Why Loan Sharks Get Five-Star Reviews — and Why It Matters

Nathan Mayo

“It’s time to end this … system of exploitative lending that keeps Americans trapped in debt. Rates on all consumer loans and credit cards should be capped at 15%.”

“I have such amazing service every time I go in to get a loan! I highly recommend coming in when you need a helping hand. They won’t let you down!”

You shouldn’t be surprised that both quotations are from people talking about payday lenders. The first is Senator Bernie Sanders; the second is a representative Google review from a payday loan user.

According to a study by Pew Charitable Trusts, the average payday loan has a jaw-dropping 390% APR. In contrast, my standard-issue credit card charges 0% for the same two-week loan. Not only that, the average loan user rolls the loan over for five months and takes out eight loans a year, which costs him $520 in annual interest. Dig even deeper, and you’ll find that 69% of loans are used for recurring expenses and 8% for nonessentials like vacation and entertainment. This means that most loans are used routinely to make ends meet, rather than for dire emergencies.

With the poor spending so much in a cycle of dependence on high-interest loans, it looks like Sanders has a point. The system seems quite exploitative. Under such circumstances, it seems like the easiest way for the victims to exact a little revenge would be to post an anonymous review to warn others: “It’s a trap!”

Yet, pick any city and search for payday lenders. I picked lenders in Fresno, California, listed on Google Maps and scrolled through the top 50. Only five had a lower rating than four stars, and many were five-star-rated — with hundreds of positive reviews. As one said, “Almost thirty years I’ve been coming here, I can’t give enough five stars!” Compare that to banks in Fresno: 38 of the top 50 were rated lower than four stars. It’s not close; compared to other financial institutions, payday lenders are beloved by their customers.

So most customers like the system, but that begs another question: If customers like the system, does that mean it’s good?

Not necessarily. Just because people like something doesn’t mean it helps them achieve their long-term goals. Indeed, cigarettes may get good reviews — yet there are millions of chain smokers suffering from cancer or emphysema who regret their decision.

On balance, there are responsible use cases for short-term loans. People with poor credit just getting started — or re-establishing themselves after a financial loss — may need a few days’ worth of margin to get by.

Yet the typical consumer uses them as an open line of credit — and the burning question is “Why?” Ignorance is at least one factor, as people in poverty are measurably worse at financial literacy. Deceptive lender practices may be another contributor. Cultural norms are likely another, i.e., the same dynamic that drives many in the middle-class to remain in credit-card debt to “keep up with the Joneses.”

Although market advocates prefer to believe that the majority of human economic decisions are rational and that absolute bans do more harm than good, there’s decent evidence that banning payday lenders has net positive effects: When forced to quit, the evidence shows that most former customers just choose not to use credit, rather than turn to a black market alternative. Similarly, the much-maligned Prohibition era effectively reduced mortality and violence, and improved health. And if junk food were banned, I’d eat less, because while I enjoy it, I wouldn’t expend the energy to hunt down speakeasy burgers and fries.

Yet, net positive effects are an insufficient reason to ban these lenders. Even Bernie Sanders doesn’t favor banning alcohol or grease, ostensibly because he believes people ought to have some level of agency to make choices.

Still “loan sharks’” immoral wealth at the expense of the poor seems to provide a rationale for restrictions on their lending practices, doesn’t it?

Alas for the demagogues! Payday loans are a low-profit business. External industry analysis puts the average storefront lender’s profit margin at around 4%, half of a typical Starbucks franchise (9%) and three times less than mainstream commercial lenders (13%).

As counterintuitive as that seems, it makes sense. First, the loans are small and short-term, so anything less than a triple-digit annual interest rate would generate only a few pennies. Second, operational costs are very high, as the business model involves brick-and-mortar stores and full-time employees. Third, default rates are very high because most customers have been rejected by credit card companies and thus pose a high default risk. Finally, competition is steep, which forces payday loans to efficiently meet the demands of their customers. A typical small town will have half a dozen lenders and hundreds of online competitors.

So three cheers for capitalism and 390% interest rates for the poor, right?

Not so fast.

The payday loan industry is a good example of a market limitation. Namely, free markets are based on exchange. They generate tremendous wealth through voluntary exchanges. However, if you can’t offer much value, you won’t receive much in return. That can leave low-income consumers in a vicious cycle of setbacks: They want to improve their situation but can’t recover from loans taken to cover the cost of flat tires, broken phones, or infected teeth.

Politicians usually “fix” these problems by berating the market for its inability to provide unprofitable goods and services or by generating government subsidies for people in need. These aid programs are inevitably one-size-fits-all and create perverse incentives that don’t improve upon the market’s limitations.

Fortunately, the market and state are not the only shows in town. Civil society — a voluntary cooperative motivated by love — is a powerful third sector. If this sounds too good to be true, recall that hundreds of millions of Americans contribute very little to the market during the first 18 years of their lives, relying instead on their families’ generous support.

Other facets of civil society are well adapted to serve people in poverty. Extended families, neighborhood associations, religious communities, and nonprofits can provide education to those stuck in poor financial situations by poor choices… and offer better options to those for whom payday loans are the only viable source of credit.

Can private charity fundamentally change the financial system for the poor?

It has in the past. Despite having drifted from their original purpose, pawn shops were invented by 15th-century Italian monks to assist the downtrodden. Today, low-interest micro-loans and mutual lending circles carry on this tradition. Likewise, the True Charity Network is a national coalition of churches and nonprofits that empower people to exit poverty and lead flourishing lives.

Part of those efforts center on helping people gain independence from payday loans. Member organizations offer relevant financial education, mentorship, transportation, affordable housing, awards for performance, scholarships, and temporarily subsidized food to help people get on their feet. Some even offer matched savings or no-interest cash advances in direct competition with payday lenders. This is accompanied by a gentle yet firm insistence that people do what they can to improve their situations.

Those who participate in such programs can end the use of routine payday loans via charitable options for borrowing in an emergency. This provides both a short- and long-term solution, as growth in their relationships and financial stability eventually means they no longer need to rely on their church benevolence fund. While many in poverty already benefit from such solutions, many others could be helped if more Americans believed civil society is as competent to solve issues in poverty as Uncle Sam or Silicon Valley.

I would love to see payday lenders close up shop for the same reason smallpox specialists no longer exist — because there is no demand for their services. Such a shift is only possible when a robust civil society addresses root causes outside of the reach of both government programs and market innovations.

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