Should a 300% Interest Rate Be Legal?

Is there anyone out there who still believes that payday lending is a respectable business? That it’s OK to charge stratospheric interest rates—often four, five or more times the amount that’s originally borrowed—to cash-strapped consumers who typically re-borrow the identical loan over and over again during the course of a year? That it’s reputable to ding these same customers—who are twice as likely to overdraw their accounts—with $30 and $40 fees every time they bounce a check?

Apparently, the payday-lending industry does. So do their most vocal congressional supporters.

According to a recent Washington Post article, both have worked up a lather about government regulators who are allegedly pressuring banks to phase out their relationships with payday lenders. Apparently, it’s beside the point that those who are complaining the loudest also happen to be the same folks who routinely reject the imposition of any form of enhanced accountability.

It’s important, however, to understand the financial and operational accommodations that are make-or-break in this line of business.

As lucrative as payday loans might be for the lenders, the deals still have to be bankrolled. The lenders also need help in extracting repayment amounts from their customers’ future paychecks—the most critical risk-management element of the payday-lending business model.

It is for these two reasons in particular that lenders who operate in this subset of the financial-services industry rely on the banking relationships they work hard to cultivate—affiliations that the banks are very happy to have in place, too.

For banks, payday loans are the gift that keeps on giving. To start, there’s all that spread: the difference between the triple-digit APRs that payday lenders charge the borrower and the single or double-digit rates the banks assess to fund these loans. Next, there’s the matter of the float: income the banks earn on the fluctuating balances both the payday lenders and their customers have on deposit from day to day. And then there are the overdraft fees…

Thanks to the regulators, though, financial institutions that once upon a time were proud to stand behind their payday-lending protégés are now looking to put as much distance as possible between them.

A regulatory problem arises, though, in the power play between federal and state authorities.

National banks—such as those that have been most active in this arena—are federally regulated. In contrast, nonbanks (which is what most payday lenders are) are governed by a hodgepodge of state-specific usury laws that calculate interest rates and fees six ways to Sunday.

A Simple Solution

The good news is that this mess is pretty easy to sort out.

Congress can institute a national usury limit that balances, on one hand, legitimate costs that are associated with originating and servicing these types of short-term loans, with, on the other, a charge in the form of an annual percentage rate. That way, consumers would be better able to assess their alternatives; at the same time, lenders would no longer have anything to gain from shifting costs between rates and fees in an effort to skirt one statutory limit or another.

Lawmakers can also designate a single regulator—the Consumer Financial Protection Bureau would be the most logical choice—to oversee these types of loans. This would go a long way toward eliminating the regulatory turf battles and conflicting directives that ensue when more than one agency is involved.

At that point, payday and other short-term lenders would have a decision to make: They can either transition to a more fairly priced and structured financial product for those who need it, or they can pack up their kiosks and storefront operations, and call it a day.

As for the banks, should they elect to fund those lenders who agree to play by the rules—or, even, pursue this business on a direct basis—they would be able to do so without fear of regulatory retribution.

Either way, this should bring the griping to an end.

This story is an Op/Ed contribution to Credit.com and does not necessarily represent the views of the company or its affiliates.