Payday lenders open branches in neighborhoods where banks won't go. They give people a place to cash their checks, and they make loans to those whom no credit card company would trust with plastic. The cash isn't free, though. The money has to be paid back, and for many borrowers, the only way to pay off a loan is by taking out another. For them, payday lending often isn't a lifeline, but a trap.
Policymakers who want to protect these borrowers from predatory lending not only risk cutting off much-needed credit for people who really need it, but they also risk implying that the poor can't make sound financial decisions on their own.
That was the complicated dilemma facing the Obama administration earlier this year when officials proposed new restrictions on the $50 billion payday industry. Under the Consumer Financial Protection Bureau's proposal, borrowers would be allowed to take out no more than two additional loans to pay back an original loan. People who really needed a loan would be able to get one, the bureau hopes, but loans wouldn't turn into a cycle of debt.
[Read more: The payday industry’s money-making model is coming to an end]
Before the CFPB acted, several states had already moved to more tightly regulate the industry, providing some idea of what effect the federal rules might have. And new research by a pair of economists on the Pacific Northwest suggests that in Washington, similar restrictions put about two thirds of the state's payday lending establishments out of business, and that many borrowers may have been better off without them.
The economists wanted to know why, exactly, borrowers in Washington were going to payday lenders. For a borrower with a minimum-wage job who needs to fix her car so she can get to work the next day, a payday loan could be worth the cost, even at very high interest.
But other borrowers might not have completely thought through the risks of taking out a loan. They might have been borrowing to pay the bills, not thinking about what they'd do next month, when it came time to pay the bills and the loan. Or they might have been borrowing impulsively to pay for a gift or a party, or just to forget about their poverty for a little while. And payday lenders, the data show, may have been benefitting from their mistakes.
The economists, Harold Cuffe of Victoria University of Wellington and Christopher Gibbs of The University of New South Wales, found that about two out of three payday lending establishments in Washington closed their doors after the new rules took effect. That wasn't surprising, but Cuffe and Gibbs also found the law had an effect on liquor stores. Compared to sales in the neighboring state of Oregon, sales in Washington were less than would be expected after the law's enactment.
Liquor stores located near payday lenders lost the most business. The apparent effect of the law on sales was three times greater at liquor stores with a payday lender within 33 feet than for liquor stores in general.
To the economists, the data suggested that many borrowers had been using their loans to buy alcohol. Once the payday lenders closed, those would-be borrowers no longer had the chance to buy liquor nearby.
Cuffe and Gibbs did not have data for individual loan recipients, so they couldn't be entirely certain that there was anything special about the connection between liquor and lending. It could be, for example, that without access to payday loans, the poor were spending less on necessities such as car repair, too. That said, the fact that liquor stores within a storefront or two of payday lenders lost the most business suggests that borrowers in Washington were making impulsive decisions -- walking out of a payday establishment and into a liquor store. To the extent that they were, they may well be better off all around with the new law in place, protected from exploitation.
Proponents of payday lending might object that the poor deserve the freedom to buy and borrow as they choose, even if that means using an expensive loan to pay for alcohol. These proponents might argue that it isn't for lawmakers in Olympia to dictate the spending habits of the poor.
Cuffe doesn't see it that way. In an interview, he argued that the decisions a person makes on impulse -- whether to buy or to borrow -- don't always indicate what that person actually wants.
For example, many people will actually volunteer for savings accounts that restrict how much money they can spend. That's an indication that people want safeguards imposed on their financial decisions, because they know they can't trust themselves.
"They may know that they won't be able to stop," Cuffe said. He went to say that although everyone makes bad financial decisions, he noted, no matter how much they make, such protections are especially important for the poor.
"We can all be equally irrational," he said. "For me, that just means the next morning, I wake up and regret my purchase, but it may pose a bigger consequence for people who, let's say, have to take out a payday loan."
That doesn't necessarily mean the poor would welcome proposals from conservative politicians around the country to restrict how welfare recipients use their benefits. These politicians have argued the poor can't be trusted to carry cash or to use their money wisely.
There's a big difference between between a check from the government and a loan from a payday lender: you only have to pay back one of them. The consequences of misusing a payday loan are much greater if doing so leads is the start of a cycle of debt. As the interest accumulates, the borrower will have less money to spend on everything, including booze.