Battling for Payday Loans

When my Foolish colleague Selena Maranjian extolled the virtues of banning payday loans for members of the military, I knew it was because she wants consumers to run their financial lives Foolishly. After all, living from paycheck to paycheck and making regular use of short-term loans is not a particularly wise use of one's financial resources.

Yet I've found the cap on payday loan rates to the military -- which effectively amounts to a ban on those loans entirely -- to be a shortsighted measure that diverts attention from the real problem: inadequate pay for our soldiers.

Credit drying up
It's hard to argue that you should be a habitual user of payday loans, at least if you ultimately want to be financially secure. As a stopgap measure, they have their place if you are in a tight spot, but short-term loans with easy qualification criteria end up costing far more when they are used for long-term needs. Yet payday loans have been singled out for congressional action, while other sources of "fast cash" are still permitted. And they come with their own problems.

For example, credit card cash advances are relatively accessible forms of debt. Cash advance checks usually come attached to your monthly statement, but they typically carry higher interest rates than purchases, offer no grace period, and come with a cash advance fee. Interest piles up immediately. Further, if you carry a balance on your credit card, any payments you make are typically applied first to your lower-rate debt, resulting in higher interest rates and total costs. And as bad as these terms may be, if you have bad credit, you might not have access to cash advances or have a credit card at all.

Perhaps tapping your home equity sounds like a better way to get low-interest cash. Well, it was until recently. Now we see that it's not just the borrowers at the low end of the FICO scale who are defaulting on their mortgages -- those with better credit are having trouble paying, too. Many supposedly responsible lenders touted the benefits of using a home's equity like a private bank -- and homeowners have seen it come back to bite them.

We could also talk about the relatively low interest rate you could get on a straight bank loan for a few hundred dollars -- except that small bank loans have pretty much disappeared. That's one of the reasons behind the proliferation of payday lending services: Traditional financial institutions have largely abandoned micro-loan customers. Even for more sizeable loans, if you don't have a bank account or a verifiable credit record, you won't be getting any cash, either.

The last stop
In reality, for the poor, the cash-strapped, and those who can't build strong banking relationships, few alternatives are available. Payday lenders are about the only financial institutions willing to make small loans. Advance America (NYSE: AEA), for example, the largest payday lender in the country with more than 2,900 financial centers, offers loans from $50 to $1,000 and charges a fee ranging from 10% to 22% depending on the loan's size.

It's true that a $15 fee for a $100 loan means you'll pay hundreds in fees if you keep rolling it over. But trying to translate those fees to an APR is misleading. When banks charge $3.50 or more to get money out of an ATM, you may not realize that you could easily pay $175 or more in fees every year just by using a cash machine once a week. And when a bank charges $29 for bouncing a $10 check, you don't typically see it referred to as charging 290% interest for a one-day "loan." The same holds for late fees on credit cards. All financial institutions make huge amounts of money on fee income -- not just payday lenders.

It's true that payday lenders have been very profitable of late. Cash America (NYSE: CSH) and First Cash Financial (Nasdaq: FCFS) both reported a 31% increase in net income this past quarter, while EZCORP 's (Nasdaq: EZPW) profits were up 22%. But these are high-risk loans that require no credit check and offer quick turnarounds. As lenders of last resort, these companies' fees are higher, but without those fees, their profit margins would disappear and they'd go out of business, leaving borrowers without any solutions at all.

The fact is, while we wish individuals would always be Foolish with their finances, life intrudes, and the ability to make it to the next payday requires a short bridge loan. Traditional financial institutions have abandoned customers with this need, whether they are civilians or military personnel. Now Congress has effectively removed even this stopgap measure for members of the military.

As is usually the case, it's far more politically expedient for Congress to attack a symptom than a cause. As we reflect on those soldiers who sacrifice their lives in service to their country, let's consider how we can do more for them -- instead of narrowing the options they have available.

© 2007 Universal Press Syndicate