Over the weekend I had a very interesting conversation with a former commercial banker who once upon a time wrote a major loan for a pay-day loan company. Generally speaking, the pay-day loan industry is seen as the absolute bottom-feeders of the consumer credit market. These are the guys that write short term loans -- generally two weeks -- at 15% interest. In the eyes of many, this looks like legalized loan sharking, extracting huge interest payments from the weak and the desperate. My banker informant, however, told me a different story.
First, he said that the default rate on pay-day loans is quite low -- around 8%. What this means is that for the vast majority of borrowers, the interest is not compounding. Furthermore, the pay-day loan companies don't want it to compound and aggressively weed out customers who try to roll the short-term loans over from week to week. The reason for this is obvious. Even though the math of 15% interest compounded bi-weekly might look appealing on paper, in practice the debtors are likely to be judgment-proof, collection costs are high, and rolling the loan over suggests that the chances of ultimate repayment are low. In other words, contrary to the imagination of many a left-leaning consumer bankruptcy professor, pay-day loan companies are not out to pile up massive interest payments on tiny principle amounts.
The second thing that I learned was that a big part of success in the pay-day loan market comes from customer service. The folks who use pay-day loans are generally treated like crap at the bank. This is hardly surprising. After all, these are the sorts of people who bounce checks and are unlikely to qualify for a nice Fannie-Mae standard mortgage that can be immediately sold in the secondary market. On the other hand, pay-day loan centers treat their customers very nicely, although they also make sure that they get follow-up calls reminding them of repayment due dates. What this means, however, is that pay-day loans are quite labor-intensive given the amount of money involved.
The last thing I learned was the relationship between pay-day loans and checking accounts. Most pay-day loan companies require that their customers have a checking account. More interestingly, however, many people go to pay-day loans because of their checking accounts. Many of these loans are written to insure that checks written on a depleted account don't bounce if they clear before pay day. The reason that people go to the pay-day loan companies is that at many banks the penalty and service fees that one pays on a bounced check are in excess of what the pay-day loan company charges. In other words, folks turn to the pay-day loan companies to get protection from more "respectable" lenders.
Of course, to really verify these stories I would want some real data. Still, I am inclined to trust my banker informant, and at the very least the story sounds plausible. Voluntary contracts have a way of working to the advantage of both parties...