Since the 1990s, millions of Americans have borrowed small sums of money each year through payday lenders or by overdrafting their checking accounts, often with poor results and high costs. But the market for small-dollar credit has improved substantially in recent years, thanks to state and federal reforms.
A look at the history of small loans and what has changed helps provide context on the underlying problems and how to ensure a safe and affordable future for borrowers.
Mass market for consumer credit replaced salary loans
In the early 1900s, unlicensed “salary lenders” offered one-week loans at annual percentage rates (APRs) of 120% or more using a borrower’s wages as collateral. As wage garnishment and abusive collection practices spread, state lawmakers sought to create a mainstream consumer credit market from state-licensed lenders. The Uniform Small Loan Law, guidance for states published in 1916, permitted 42% annualized interest on loans of up to $300 (equivalent to more than $8,000 today). Two-thirds of states adopted some form of the law.
As the century progressed, larger consumer loans from banks and credit unions became commonplace for borrowers with strong credit histories, but small loans to customers with limited or weak credit histories remained rare. Federally chartered banks and credit unions have long enjoyed exemptions from state laws, so they were not governed by the Uniform Small Loan Law or other state-level consumer protections. Federal law can provide meaningful alternative protections, but two important gaps emerged in the market for small-dollar credit.
Two major exceptions in the regulatory framework
Modern payday loans emerged in the early 1990s, in part due to industry deregulation and a lack of mainstream providers of small loans. Deferred presentments (small loans made against a check postdated to the borrower’s next payday) became legal in more than 30 states. These “payday loans” carried APRs usually over 300%—a practice made legal in most cases via statutory exemptions from state usury rate caps.
Meanwhile, fee-based overdraft became common on checking accounts from depository institutions. Fueled in part by federal regulatory decisions to treat overdraft as a service and not a loan—which exempted the practice from Truth in Lending Act disclosures and other protections—bank overdraft fee revenue grew steadily and exceeded $15 billion as recently as 2019.
Struggling consumers wanted better options
Most payday loans are for recurring expenses, such as rent or utilities. About 80% of payday loans are renewed or quickly reborrowed. This is because the single, lump-sum payment takes a third of a typical borrower’s next paycheck and a new loan covers the gap created by the prior loan. All payday loan customers have a checking account—lenders require it—and about 8 in 10 said in a survey that they would borrow from their bank if it were possible. Yet until recently, overdraft was virtually the only alternative their banks offered. There is evidence that a third of overdrafters use it intentionally to borrow money.
Regulators successfully encouraging banks to provide safe small-dollar credit
More than a decade ago, a handful of banks created “deposit advance” products that mimicked payday loans. But the products drew regulatory scrutiny for replicating the shortcomings of payday loans—including unaffordable lump-sum payments that took a quarter or more of typical borrower paychecks—and most disappeared by early 2014.
By 2018, U.S. Bank became the first major bank to offer a true credit alternative to payday loans—available to those with damaged credit histories, repayable in affordable installments, and costing only a small fraction of what a payday loan costs. In 2020, joint guidance from federal regulators greenlighted this kind of small installment loan or line of credit from all banks and credit unions. By 2023, six of the eight largest banks offered responsible small loans. Meanwhile, many large banks eliminated or substantially improved their overdraft programs. In just five years, loans that cost 15 times less than payday loans, with far superior consumer protections, became available nationwide to millions of individuals. Going forward, this has the potential to dramatically alter the market for payday loans and other high-cost services, such as auto-title loans and rent-to-own agreements.
States start to modernize their laws
Payday lenders today operate in 32 states, down from 36 in 2014 and more than 40 in the mid-2000s after some states effectively outlawed them. Several allow single-payment payday loans with limited safeguards to reduce cost or usage. But most payday loan states have few safeguards in place.
In 2010, Colorado became the first payday loan state to reform its law by requiring equal periodic installments and other safeguards, including substantially lower prices (borrowing $500 for four months now costs about $110, versus $600 or more in conventional payday loan states). The Colorado law achieved the goals of its creators by making loans dramatically safer while keeping them widely available.
Hawaii, Ohio, and Virginia have similarly modernized their payday loan statutes. In each case, reforms replaced single-payment payday loans with loans repaid in small installments, and they prevented loopholes such as brokering fees. Evidence shows that these reforms corrected the problems of single-payment payday loans while reducing the typical cost of borrowing by hundreds of dollars and keeping credit widely available from state-licensed lenders.
The future depends partly on action by banks and credit unions
Experts, and common sense, caution against borrowing money to make ends meet. But for too many Americans, this is an unfortunate reality. Responsible small installment loans and lines of credit from banks can meet this need while saving customers billions of dollars per year compared with nonbank alternatives. This is true for the 12 million individuals who use payday loans (including payday installment loans and similar high-cost lines of credit) each year, despite having a checking account, and for millions of others who use services such as pawn, rent-to-own, or auto-title loans. Banks are now offering small loans to millions of customers in this market while adhering to standards of safety and affordability. If regulators and community advocates continue to support it, and with leadership from bank executives, this positive trend is poised to continue.
Continued modernization of state laws also essential
Experience has shown how states can successfully reform their payday loan laws. The single-payment feature of payday loans should be outlawed. This could be accomplished through traditional usury rate caps such as those enacted in Illinois, Nebraska, New Mexico, and South Dakota. If done right, this stops payday and other high-cost loans, as banks and credit unions step in to increasingly make safe credit available.
Alternatively, if lawmakers want safer forms of small-dollar credit available from state-licensed lenders, they should follow the modernizing example of states like Colorado, Hawaii, Ohio, and Virginia. In these states, payday loans are now repaid in small installments and cost three to four times less than before the reforms, credit continues to flow, and safeguards prevent loopholes and abuse.
Federal regulators can help by stopping bad actors from abusing relationships that enable lenders to avoid state consumer protection laws and continuing to encourage banks and credit unions to provide small-dollar credit that meets standards of safety and affordability.
Alex Horowitz is a principal officer and Gabe Kravitz is an officer with The Pew Charitable Trusts’ consumer finance project.
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