A vanilla option for payday loans?

As a somewhat libertarian-ish writer, I generally find myself on the side of free markets and against crazy government intervention into the economy, but when it comes to payday loans, I have a real hard time finding any good or justifiable reason why some serious reforms shouldn’t take place. 

Essentially, the payday loan industry is loan-sharking minus the broken kneecaps, and it preys upon the poorest Americans in their most dire straits.  Unlike credit cards, which can actually be extremely useful for extending credit to lower income Americans, payday loans are structured to pretty much trap people in an endless cycle of debt.  Yes, credit cards can do this, too, but not as quickly.  Take this reader email at The Dish, for instance:

A good friend of mine got sucked into the payday loan scam a while back.  They had some medical bills and things got tight so they borrowed $600 from a payday loan place.  The terms of the loan were as follows:

1. The loan had to be paid off in full all at once.  So in any given month you were not permitted to pay down any fraction of the principal.  You had to come up with all $600 all at once.
2. The interest rate on the loan was 50%/month.  So to keep the loan current it mean paying $300/month. 

This of course meant that they would have to be able to scrap together $900 in any given month in order to pay off the loan.  Given that they were struggling to get $600 together in the first place, getting $900 all in one month would have been a stretch.  Paying the $300/month was painful but doable, but the problem was that they couldn’t get out from under the loan because they couldn’t get all of the principal together in any given month. 

Now, this is pretty horrible, and I know not all payday loans are structured this way.  I’ve known people who have taken out payday loans and who were actually helped by doing so – if at an unreasonably usurious price.

Nevertheless, there are dangers with taking out a payday loan – even if the terms aren’t quite as crazy as those in the above email.  The interest rate is typically far, far higher than anything you’d get on a credit card.  The terms are not easy to understand.  And the loan, by its very nature, is one taken out when the borrower is completely strapped for cash.  This, of course, is a great time for a borrower to get money, but it puts them at a major disadvantage with the lenders.

Admittedly, these sorts of borrowers are a risk – but surely the level of risk even here doesn’t justify a 650% APR.  Mike Konczal of the excellent blog, Rortybomb, has talked up “vanilla options” for a number of financial products – most recently vanilla options for securitization, but also for derivatives, stakeholders, and credit cards. 

A vanilla option is basically a no-frills, no bells and whistles, easy-to-understand and very limited credit option for higher risk – or lower income – borrowers.  Essentially a vanilla credit card would come without all the perks, probably with an annual fee, and a limited credit line, but without the super high interest, the exorbitant fees, or any of the other extortionary tricks that you miss when you don’t read the fine print.

I wonder if a similar product could be available at the payday loan level?  I see no reason why this wouldn’t be possible, though people in the industry might claim that these loans are so risky no vanilla option would be safe enough.  I think this is stretching the truth, but I could be wrong.  Hopefully Mike will weigh in at some point. (Maybe he already has?)

In the end, easy credit is a double-edged sword.  It can perpetuate the sort of immature spending that so many Americans participate in and which gets so many of us far too loaded up on debt, but it can also help out families when they have nowhere else to turn to.  No reform is going to perfectly fix the credit problems, either.  The nature of the business is to charge against risk, and this leads – paradoxically – to those with the lowest capacity to pay back their loans, paying the most in fees and fines and interest rates.  The flip side, of course, is that low income people could be denied credit altogether.  From a paternalistic standpoint that might sound like a good thing.  But from the point of view of those people who need a payday loan to pay the gas bill or buy groceries, it’s another story altogether.