January 12, 2004

It started small—a $60 loan from a local payday advance outlet. Pretty soon, Lisa Engelkins was caught in a spiral of debt that would take three years to escape.

A single mother in Winston-Salem, Engelkins has a high school degree and some college credits. In 1998, she was working as a temp and raising her 5-year-old daughter with unreliable child support. "I'd always heard about these payday advance places, they're advertised everywhere. I kind of went in to see how it worked, and I saw how easy it was," she says. She wrote a check for $60, and received $49.41 in cash, paying $10.59 in fees.

A week later, Engelkins was back at Urgent Money Services for another small loan. Within three months, she was a regular customer: to pay basic bills, she would write a check for $300 and get $255 in cash (the store charged a $45 fee for the loan). Two weeks later, the lender would cash the check as agreed. Her $600 biweekly paycheck cut in half, Engelkins would find herself short again, and return to the storefront for another loan—a cycle that happened 19 times between 1998 and 2000.

Lisa Engelkins

Suddenly, she had a bigger problem than the one she'd gone there to fix. "I spent over $1200 in fees to keep borrowing for that one $255 "revolving cash loan" she says. "This was really stressful on me and the weird thing about it is—I hear this from a lot of other people—that most people go in thinking that it's supposed to help them and they don't realize until they're out of it how much of a burden it's become."

Targeting Working Parents
Today's low interest rates should make borrowing money more affordable—but hundreds of thousands of low- and middle-income American families can't take advantage of these rates when they take out a loan, cash a paycheck, wire money to relatives, or carry a balance on a credit card.

Often higher rates charged to certain borrowers are a fair reflection of the extra risk these borrowers present, because they have bad or no credit histories. But advocates warn some lenders charge rates that outstrip the risk and attach exorbitant fees to every transaction—practices that fall under the label predatory lending. Payday lenders in particular have been criticized for their high fees. Critics note that the risk of default is limited, since lenders hold "live" checks and have proof of employment and wages.

What Is Predatory Lending? More than 10 million Americans have no formal relationship with a mainstream bank. To cash checks, they depend on check-cashing outlets, payday lenders, pawnshops, grocery stores and retail outlets that charge upwards of 10-15 percent per check. Payday and tax refund advance companies are considered predatory if they: Charge triple digit interest rates. Despite very low risk of loss, payday lenders typically charge fees equal to 400% APR and higher. Require a short minimum loan term. The Loan must be repaid in full within two weeks (small consumer loans have longer terms). Single balloon payment. No partial repayment is allowed; this encourages chronic borrowing, advocates say. Encourage loan-flipping through extensions, rollovers or back-to-back transactions. Loan an amount greater than lendee's ability to pay. Adapted from The Nine Signs of Predatory Lending, the Center for Responsible Lending

Instant Cash, Growing Debt This year, more children will live through their parents' bankruptcy than their divorce, Harvard Law professor Elizabeth Warren notes in her book,The Two Income
Trap: Why Middle Class Fathers and Mothers are Going Broke. Government data shows it's not consumables like designer clothing, vacations and fancy meals that are pinching families—it's the rising costs of college, health insurance and, for many, basic needs such as housing.

Every year, low-income households spend as much as $5.45 billion a year on check cashing services, payday loans, rent-to-own transactions and auto title loans, according to the Fannie Mae Foundation.

While low-income workers qualified for $30 billion in Earned Income Tax Credits last year, they paid $1.8 billion of that to companies that helped prepare their returns and gave them an advance on their expected refunds. That number is likely to rise if Congress approves a proposal to require more paperwork from those filing for the EITC.

A Booming Business
The non-bank financial services sector is booming. In 1986, there were 1,350 check-cashing outlets in the U.S. In March 2002, there were 13,000 according to the Annie E. Casey Foundation (AECF)—an increase of more than 860 percent.

Payday advance services, like the one Lisa Engelkins turned to, are growing even faster, from roughly 300 in 1994 to well over 8,000 today.

Why such growth? "There's an insatiable demand for short-term credit. Profits are high and we lack an effective regulatory framework to balance the need for credit with protection of the consumer," says Peter Skillern, executive director of the Community Reinvestment Association of North Carolina.

The Community Financial Services Association of America, a trade group of payday lending companies, says its members are there to provide short-term solutions only and tell clients advances shouldn't be part of long-term budget plans.

In many areas, it's not easy to find a bank: Between 1985 and 1995, the number of mainstream bank branches per capita dropped by more than 20 percent—more than half of these closings were in low- and moderate-income neighborhoods. In 2000, almost one in four non-metropolitan areas was serviced by two or fewer banks, according to AECF.

Even if there is a local branch, many financial institutions resist offering loans under $500 (as payday advance companies do), because it costs roughly the same as servicing larger loans, which carry greater returns.

Many households with no credit problems avoid traditional banks because of an inability to maintain minimum balances, distrust, low literacy or, even among legal immigrants, fear of drawing unwelcome attention.

Families in Harm's Way
A short stroll from the Fort Bragg army base in Fayetteveille, North Carolina, lands you in an area teeming with storefronts sporting garish signs hawking rent-to-own furniture and appliances. Others advertise a simple commodity: cash, fast.

Landscapes like this are the reason the National Consumer Law Center recently reported that military families are "in harm's way at home"—threatened by a growing number of unscrupulous and predatory lending operations. The military population, heavy on young couples with young children living on modest military salaries, is particularly susceptible to "no money down" pitches that obscure the costs of a transaction.

When it comes to payday advance services, middle-class parents are the most common customers, according to the Credit Research Center (CRC) at Georgetown University. By definition, they are employed. About 40 percent are homeowners.

Companies typically charge 15 to 17 percent for small short-term loans that range from $100 to $500. If, when the next paycheck arrives, the borrower can't repay the loan, it's "rolled over" for another two weeks. No new money is loaned, but an additional 15 to 17 percent fee is charged. Some borrowers, like Engelkins, repay the loan only to take another one immediately to cover the repayment.

Seventy-five percent of payday advance borrowers renew at least once, according to CRC. In states that allow unlimited roll-overs, a payday loan can carry a more than 400 percent annual interest rate.

Many states have laws limiting roll-overs, and some prohibit them altogether. In these states, borrowers can sometimes get on an installment plan and pay the loan off incrementally.

"That's one of the essential reforms that advocates are calling for," says Skillern. "The two-week balloon payments are what capture people in this cycle of debt. That and the high cost are the two key abuses in the payday lending model."

Advocates say their resources and regulations may not be keeping pace with the burgeoning market. A July, 2003 study by Consumers Union found that Texas payday lenders were routinely skirting regulations on maximum allowable interest rates and limited roll-overs. And pay-day lenders have moved on-line, creating a challenging new landscape for regulators.

For now, the most important tool in fighting predatory lenders is education and financial literacy. In 2002, Lisa Engelkins began working for Consumer Credit Counseling Service of Forsyth County, an agency providing low-cost budget counseling and debt management services. It receives funding from HUD, the United Way, and other sources. Many of the clients are parents in situations similar to hers, some in debt to more than one payday lender at the same time.

"For the folks who live paycheck to paycheck—and there are many, I'm still one of them—there's already money management issues to begin with, payday lending is not going to make it any better at all," says Engelkins.

Financial Literacy Tools
By providing credit counseling and budget planning, offering Individual Development Accounts and other services, community-based nonprofit financial institutions are trying to help more people avoid taking on expensive short-term debt—and even turn the money they'd spend in fees into investments. (See the Connect for Kids article on Individual Development Accounts, Downpayments on a Dream.)

• Credit Smart, Freddie Mac
• The National Community Reinvestment Coalition has developed an extensive financial literacy curriculum and a train-the-trainer workshop outline
• The Federal Deposit Insurance Corporation (FDIC) offers a Money Smart Financial Literacy Curriculum that's available in English and Spanish.

For More Information

• The Center for Responsible Lending
• Brookings Institution report on EITC Advances
• The Community Reinvestment Association of North Carolina
• Freddie Mac's Don't Borrow Trouble
• The Mortgage Bankers Association's Predatory Lending Resources page.

Talk Back

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Caitlin Johnson is a freelance writer.