It's a dirty word now, but subprime—as in the dubious lending practices blamed for the recent financial crisis—entails, most simply, extending credit to those who don't often have access to it. People who have low credit scores or no credit history are subprime borrowers; often so are blacks and Latinos, who may find it easier to access credit outside of traditional banking institutions.
The industry is comprised of both the earnest and the occasionally devious—the credit union and the pawnshop. Subprime lenders include the ubiquitous corner stores offering check cashing, tax refund loans, auto title loans, and payday loans. The neon signs that front these businesses mark them as targets for consumer activists, who allege that their practices are predatory. The industry claims to serve poor people but actually exploits them, its opponents say, with high interest rates and impossible loan terms.
They've made payday lenders a particular object of their ire. "It's just like loan sharks, but with worse interest rates," says Jordan Estevao, who directs a banking accountability campaign for National People's Action, a coalition of community groups.
Borrowers of payday loans use their paycheck—or their unemployment or social security check—as collateral against a small loan, usually less than $400. Such loans generally come with attached fees of $15 to $18 per $100 borrowed, which lenders are required to express in lending statements as an annual percentage rate. Depending on the length of the loan, that can mean APRs in the triple, even quadruple, digits. Other provisions work to make repayment difficult: with balloon payments, for instance, borrowers pay only interest for most of the life of the loan—and get walloped with the entire principal on the final repayment. Borrowers in such circumstances may end up taking out another loan to pay off the first, either from the original lender or from another.
"The business model relies on people coming back for another loan," says Estevao. "They keep racking up that interest, not paying off the principal. And that's the trap that is set."
When Jennifer (who doesn't want her last name published) planned to take out her first payday loan, she says she was discouraged by a friend who was deep in debt. "He almost yelled at me," she says. "He said it had gotten so bad that he was taking out a loan to pay off another loan, and just trying to keep up."
Still, she needed the money for repairs on her car. Jennifer says that she makes "a decent amount" at her job with a Chicago nonprofit housing organization, but "savings for emergencies, I don't really have." She took out her first payday loan from an online lender whose infomercials she'd seen on television.
She says that though she paid the first loan back quickly, the process of taking it out was tricky—the lender leaned on her to borrow more than she wanted to. "They was like, we have to give you $3,500," she says. "And I was like, I don't need that much, I just want $1,500. And I think that's how they get people in a bind, because you get all that money and they say, well, you can just give $2,000 back. And who's gonna give $2,000 back?"
Jennifer did give the $2,000 back—it was the first payment she made after borrowing the full $3,500. She can't recall how much her total repayments were. "I paid a lot back because of the interest," she says. "It wasn't double, but it was almost."
She took a second loan out last year, this time from a brick-and-mortar lender downtown. The money would've been paid back by February, but her lender convinced her to extend the loan. "It was Christmastime last year and they called and said, you're eligible to get this much, and we'll just refinance your loan." She wanted the extra money to spend on her kids for the holidays.
"I didn't know that that would restart it all over again—that wasn't completely explained to me," she says. "They were calling and saying, 'We're having a special, do you wanna . . . ?' And a couple times I said no, and then that one time I didn't." She's now slated to pay about $160 every two weeks—taken automatically out of her checking account—until February 2012, though she hopes to pay it back earlier with the help of her income tax refund. "And then I will stay away from them," she says. "Forever."
Illinois activists have been pushing for stronger regulation of payday lenders for more than a decade. This spring they got some of what they wanted: a law designed to end several abuses went into effect in March. It prohibits balloon payments and caps fees, and it establishes a tracking system to prevent borrowers from being caught up in a cycle of debt. It also requires that repayment be based on the borrower's monthly income.
"These are huge consumer protections that ten years ago we never thought we'd get in Illinois," says Lynda DeLaforgue, who as codirector of the activist group Citizen Action helped negotiate the bill.
The first attempts at regulation in Illinois came in 1999, after a parishioner approached Monsignor John Egan, an activist Catholic priest, and said she'd taken out two short-term loans she was struggling to repay. Egan, whose opposition to credit exploitation dated to the 1950s, raised the money himself; he also contacted local unions and citizen groups to learn more about the issue.
Egan was a driving force behind the coalition that formed to fight what he saw as exploitation. When he died in 2001, the coalition renamed itself the Monsignor John Egan Campaign for Payday Loan Reform.
The coalition's initial aim was state regulation to rein in the worst abuses. Rules eventually implemented by governor George Ryan mandated, among other things, the prevention of back-to-back borrowing—requiring a cooling-off period between loans in hopes of preventing borrowers from compounding their debt. The rules, which also required underwriting based on the borrower's income, applied to loans with terms of up to 30 days.
The industry responded by creating a new product: a 31-day loan. "That allowed them to get around the rules," DeLaforgue says.
So the coalition began pushing for new laws. In 2005 then-governor Rod Blagojevich signed the Payday Loan Reform Act, which was supported by both the Community Financial Services Association—a national trade group for payday lenders—and the Egan coalition. It codified some of the rules that had been subverted, requiring more time between loans and more thorough underwriting.
But there was a loophole. The law established a regulatory regime that governed payday lenders whose loans had terms of 120 days or less. Lenders, DeLaforgue says, simply started writing loans with longer terms than that.
Outside of the 120-day limit, they fell under the banner of the Consumer Installment Loan Act (CILA), which governed non-real-estate consumer loans of up to $40,000. The criteria for lending under CILA were much less stringent than those of the new payday law: it placed no caps on interest rates and required no underwriting.
"We didn't realize that the entire industry could so successfully morph into this other product," says DeLaforgue—but that's what happened. The legislation capped rates at 403 percent for "short-term" loans, but the new loans being offered were no longer classified as such.
DeLaforgue showed me a copy of a 2007 consumer lending agreement from a payday loan store. The amount borrowed, $400, is dwarfed by the amount owed: $1,098, with an annual percentage rate of 702 percent.
Then she showed me another statement—this one reflective, she thinks, of a new loan product offered under the regulations that went into effect in March, designed to close the CILA loophole. Its principal is $1,000; at a lower APR, 400 percent, the total payments come to $2,251.51. Even under the new law, this borrower still pays back more than twice the amount of the loan's principal. "They're actually advertising on the front of their stores that they've taken the rates down by 40 percent," DeLaforgue says. "Well, they're forced by law to do that."
Bob Wolfberg thinks that complaints about the steep interest rates attached to payday loans are a "red herring." Wolfberg and his brother Dan started PLS Financial Services in Chicago in 1997. The two come from a lenders' lineage extending back to their grandfather, who was a movie projectionist by night in Chicago in the 1920s and 30s. By day he ran a check-cashing business.
Check-cashers cash checks for a fee (usually 2 to 4 percent); they provide convenience and access—longer hours, more locations, and faster service, often in neighborhoods where banks are scarce and customers don't have accounts. PLS offers check-cashing services, too, as well as auto title loans (which use auto titles as collateral) and income tax preparation. It now operates over 300 stores and employs more than 3,000 people in nine states.
Wolfberg participated in the negotiations for the recent bill. It's designed to end the cycle of debt, and he thinks it will accomplish that.
The bill places a cap of $15.50 per $100 borrowed on loans with terms of six months or less. That still means high APRs, as DeLaforgue pointed out. But lenders say that since their loans aren't issued by the year, listing the interest on an annual basis doesn't make sense—that it's inaccurate and unfair. Wolfberg ran through a litany of examples:
"I don't know if you've ever bounced a check?"
Sure, I said. The overdraft fee was about $40.
"So how much was the check? Like $50, $100? So that's like 4,000 percent interest. . . .Have you ever taken a taxi?"
Sure, I said. It probably cost $10 or $20.
"Well, that's a rip-off, right? If you had taken that taxi all the way to Disney World, it would've cost you $3,000. Have you ever put money in a parking meter in Chicago? Have you ever stayed in a hotel?"
Payday lenders also argue that they provide an important service to people with little access to traditional credit. They make loans that aren't available in many traditional banks; compared with those institutions, their service is faster and their hours better. In many neighborhoods they're ubiquitous. A payday loan is "easy to get," admits Jennifer, the two-time borrower. "Even when you sign your paperwork and they tell you how much you're gonna pay back—that should make you wanna go out the door. But if you're in a bind and you need the money, you do what you gotta do."
Most payday borrowers are racial minorities, and most are women. A recent report by the Woodstock Institute found that African-American communities were almost four times as likely to have individuals with bad credit scores as predominantly white communities. The lowest average neighborhood credit score in Chicago is in Garfield Park, which is 98.5 percent black; the highest is an area on the city's near-north side with an African-American population of 5.3 percent. Bad credit scores, the authors of the Woodstock Institute report noted, make it harder to get low-cost mortgages, auto loans, and credit cards.
Another report, released in February by National People's Action, studied five metropolitan areas, including Chicago, and found some black and Latino neighborhoods with four times as many payday lending outfits than white neighborhoods. Areas with a prevalence of subprime credit purveyors—like payday lenders—also have a dearth of prime credit options for would-be borrowers, the report noted.
For many people who need money, good alternatives to payday loans simply don't exist. National banks have largely shied away from offering small-dollar, low-interest loans to people with poor credit, saying that they're too risky. (They haven't failed to notice the money that can be made from the business, though—the payday industry relies heavily on financing from major banks like Wells Fargo and JPMorgan Chase.)
Jennifer tells me that when she needed a loan, she didn't consider looking for alternatives to payday. "I have a bank account in Chase and Bank of America—they don't do stuff like that [making small loans]. Maybe if I would've had a credit union, but I don't have a credit union."
Andrea Kovach, a staff attorney at the Sargent Shriver National Center on Poverty Law, helped organize a 2009 symposium designed to promote alternative small loans in Illinois. The Shriver Center and other think tanks and policy advocates comprise the Illinois Asset Building Group, a coalition that aims to promote long-term financial stability in poor communities in Illinois. As activists work to regulate payday lenders at the legislative level, Kovach says, they'd also like to "try to increase the supply of responsible alternatives to payday loans."
Part of the battle is convincing banks that making loans to poor people is sustainable—and maybe even profitable. A few banks make such loans; Kovach points to Lake Forest Bank and Trust, which offers a small loan with an interest rate a little over 8 percent. And most every consumer activist I spoke with identified a local exemplar in the Payday Alternative Loan (PAL) offered by North Side Community Federal Credit Union in Uptown.
CEO Jennifer Sierecki says that North Side instituted the PAL in 2002 at the behest of its members. One customer in particular, Sierecki says, had about seven payday loans outstanding. "She owed about $2,800 in total, and had already paid about $3,000 in interest and fees, and the principal hadn't been paid down. My predecessor, Ed Jacob—he said, well, we can do something that's more reasonably priced and can provide people with options." (Jacob was mentioned in a 2008 Newsweek article by Daniel Gross, "A Risk Worth Taking," as an "ethical subprime lender.")
The standard PAL is $500 (repeat customers are eligible for a $1,000 "Step Up" loan), available every six months at 16.5 percent interest. Though the program has been successful—North Side has made about 6,000 small loans since its introduction—it's only available to credit union members. Sierecki says that in 2003, North Side made the loan available to nonmembers. But because of losses from delinquencies, after two years the credit union restricted the loans to members again.
Andrea Kovach says that community banks and credit unions have generally been more enthusiastic than larger banks about making small-dollar loans—but even they have grown reluctant during the slumping economy. Institutions that do offer such loans aren't always eager to publicize them for fear of an onslaught of customers. "There's a sense that 'If we put up the billboards, our doors will be rushed by all these people that want to get this loan,'" Kovach says.
Like DeLaforgue, Kovach says the regulations that went into effect in March offer "necessary consumer protections." But she's skeptical about the impact they'll have on the landscape of the payday lending industry—and on the nascent attempts of financial institutions to provide alternatives. "Unless some really large national banks get into the game of offering responsible alternative small-dollar loans, it's going to be hard to really make a dent."
E-mail Sam Worley at firstname.lastname@example.org.