In nearly every New Mexico legislative session there are proposals to regulate payday loans and other short-term loans to sub-prime borrowers. In the most recent legislative session a constitutional amendment was proposed to cap the total charges on all loans at an annual percentage rate of 36 percent.
The proliferation of lenders clearly demonstrates there is a substantial demand for short-term loans. Because of the short duration of the loan, the substantial possibility of default, and the lack of sophistication of many borrowers, the effective annual percentage rate on such loans can easily exceed 100 percent or 200 percent. Lenders assert that 36 percent or a similar cap would eliminate most short-term lending.
An alternative to capping interest rates would be to try to generate options for short-term borrowers in addition to existing lenders.
One possible alternative to payday loans is employer loans. Almost by definition, a payday borrower has a job and is taking out a loan intended to be retired on his next payday, or one or two paydays later.
The most efficient source of such a loan is probably the employer. The employer knows whether the employee is a substantial credit risk. Assuming the employee is unlikely to be fired, the loan should be collectible. The transaction costs of an employer making a loan would be slight, and the employer probably would not need to go to credit markets for financing.
Changes would be required in New Mexico’s lending laws and employment laws to permit employers to make these loans and to charge fees or interest. Employers may be willing to accommodate employees with occasional loans but unwilling to become licensed as small loan companies.
In addition to legal changes, changes in public perception are necessary. It seems unrealistic to evaluate these very short-term loans with the commonly-used metric of annual percentage rates. An employer who makes a $500 loan for two weeks and charges a fee or interest of $15 would be charging an annual percentage rate of approximately 80 percent. Charging employees such a percentage rate might be criticized, but this would be a more favorable arrangement for the employee than is easily available in the existing market.
Another alternative to existing payday loans, besides employer loans, is a market-based solution.
Advocacy groups and reform-minded individuals assert that the short-term loan business will thrive and meet the demand even with much lower interest rates. The 36 percent rate in this year’s proposed constitutional amendment is frequently suggested.
If this is true, and if current lenders are over-charging, there is a market opportunity. A lender charging lower rates should be able to capture a sizeable portion of the market.
People who believe it is possible profitably to make small short-term loans at 36 percent APR, or some other rate substantially below the existing market, should do it.
Entering the short-term loan business is not expensive. The principal requirements are one or more offices, a few employees and working capital or a line of credit of a modest amount. Advocates who believe it is possible and important to reduce the cost of these loans should find and fund someone to operate such a business.
Optimally, the business would profit, the borrowers would be treated fairly, and existing lenders would have to lower their rates to compete.
While many reformers may not wish to engage in this business, a few might see an opportunity to profit and to serve a socially useful mission.
An interim legislative committee, employers and advocates of reform should address these issues before the next legislative session.
Dick Minzner is a former New Mexico Taxation and Revenue Secretary.