University of Minnesota Law School Scholarship Repository Minnesota Law Review 2002 Payday Loans: Shrewd Business or Predatory Lending? Creola Johnson Follow this and additional works at: https://scholarship.law.umn.edu/mlr Part of the Law Commons Recommended Citation Johnson, Creola, "Payday Loans: Shrewd Business or Predatory Lending?" (2002). Minnesota Law Review. 744. https://scholarship.law.umn.edu/mlr/744 This Article is brought to you for free and open access by the University of Minnesota Law School. It has been accepted for inclusion in Minnesota Law Review collection by an authorized administrator of the Scholarship Repository. For more information, please contact [email protected]. Payday Loans: Shrewd Business or Predatory Lending? Creola Johnsont I. The Nature of Payday Lending .......................................... 8 A. What Are Payday Loans and Who Uses Them? . 9 B. Payday Loans: Ordinary Check-Cashing Services or Lending M oney? ................................ ......................... 12 1. Payday Loans Are Covered by the Truth in Lending Act ........................................................... 13 2. Disguising Payday Loans Through Sham Transactions ........................................................... 18 II. Criticisms of the Payday Loan Industry .......................... 25 A. Unfair and Unlawful Practices Before or At Contract Form ation ................................................... 26 1. The Cost of Payday Lending: Triple-Digit Interest Rates ......................................................... 26 2. Ohio Survey Shows Lenders Fail to Provide Basic Inform ation ................................................. 32 B. Egregious Practices Post-Consummation ................. 55 1. The Debt Treadmill: Rollovers .............................. 55 2. Inappropriate Collection Practices ....................... 77 III. Economic Realities and Current Law Permit Consumer E xploitation ...................................................................... 97 A. Demographic Data About Payday Loan Customers ...... 98 t Assistant Professor of Law, The Ohio State University Moritz College of Law. The author is grateful for thoughtful comments provided by Richard Alderman, Patrick Bauer, Douglas Berman, John Caskey, Ruth Colker, Thomas Crandall, Jean Ann Fox, Arthur Greenbaum, Michael Greenfield, Dennis Herrington, Louis Jacobs, Kathleen Keest, Robert Lawless, Alan Michaels, Mary Dee Pridgen, Allan Samansky, Deborah Schmedemann, and Douglas Whaley. The author received invaluable research assistance and secretarial support from Loraine Brannon, Kamau Edwards, Robert Feigel, Jeffery Harris, Denean Hill, Raymond Keyser, Arleesia McDonald, Carol Peirano, James Sarconi, and Michele Whetzel-Newton. Thanks to the University Seed Grant Program at The Ohio State University for providing the funding for the author's study of payday lenders in Franklin County, Ohio. MINNESOTA LAW REVIEW [Vol 87:1 B. Packaging Payday Loans to Take Advantage of Gaps in Applicable Law .................................................103 1. Exploiting Ambiguities in State Law .....................104 2. Rent-A-Bank: Evasive Partnerships with Traditional Banks ....................................................105 IV. Proposed Federal Regulation ..............................................116 A. Economic Theory Justifies Regulation of the Payday Loan Industry ...................................................117 B. Why State-by-State Regulation Would Be In adequate ......................................................................122 C. Minimum Consumer Protections ..................................133 INTRODUCTION Payday loans are extremely high-interest, short-term loans offered to cash-strapped consumers. Some of the problems with payday loans can be illustrated succinctly by the experience of one payday loan customer, Leticia Ortega.' Realizing that her next payday was two weeks away, Ortega worried about how she was going to get enough cash to pay overdue telephone and electric bills.2 Then Ortega, a cashier in San Antonio, Texas, spotted an advertisement by National Money Service in a local weekly newspaper. 3 National Money Service charged her a $90 interest fee for a $300 loan, due by her next payday.4 Calculated on an annual percentage rate (APR) basis, this fee amounts to an APR of 780%. 5 When the loan's due date arrived, Ortega did not have sufficient cash to repay the entire loan.6 Consequently, for almost a year, National Money Service 1. Ortega is a typical payday loan customer. For further explanation as to why she is considered a typical payday loan customer, see discussion infra Part I.B. 2. Adam Geller, Payday May Day: Short-Term Lenders Under Fire, Hous. CHRON., Jan. 26, 2001, at B1,available at 2001 WL 2995313. 3. Id. 4. Id. 5. The court in Cashback Catalog Sales, Inc. v. Price, 102 F. Supp. 2d 1375, 1379 n.3 (S.D. Ga. 2000) set forth the formula for calculating an APR. Based on a fifty-two week year with "R" representing the APR, "1" the finance charge, "2" the term (weeks) of the loan, and "P"the loan principle: (R x P/52) T = L Applying this formula to Ortega's loan yields the following calculation and result: 1. (R x $300 / 52) 2 = $90. 2. ($300R /52) 2 = $90. 3. 5.77R x 2 = $90. 4. 11.54R = $90. 5. R = $90 /11.54. 6. R = 7.80. Accordingly, Ortega's loan carried an APR of 780%. 6. Geller, supra note 2. 2002] PAYDAY LOANS debited Ortega's bank account every two weeks in the amount of $90 as interest to "roll over" the loan (i.e., extend the due date).7 Because none of the $90 interest payments counted as principal, Ortega still owed National Money Service $300 even though she had paid $1800 in interest charges. 8 Subsequently, Ortega filed a complaint against National Money Service with the state and learned that Texas usury law restricts lending charges. 9 Because it had partnered with a bank located in Delaware, however, National Money Service claimed it was not subject to Texas usury law but could instead issue payday loans charging the maximum interest rate allowed under Delaware law, the bank's home state. 10 This lawsuit is still pending. Ortega's experience with National Money Service brings to light three of the major criticisms lodged against the payday loan industry."1 First, because payday lenders charge fees constituting extremely high-interest rates, these lenders are modern-day loan sharks. 12 Second, because the payday loan business model requires payment of the loan in full and does not allow partial payments or renewal fees to reduce the 7. Id. 8. Id. 9. Id. Under Texas's consumer loan law, a lender can charge up to $15.60 for a fourteen-day loan of $300. See 7 TEX. ADMIN. CODE § 1.605(c) (West 2002) (containing an exhibit that "provides examples of the maximum authorized rates for loans made under Texas Finance Code"). The lender cannot renew or roll over a loan if doing so results in charges exceeding that maximum permitted fee. See id. § 1.605(f)(1). 10. Geller, supra note 2. The Delaware bank is the County Bank of Rehoboth Beach. Id. 11. The Community Financial Services Association of America, a payday lending industry trade group, operates a website that responds to these criticisms at http://www.cfsa.net/pressreleases/bestpractices-pr.html. 12. See Jean Ann Fox, What Does It Take to Be a Loan Shark in 1998? A Report on the Payday Loan Industry, in CONSUMER FINANCIAL SERVICES LITIGATION 1998, at 987, 990 (PLI Corporate Law & Practice Course, Handbook Series No. B-1047, 1998) (comparing salary lenders, who were considered loan sharks at the beginning of the twentieth century, with payday lenders), available at WL 772 PLI/Comm 987; Lisa Blaylock Moss, Note, Modern Day Loan Sharking: Deferred Presentment Transactions & the Need for Regulation, 51 ALA. L. REV. 1725, 1725 (2000) ("[Mlodern day 'loan sharks' are making short-term loans at usurious interest rates to consumers under the guise of various 'deferred presentment transactions."'); Press Release, Consumer Federation of America, Payday Lenders Charge Exorbitant Interest Rates to Cash-Strapped Consumers (Nov. 10, 1998), at http://www.consumer fed.org/loansharkpr.pdf. MINNESOTA LAW REVIEW [Vol 87:1 principal, payday lenders trap consumers in a vicious cycle of indebtedness. 13 Third, payday lenders are partnering with national banks in order to take advantage of a loophole in federal banking law that allows them to charge rates in excess 14 of state law. Disguising payday loans, threatening criminal prosecution, and collecting excessive damages are among the other major complaints lodged against the industry. To evade compliance with state usury limits and federal and state disclosure requirements, payday lenders in some localities disguise the payday loan transaction with a layer of subterfuge such as selling advertisements to people who only need cash. 15 For example, a customer pays a lender a $33 fee for a $100 cash loan and promises to repay that amount in two weeks in return for the $100 and the opportunity to place an advertisement such as "Go Cowboys" in a paper circulated only to the lender's customers.16 Once a customer obtains a loan and has difficulty repaying it, many payday lenders intimidate customers by threatening to have them prosecuted for the crime of passing bad checks because they lacked sufficient funds in their bank accounts to cover the checks.17 Many payday lenders are going beyond threats and are filing complaints with prosecuting attorneys or are having customers arrested. 8 Moreover, in civil