Interest Rate Disclosures Allow Apple-to-apple Comparisons, Protect Free Market Competition

Loan terms are often complex and may include a number of extra fees that make the real cost to the borrower difficult to decipher and difficult to compare across credit options. Congress developed the APR, or Annual Percentage Rate of Interest, as a standard measure that calculates the simple interest rate on an annual basis (including most fees), accounts for the amount of time the borrower has to repay the loan, and factors in the reduction in principal as payments are made over time.

For centuries, the standard has been to compare interest rates on an annual basis, whether the loan is scheduled to be paid off in less than one year, more than one year, or in multiple years. U.S. consumer lending law applies this measure across the board, whether for car loans, mortgage loans, cash advances on credit cards, or payday loans.

The Truth in Lending Act: Consumer Protection, Free Market Competition

Congress passed the Truth in Lending Act (TILA) in 1968, a central feature of which was the requirement that lenders disclose the APR for all types of loans. The intent was to give consumers an accurate measure of the cost of the various credit options they might be considering, so that they need not pay unnecessarily high rates of interest or be caught in loans with hidden fees or arduous terms that make it more difficult to pay off the loan.

TILA has the effect of protecting free market competition by ensuring that consumers can comparison shop and choose the form of credit that best fits their needs and their budget.

As Senator Paul Douglas, co-author of the Act said in 1963, TILA gives a consumer "the right to be informed-to be protected against fraudulent, deceitful, or grossly misleading information, advertising, labeling, or other practices and to be given the facts he needs to make an informed choice." He also noted that it serves to "invigorate competition" by protecting the "ethical and efficient lender." [1]

Fed Ruled on APR and Payday Lending in 2000

In 2000, the Federal Reserve Board formally clarified, over objections from the payday lending industry, that APR disclosures are required specifically for payday loans.[2] The Fed made explicitly clear that the legal definition of credit includes payday loans, whether they are called cash advances, deferred deposit checks, or other similar terms, and, as such, their cost must be disclosed in terms of APR under TILA.

APR Matters For a Two-Week Loan, Even Though Most Payday Debt Is Longer Term
Since APR disclosures are legally required, lenders do usually post them on loan documents, websites, and signs within payday stores. But payday loans are often advertised as costing around $15 per $100 borrowed, and lenders frequently quote a simple interest rate of 15 percent or so. Moreover, payday lenders have engaged in an extensive campaign to discredit the use of APR, targeting policymakers as well as the general public.[3]

Even if a payday loan is paid off in two weeks on payday, and no new loan is opened from the same lender (which is not usually the case), the APR is important because it tells the borrower the true cost of the loan compared to other options, including both time and dollars. Without both of those elements, the borrower lacks the necessary information to make an informed judgment regarding whether he or she can repay the loan or whether there is a more affordable option.

For example, a consumer considering the following two options might believe that a payday loan is the less expensive option if costs are expressed this way:

Credit Card Cash Advance = interest rate of 18%
Payday Loan = interest rate of 15%

But if expressed in terms of APR, the true cost is easier to understand. The APR is calculated by taking the simple interest and multiplying it by the number of times the term goes into one year:

Credit Card Cash Advance = APR of 18%
Payday Loan = 15% times 26 two-week terms = APR of 390%

In terms of dollars, the difference is stark. Say a person needs $300 for a month for an emergency car repair. If the person takes out a payday loan and has a typical two-week pay period, the borrower must carry the loan for two terms to have it for one month. In this case, the real cost of the payday loan—$45 per term, or $90 total—would equal 20 times more than the credit card cash advance carried for one month.[4]

Assumes borrower takes an initial two-week payday loan and then re-opens that payday loan for an additional two weeks. If borrower is paid monthly and so is eligible for a 30-day loan, the cost would be $45, still ten times the cost of a credit card advance.

APR Matters For Long-term Payday Debt, The Norm For The Industry
Most borrowers are stuck in payday debt for much longer than the time they expect to carry the loan.[5]

• One of seven Colorado borrowers has been in payday debt every day of the past six months. (The business works similarly in other states where payday lending is legal; we cite Colorado because this particular data point is available.)
• The average payday borrower nationally conducts nine transactions per year, generally on a consecutive or "back-to-back" basis.

In fact, the industry depends on this cycle of indebtedness for its business model to work. As documented in our report, Springing the Debt Trap:[6]

• 60% of payday loans go to borrowers with 12 or more transactions per year.
• 24% of payday loans go to borrowers with 21 or more transactions per year. Assuming a typical two-week term, that equates to ten months of indebtedness.

Industry insiders and analysts alike confirm the industry's dependence on payday customers being caught in a cycle of long-term, high-cost debt. During a legislative battle in Virginia, a lobbyist for Advance America commented that the company could not live on five loans per year per borrower.[7] A payday lender in Washington State acknowledged that a limit of eight loans per year per borrower would likely put him out of business.[8]

And Morgan Stanley had this to say about long-term borrowing in an analysis of Advance America's financials: "…38.1% of customers took out 9 to 14 or more advances per year. This statistic is worrisome. These customers bore the exceedingly high APRs associated with payday loans for almost half a year, or longer. At a 300% APR, the interest on a payday advance would exceed the principal after about 4 months. In these circumstances, the loan starts to look counterproductive: rather than bridging a gap in income, the payday advance may contribute to real financial distress."[9]

APR Matters
APR matters whether a borrower takes out a single loan or is indebted to a payday lender for an entire year. Regardless of how often borrowers use payday loans, they must be able to compare these loans with other options, such as a cash advance on a credit card or an unsecured loan from a finance company. Disclosure of the APR also signals to consumers, policymakers, and regulators that this type of loan carries costs that are far above what is considered acceptable. In times of economic stress, corrective measures take on an importance that is hard to overestimate.

A Cap for Economic Recovery

Congress should support the "Protecting Consumers from Unreasonable Credit Rates Act of 2009," introduced by Senator Dick Durbin (S. 500) and Representative Jackie Speier (H.R. 1608), as a quick and essential step toward economic recovery. Such a cap will cost taxpayers nothing and protect the earnings and government benefits of American households, thereby allowing these families to save, spend, and recover from their financial shortfalls in the long term.

See Attachment: Real TILA Disclosures

This Advance America contract from a North Carolina payday lending store shows an APR disclosure of 456.25% for a two-week loan of $200. Because new documents were issued for each loan, what this one sample does not show is that the borrower was in continuous debt with Advance America for five years and paid over $5,000 in interest for one small loan. Following "best practices" of the Community Financial Services Association of America, Advance America did not roll over this loan, but repeatedly closed and immediately re-opened it.

[1] 109 Cong. Rec. 2029 (1963) (remarks of Sen. Douglas)
[2] Truth in Lending, 65 FR 17129, 17130 (March 31, 2000). Available at http://www.newyorkfed.org/banking/circulars_archive/11241.pdf.
[3] "FISCA supports the development of an alternative measure of the cost of credit that is meaningful and understandable." Currents, Financial Services Centers of America newsletter, p. 17, 30. (March 2009). Also, a consumer survey found that 94.5% of respondents cited the finance charge for a payday loan at around 15 percent. Only 34.5% offered a guess of the APR. Of those, only about half (49%) knew that their loans had an APR of over 200 percent. Thirty-four percent thought the APR was below 30 percent. Overall, this means that only 17 percent of all payday customers know what their loans really cost in terms of APR. Gregory Elliehausen, An Analysis of Consumers' Use of Payday Loans, George Washington University School of Business, (January 2009). Available at http://www.business.gwu.edu/research/centers/fsrp/pdf/m41.pdf. Also, in a survey of California borrowers, most respondents were aware of the fee associated with borrowing, but did not understand the APR that is associated with long-term borrowing. They could articulate the amount of the fee, but most could not articulate the interest rate being charged or how it was calculated. 2007 Department of Corporations Payday Loan Study, Applied Management and Consulting Group for the California Department of Corporations (December 2007). Also see materials from payday lending companies: from Check into Cash cartoon entitled "6 Scary Myths": "There is a logical explanation for these rumored 391% APR "sightings"… and as with most myths, it's because people think they're seeing one thing when they're actually seeing something else. Call it "fuzzy math" or "an error in judgement," but when it's all said and done, it's a story fabricated to entertain, frighten, and baffle the storyteller's audience." As of June 17, 2009, available at http://paydayfacts.org/?q=node/10. Also see Check N Go video downplaying the importance of the APR for payday loans. As of June 17, 2009, available at http://www.youtube.com/watch?v=mSWnN9BAol8.
[4] 54.4 percent of payday borrowers have a bank-issued credit card. Gregory Elliehausen, An Analysis of Consumers' Use of Payday Loans, George Washington University School of Business (January 2009). Available at http://www.business.gwu.edu/research/centers/fsrp/pdf/m41.pdf.
[5] Uriah King, Leslie Parrish, Ozlem Tanik, Financial Quicksand: Payday Lending Sinks Borrowers in Debt with $4.2 Billion in Predatory Fees Every Year (November 2006). Available at http://www.responsiblelending.org/payday-lending/research-analysis/rr012-Financial_Quicksand-1106.pdf. And Uriah King and Leslie Parrish, Springing the Debt Trap: Rate Caps are Only Proven Payday Reform (December 13, 2007). Available at http://www.responsiblelending.org/payday-lending/research-analysis/springing-the-debt-trap.pdf.
[6] Uriah King and Leslie Parrish, Springing the Debt Trap: Rate Caps are Only Proven Payday Reform (December 13, 2007). Available at http://www.responsiblelending.org/payday-lending/research-analysis/springing-the-debt-trap.pdf.
[7] Jeff Shapiro, "Payday-loan fights loom," The Richmond Times-Dispatch (February 29, 2008).
[8] Russell, James. Payday loans: Reform, but too fast. Posted May 22, 2009 at Payday loans: Reform, but too fast http://wenatcheeworld.com/article/20090522/OP03/705229867/-1/OP
[9] Morgan Stanley Report, Advance America: Initiating with an Underweight-V Rating, January 25, 2005.