A matter of interest: Payday loans

Payday loans, the most reviled financial product legally on offer in Canada, aim for the mainstream.

You have to respect an optimist like Bob Whitelaw. The former head of the Canadian Payday Loan Association was recently hired by Alterna Savings to research the possibility of setting up a payday loan product for the Ontario-based credit union. He’s also busy lobbying the federal government on behalf of Alterna to allow credit unions into the payday loan industry. He’s got his work cut out for him.

Payday loans, after all, are those high-interest advances offered out of tacky, neon-lit storefronts, where up to 50% of your next paycheque can be extended to you–for a fee–at any time of day or night. They are also, perhaps, the single-most reviled financial product offered for legal sale in Canada. Who, other than the financially illiterate or the utterly desperate, would pay as much as 40% on a loan? According to critics, the industry is nothing more than a giant scam targeting the working poor. And, perhaps, the military. In the United States, the number of low-earning servicemen who have lost their security clearance as a result of financial problems climbed 1,600% between 2000 and 2005 (the same period in which the payday loan industry flourished). That prompted one navy captain to suggest: “This is a direct threat to military readiness.”

That’s some heavy verbal artillery. It suggests the task of taking payday loans mainstream is more than a challenge–and may be downright Sisyphean. Yet Whitelaw is having some success. It appears a bill will soon be introduced in Parliament that will clear up a legal grey area around the loans (some contend the interest rates charged on these loans contravene the Criminal Code of Canada) and allow credit unions to venture into a market they have thus far avoided. Whitelaw, no surprise, talks about the benefit to his company’s clients. “Our customers are asking for these,” he says, chatting away in an Alterna branch at College and Bay streets in downtown Toronto. “Our members are using payday loans. Can’t we offer these?”

Interestingly enough, that just might be what the industry needs, and may be an initiative on which even the social activists can agree. Chris Robinson is a finance professor at Ontario’s York University and the author of a report for ACORN Canada, a non-profit, member-run group that looks out for the interests of low-income families. In a telephone interview, Robinson talks about the internal dynamics of the industry and confirms some of the worst suspicions about payday loans, including the idea that they trap people in a never-ending spiral of debt.

Contrary to what you might think, payday loan operators don’t lend that much money, says Robinson. In fact, he says the total amount of debt outstanding for the entire Canadian industry, at any one time, is likely less than the outstanding mortgages at one branch of a Big Five bank. Nevertheless, each loan outlet has, on average, 150 to 200 regulars who depend on access to a couple of hundred bucks at the end of each pay period. After all, if you’ve already been advanced 50% of your paycheque, there’s a good chance you’ll be back soon to get through to the next cheque. It’s the repetitive nature of the borrowing and the high rates that provide the return at a payday loan outlet. “They’re more like small businesses in the community,” says Robinson. “The big risk in opening one up is whether you’ll get any customers. If you do, you’re set.” According to a 2004 Ernst & Young report, payday lenders, on average, provide 15 repeat or rollover loans for each first-time loan they provide.

That said, Robinson is in favour of legislation that would take the industry mainstream. He explains that for people without credit or those with very low incomes, emergencies still arise. So while there is a chance of winding up in a debt trap, for many the option is important. “Having access to short-term, unsecured credit is a good thing, especially for many low-income people,” says Robinson. “And if new competition brings down the rates, that’s good.” The head organizer of ACORN Canada, Judy Duncan, agrees. “Our stance is that we want a product that people can access with low rates,” she says. “Mainstreaming it will lower rates, and we think that’s a good thing.”

In fact, payday loans do make economic sense, in some cases. A report from the Credit Research Center at Georgetown University points out, for example, the benefit of taking out a short-term loan to avoid a higher charge being tacked onto a missed credit card payment. And for people with bad credit, the financing option of payday loans can provide needed flexibility. The payday outlets provide lots of services beyond short-term loans, such as cheque cashing and money transfers, and represent an alternative chain of financial services for those who cannot access standard banking services. In fact, Money Mart, the sector leader, works hard at cultivating a respectable image by minimizing the gaudy neon, employing modern design and providing relatively low fees and few controversial products. Call it a “mainstream-aspirational” financial service firm. They even offer prepaid credit cards branded by MasterCard, which can be vitally important for many people, says Robinson–as long as the fees are kept in check.

And that’s exactly what the proposed payday loan legislation, proposed by the federal Conservatives, is designed to do. Alterna’s Bob Whitelaw points out that credit unions, because of their advanced technology and deeper resources, will be able to offer cheaper payday loans. In fact, if credit unions come into the industry, customers would likely force many of the dodgiest players in the sector (the ones that offer rollover loans, which incur increasingly exorbitant interest rates and fees) out of business. The bill could also limit the amount of a loan and its maturity date, helping to reduce dependency. For Whitelaw, the bill is actually a return to the way things used to be. He says many companies now rely on outsourced payroll firms to deposit paycheques directly into a worker’s bank account. That cuts out the possibility of asking an employer for a small advance, something that used to happen all the time. “That doesn’t go on anymore,” says Whitelaw. “But it was quite common.”

But the larger and still open question is why the sector expanded so rapidly. Back in 1993 there were no payday loan stores in Canada, a number that has grown to 1,350 today. There’s even a payday loan store in the Ottawa building complex that houses the Department of Finance. What happened?

It’s interesting to note the remarkable correlation between the decline in the savings rate of North Americans and the rise of the payday loan industry. In a Bank of Canada study of the decline in savings, the long-term reduction in interest rates and lower future inflation expectations were cited as the likely reasons for giving Canadians the confidence to spend more than they used to.

But that explanation doesn’t seem to get at the root of the payday-loan phenomenon. Few customers are considering the long-term inflation outlook when borrowing a hundred bucks until payday. What else might be at play here? Another clue can be found in an investor presentation for Pennsylvania-based Dollar Financial Corp. (Nasdaq: DLLR), the parent company of Money Mart. In a section that outlines the reasons investors can expect growth in the company’s stock, the advent of the “barbell economy” is mentioned. That’s a reference to the idea that middle-income earners are disappearing, replaced by an expanding pool of high-net-worth earners at one end and low-income earners at the other. Perhaps telling of this trend is the attractiveness of VFC Inc., a company that provides sub-prime auto loans through car dealerships. VFC stock rose 148% since its initial public offering in 2003. Toronto-Dominion Bank now owns 99.99% of the delisted stock.

The business case for credit unions becoming payday loan providers is very good, says Whitelaw. “I’ve been getting calls from across the industry,” he says. “There’s a lot of interest in this project.” And it looks like it’s only going to get better. According to a recent Ontario economic report, the personal savings rate in the province fell to 1.3% in 2005, the lowest rate in more than 50 years, while consumer spending outpaced the growth of personal disposal income. Anyone feel like they need a loan yet?

“If new competition brings down the rates, that’s good,” says Robinson.