money within the time frame indicated by the bank.

If Scott were to write a bad check to the electric company, he also runs the risk of having his electricity turned off. He then must pay a hook-up fee on top of all the other insufficient fund fees.

The bank also has other options for people with savings accounts or credit. If Scott had a savings account with the funds in it, he could link to the account at a substantially lower cost, just the $5 transfer fee.

The line of credit is a $15 and 12% on the amount. For Scott's $400 need, it would be $15 + $400*(0.12/365)*14 or $15 + $1.84 or $16.84. This corresponds to an interest rate of $16.84/$400 or 4.2% for the 14 days.

The cash advance on the bank credit card costs $3 plus 18% of the balance. For Scott, the cost would be $3 + $400*(0.18/365)*14 or $5.76, which is a percentage cost of less than 1%. Because this is below the minimum cost of $15, Scott would owe $15 or 3.75% on his $400 loan for 14 days.

For current bank charges, Bankrate.com (http://www.bankrate.com) conducts an annual survey of interest rates and fees from banks around the country.

3. Scott says that he tried to use the bank but they wouldn't help him. Is his reluctance to go to the bank to see if he can find an alternative justified?

Scott indicated that the bank says was not helpful and made him feel uncomfortable. Scott may have previously been turned down for a loan from a bank. Most payday loan customers have been turned down for a loan from a traditional bank.

According to the 2004 Survey of Household Finances, 10.6% of households do not have a checking account. The reasons are varied but 22.6% of households without checking accounts answered that they didn't have an account because banks intimidated them. This provides some support for Scott's fears.

For many students, the idea of being uncomfortable at a bank will be an unusual idea. However, it allows for discussion on what is it like to be turned down for a loan or having to interact with bank employees after you have had insufficient funds charges.

4: What is the dollar and interest rate cost of using the credit card for Scott's expenses? Why doesn't Scott use a credit card?

If Scott had a credit card that charged 15% annual percentage rate, a $400 charge would cost him $2.30 in interest for the fourteen days. The 15% annual rate is 0.04% daily rate. If Scott paid the balance, when he received the bill, there would be no interest charges. More likely, Scott would not pay the balance at the end of the first month and would incur interest charges each day until he paid the balance. Fifteen percent compounded daily for one year is 16.18%.

Effective interest rate = {[[1+ (0.15/365)].sup.365]} - 1 = 16.18%

If Scott took a cash advance from the credit card, he would be charged 22% annual percentage rate or 0.06% daily. For fourteen days, the $400 would cost $3.38. The interest also incurs interest charges during the fourteen days. Annualized, the effective cost is 24.6%.

Using either a cash advance or a credit charge, the charges are substantially less than the payday loan. Scott doesn't use a credit card because he has had one and fell behind on the payments. After almost declaring bankruptcy, Scott hasn't been able to get a credit card and he decided to live on an all cash basis to avoid accumulating debt like that again. Of course, the payday loan can also lead to a spiral of accumulating debt. For people who use payday loans, credit cards are either not available or they have maxed out the available credit and cash advance.

5. What is the dollar and interest rate cost of the loan from the credit union?

The credit union will charge an interest rate commiserate with one's credit rating. Typically, credit unions charge about 2% less than a credit card for a customer will an account. As Scott points out, if he had been able to save the money, he would not have to get a payday loan. At 13% a year, the $400 would cost $2.00 for the fourteen days. This amount is just 2.5% of the cost of the payday loan. However, it must be reiterated that the rate that the credit union will charge depends upon one's credit rating and whether or not one has an account with the union.

While Scott currently doesn't have the $400, if he was able to save that amount, he could against the collateral at a substantially reduced rate than the payday loan. Because Scott anticipates that he will have to rollover the loan, it is reasonable to assume that he will need money again in the future. By saving $400, Scott is able to borrow another $400 for a year, not two weeks. This would allow him greater time to get his finances in order.

Scott could also check to see if he is eligible for the 50-day payday loan, which is at a lower interest rate than a traditional payday loan.

6. Scott indicates that he is worried about losing his job and the health care benefits. He does not want to accumulate so much debt that he has to declare bankruptcy. Is this a legitimate concern?

Many jobs, especially those that deal with money, require the employees to have a good credit rating. It is a very real concern for Scott that if he had financial problems, he could lose his job. Students will wonder why a government facility would care. Financial distress puts employees under additional stress. The additional stress could cause the employee to be more susceptible to bribes or stealing. Thus, it is important for employees to understand this additional cost to bad credit. One can lose an existing job or not be eligible to be hired based on the credit rating and/or debt levels.

7. The professor gives some figures on the cost of starting a storefront. Assuming that loans average $400 for 14 days and $20 per $100 interest and fees, how many loans must the store have to earn a 15% rate of return?

The professor states that an average payday loan store costs about $100,000, of which half is available for lending. If the store was to return 15%, that would be a $15,000 return on the $100,000 investment. Because only $50,000 is available for lending, the interest rate is $15,000 divided by $50,000 or 30%. If the average loan is $400, the store can have 125 loans outstanding, $50,000 divided by $400. Each $400 loan brings in $80 in revenue. If the goal is $15,000 and the revenue is $80, the store needs to make 187.5 loans. Since the store can do 125 loans at any one time, the 187.5 loans is very realistic.

If we assume the store averages 100 loans every two weeks, that is 2600 loans in a year. At $80 a loan, the store would have revenues of $208,000. This amount is much higher than what is required and confirms the belief that payday loans stores have a payback period of less than one year.

The cash flow capabilities of a payday loan store reveal several things. First, the required return of 15% must not be enough to compensate for the risk of a payday loan. The required return must be much higher. In addition, the costs of running a payday loan store must be higher than the $50,000. Finally, there are many stores in order to make payday loans convenient but they must not be loaning out anywhere near their maximum amount.

8. Several states that have capped the amount of interest on a payday loan. Do you think this is correct or should payday loan business be allowed to charge what it wants?

After the states limited the interest rates, payday loan businesses left or dramatically reduced their stores in the state. The students can discuss the benefits and costs of increased regulation. While most students will feel sorry for a senior citizen who may be taken advantage of, other students will believe in a more buyer beware philosophy. The students will learn that is a fine line between regulating an industry and over-regulating an industry. Most students will want a fair solution where the firms can still exist but that the customer understands the risks. One of the keys to a fair solution is full disclosure. If the payday loan companies had to provide the customers with the true cost of the loan, some of the people may not take out a loan. With full information, the decision rests with the customer. However, the information must be presented in a way that the customer understands.

Morgan and Strain (2008) find that after a state imposes a cap, the payday loan stores leave and that consumers are more likely to have overdraft charges and more likely to file for bankruptcy. The Center for Responsible Lending (2008) challenges these findings based on the data selection. The increase in bankruptcy could also be due to the bankruptcy law change and that those that file for bankruptcy would have filed whether payday loans were operating in the state or not.

9. Are there any ethical dilemmas with the payday loan industry?

While student answers will vary, it should be clear to the students that the payday loan business caters to those people who believe that they have no other alternatives. In order to get a payday loan, one must have a job and a checking account. Thus, the customers are employed but not able to make ends meet. Loans of this type are classified as subprime lending.

Because most customers roll the loan over four times, it indicates that the customers do not have the ability to pay back the loan in the agreed upon time frame. The payday loan store is simply able to assess charges and keep the customer in debt. The time frame for repayment is too short for most customers. By keeping customers in debt, the payday loan store is able to add fees and interest charges; sometimes to the point that the fees and more than the amount borrowed.

It could be argued that credit cards also create an environment of spiraling debt. The payday loan industry is signaled out only because of the high interest costs and fees. Even the banks through its insufficient fund fees are profiting from those that need cash quickly.

Payday loans locate near populations that are more likely to use it, which makes good business sense. Some students will point out that the payday loan store may set up an arrangement where it can draft out of a person's bank account. The emphasis on marketing to seniors and their Social Security checks is another ethical dilemma. Many seniors don't have the mental capability to correctly assess the cost of a payday loan.

Another ethical point is the collection of bad payday loans. Because the payday loan business is able to pass the collection process of to the district attorney's office, it is able to pass part of its risk onto the taxpayers. The payday loan client is assessed the charges for collection further reducing the cost to the payday loan store.

Various laws, such as the Equal Credit Opportunity Act and the Truth in Lending Act, require the customers are aware of the true cost of loans and deceptive practices are not used. One could argue that payday loan customers do not know the true cost of the loans. The payday loan stores would reply that they provide that information whether or not the customer understands it. If payday loans stores had to show the effective cost of rolling over the loans, customers might be more hesitant to use payday loans.

10. What should Scott do?

Most students will answer that Scott should try to repair his credit rating in order to be able to use a credit card. However, Scott makes the point that when he had a credit card, his debt level became so high he feared bankruptcy. Certainly, the credit union and the credit card are cheaper alternatives. The bank's overdraft protection saves Scott the bad check mark on his credit report but he ends up paying $60 to $95, in line with the cost of the payday loan. It is because of the lack of a clear alternative for Scott that makes the payday loan industry so viable and profitable.

By examining the weightings in a credit score, students are able to see that the amount of debt and paying regularly on that debt is most important. For Scott, he has trouble paying on the debt regularly even though he doesn't need to borrow much. The students can discuss the importance of building a good credit score when young so credit is available later when one needs it.

REFERENCES

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Center for Responsible Lending (2008). Accessed from, http://www.responsiblelending.org/

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Anne Macy, West Texas A&M University