I originally wrote this article for The Capital Good Fund’s blog

Here’s a simple dilemma that plagues many American families: how does someone that lives from paycheck to paycheck and is without a credit score—and therefore without a credit card—afford to cover unexpected expenses between paychecks, such as fixing a flat tire, a doctor’s visit, or even regular expenses such as groceries and phone bills?  For higher-income families, this simply is not a problem.  For one thing, consider how often you use a credit card to make purchases; doing so enables you to delay paying for the item until you have received your paycheck and can afford it.  And of course, being higher-income by definition means that one can most likely already afford most expenses that occur between paychecks.  But in the case of lower and moderate-income families, a lack of access to credit combined with a lack of savings forces them to so-called payday lenders to make ends meet during the week.

The Definition of, and Problem with, Payday Lenders

If you go to any lower income neighborhood, you will invariably find on almost every street corner places that offer check chasing, payday loans and other fringe and predatory financial products and services. A payday loan is a small loan designed to cover the borrower’s expenses until they receive their next paycheck.  For many Americans, this is the only way to make ends meet.  The problem with check cashing, as a recent article on Slate.com makes obvious, is that “the average payday loan has an annual interest rate of more than 400 percent.” What this means is that “a customer who takes out a $100 loan each pay cycle and repays it the following one will have spent nearly $400 over the course of a year.” The borrower would have been much better off covering expenses with a credit card, as “the APR on most credit card debt is 16 percent” and therefore far lower, but many payday loan customers don’t qualify for credit cards because they have no credit.

The same Slate article pointed out that a recent study by economists at the University of Chicago found that many payday loan borrowers don’t fully understand the true cost of the loan and that “providing a clear and tangible description of a loan’s cost reduced the number of applicants choosing to take payday loans by as much as 10 percent.” In other words, 9 out of 10 people have such urgent interim financial needs that they are willing to pay 400 percent APR to cover them.

Some Interesting Conclusions

These findings lead us to some interesting conclusions.  First, financial education is essential.  If families understand the true cost of their debts they can make more informed decisions about the debts they do incur.  Second, many people would be better off using a credit card to finance interim debt.  In order to be able to get a credit card, however, these same people would need help establishing and building credit to first quality, and then truly take advantage, of a credit card.  Lastly, payday loans borrowers would benefit greatly from financial literacy training. For example, by learning how to budget and coming up with a plan to do so, they could reduce the need for payday loans in the first place, reserving them only for emergencies.

Capital Good Fund is working to offer all of these solutions.  We provide financial literacy to our borrowers, teaching them about budgeting, credit and various loan products.  We are developing a credit builder loan designed specifically for those with no or poor credit history.  This loan is the first step towards being able to get a credit card and qualifying for other mainstream loan products and services, such as mortgages and car loans.  Lastly, we encourage all our borrowers to open and maintain bank accounts, and to use them properly.  Many advocates refer to what they call “the high cost of being poor,” which speaks to the fact that lower-income individuals end up paying more for basic services such as check cashing and loans. The services offered by Capital Good Fund, combined with our loan products–which enable our borrowers to increase personal income and access more benefits through citizenship–are an important step to reducing the cost high of being poor.

Source: 400 Percent APR–Is That Good? Fisman, Ray July 22, 2009 http://www.slate.com/id/2223378