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The Pew Charitable Trusts recently released the fourth report in its series Payday Lending in America. The focus this time is on fraud and abuse in online lending.

The report calls out payday loan structures that are designed to prolong indebtedness by front-loading fees on loans that average 650% APR. It also describes incidents of unauthorized withdrawals after loans were paid off as well as other unfair, deceptive and predatory practices. The report says that some consumers were also threatened.

Regulating these companies has been difficult. Pew estimates that 70% of payday lenders are not licensed by the states in which they do business. Instead, these companies search for jurisdictions with laws that are most accommodating for the type of business they do and use them to govern the contracts they write.

Interest rates are a good example of how that can affect consumers. Usury limits vary among states. So does the manner in which they’re calculated. An unscrupulous lender’s goal, therefore, would be to select as its governing state the one that permits the highest rate or the most latitude for calculating it. Lately, however, several states—such as Arkansas, Colorado, Illinois, Maryland, Minnesota, New York, North Carolina, Vermont, Washington and West Virginia—are challenging the legality of this tactic with some success.

How Payday Loans Work

Consumers who are having trouble making ends meet—either because of an unexpected expense or because their household budgets are out of balance—are the most likely to pursue short-term financing to help bridge that gap. But because of their tenuous financial circumstances or limited ability to pledge valuable collateral to secure the loan, they’re unlikely to gain access to credit that’s reasonably priced—or any credit, for that matter. (Editor’s Note: Good credit means access to better interest rates. You can see where your credit scores stand for free on Credit.com.)

Payday loans were developed to address this need. The consumer-borrower pledges next week’s paycheck—which acts as the aforementioned valuable collateral—for the cash he needs today. Bill-pay loans are a variation on this theme, where consumers borrow to pay this month’s utility or cellphone bill with cash that’s advanced from next month’s paycheck. Also similar are so-called merchant advance loans that are marketed to small businesses, although in that case, today’s cash comes from next week’s or next month’s accounts receivable.

There are two fundamental problems with this mode of financing. The first is that it’s almost certain to inspire repetitive borrowing. That’s because loans of this type aren’t introducing new cash into a consumer’s household or small-business’s operation. Rather, it’s speeding up the cash these borrowers would otherwise have received in normal course. Consequently, the cash-flow hole that’s created when next week’s paycheck or next month’s accounts receivable is exchanged for a roll of hundreds today will need to be filled a week or month later, unless the borrower’s financial position improves by a factor of two.

The second problem has to do with cost. Aside from the obvious greed factor on the part of certain lenders, these loans are comparatively expensive because they’re outstanding for a relatively short period. But that seems counterintuitive given that brevity of tenure is a traditional hedge against risk.

The reason is, it costs money to approve, document, fund and service (collect payments for) a loan—costs that are typically spread over the life of the contract. So the longer the loan’s duration, the less of an impact the adding-on of these costs will have on the payment amount. The interest rate is also only moderately affected because of the effect that the time value of money has on the calculation.

The opposite, though, is true for short-term loans. And in the case of certain payday loans in particular, some lenders exacerbate that problem by structuring their contracts so that fees are credited before principal.

Setting Standards

With all that in mind, PCT suggests several policy considerations: Ensuring that borrowers can actually afford to repay their debts, requiring that loan costs are more evenly spread over the duration of the contract, and that consumers are protected against predatory practices.

But what’s needed most is regulatory oversight at the federal level that would be responsible for enforcing a set of standards that govern all short-term lending—for the benefit of consumers and small businesses alike. Usury limits, for example, should be annual APR-based, and practices that are intended to take advantage of unwitting borrowers should be outlawed.

The APR calculation combines interest rates and fees into a single metric that enables prospective borrowers to easily compare alternative-financing offers. No longer would unscrupulous lenders stand to gain from parsing the true charge into separate categories of interest rate and fee, or by shopping for jurisdictions that calculate usury by taking only one of these elements into account.

So, too, would borrowers be protected against lenders that, for example, change their so-called merchant identifiers, which they do to circumvent the automated clearing house (ACH) blocks that borrowers put into place to prevent post-repayment debits against their accounts. The same goes for borrowers whose loan agreements require them to share user names and PINs, even though these should also be changed as soon as the last payment is made.

Short-term lending plays a legitimate role in the realm of consumer and small business finance. What must be done, however, is to reform or remove those players whose business practices are harmful or corrupt. But given how much money is at stake (payday lending alone is a $27 billion a year business, according to the Center for Responsible Lending), the often fragile financial positions of the borrowers who seek these products and the cunning intractability of some of the companies involved, Pew is correct to call upon the regulators to pick up where the industry’s self-policing efforts have left off.

This story is an Op/Ed contribution to Credit.com and does not necessarily represent the views of the company or its partners.

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