Legal loan sharking or essential service? The great "payday loan" controversy.

FEW THINGS FIRE up professional consumer advocates as quickly as a whisper of "payday lending."

"Payday loans are a transfer of wealth from the poor and the poor-risk to the predatory and the powerful," says Jean Ann Fox, director of consumer protection at the Consumer Federation of America. "America hasn't come very far from the turn-of-the-century 'salary buyers' and 'loan sharks.'"

Indeed we haven't. People have always needed small, short-term loans, and others have always been willing to provide them. Fox is right: Today's thriving industry of payday lending looks a lot like the "salary lenders," later renamed "salary buyers," that thrived in the late 19th and early 20th centuries. "In current dollars, they would buy $650 worth of salary by writing a check for $500," says Lendol Calder, a professor of history at Augustana College and author of the 1999 book Financing the American Dream: A Cultural History of Consumer Credit.

These days, if a person wants to borrow $200 on the first of the month, he'll write a check for $234 dated the 15th When the 15th rolls around, either he pays off the loan in cash or the lender cashes the check. If he can't afford to pay off the entire amount, the lender will roll over the loan for an additional fee.

One hundred years ago, the leading critic of "salary loan lending" called such people "sharks, leeches and remorseless extortioners." Today's consumer advocates call payday lenders "predatory" and "legal loan sharks."

"It is as misinformed and as vicious a fight as you'll ever see," says Thom Branch, senior vice president of the Union Bank of California. Branch entered the fray when he led his employer's effort to partner with Nix Check Cashing, a purveyor of payday loans. "It's been ugly. It's not a new ugly, and it's based on misinformation and paternalism that is misplaced on the best of days."

Branch is on to something when he talks about the Critics' paternalism. "Borrowing money at triple-digit interest rates is never the right solution for people in debt, decrees Consumers Union in a fact sheet on payday loans. The U.S. Public Interest Research Group (U.S. PIRG) and the Consumer Federation of America also know what's best for cash-strapped people. "Consumers in need of short-term cash [should] avoid extremely expensive short term loans, and [should] instead build up a savings nest-egg to cover financial emergencies, seek budgeting and debt management assistance from non-profit consumer credit counseling services, and shop for credit based on both the dollar finance charge and the Annual Percentage Rate," advise the two organizations in a summary of a November 2001 study bashing the payday loan industry.

Yet people short on money often neglect the advice of the professional scolds and instead turn to the damnable moneylenders. This was true a century ago, when, Calder notes, many people preferred to pay higher rates at pawnshops rather than listen to the personal finance lectures that charities would impose as a condition of a lower-interest loan.

Such behavior is still with us today. The best estimates peg the short-term loan industry as growing from a few hundred stores at the start of the last decade to roughly 10,000 today, lending nearly $14 billion a year. Unlike the majority of customers at check cashers, every payday loan customer is part of what consumer advocates consider the financial mainstream: To get payday loans, they must have a checking account and a steady job. Half the borrowers come from households with incomes between $25,000 and $50,000 a year, according to an industry-funded study conducted by Georgetown University's Credit Research Center. A quarter make more than $50,000 a year, and a quarter less than $25,000.

Payday loans "are a product of middle-class idiocy," says the Progressive Policy Institute's Anne Kim, who studies the issue. "Can't you just wait two days for that new TV set?" Edmund Mierzwinski of U.S. PIRG has a more measured response: "Consumers' financial literacy is unfortunately not necessarily high enough that they are aware that an 18 percent overdraft loan on their checking account is better than a 350-to-700-percent payday loan."

But according to the Georgetown study, three out of four customers pegged the dollar cost of their loans accurately. The annual percentage rates may well be sky-high, but payday loans are often less expensive than the alternatives: bounced check fees or illegal loan sharks. "The average bounced check costs $6o in fees," says Billy Webster, CEO of Advance America, a payday loans company, and president of the Community Financial Services Association of America, the industry trade group. The payday lenders are assailed for collecting $1.6 billion in fees a year, but Webster says banks charge $7 billion a year for bounced checks. "If you convert that to an APR," he says, "it goes up to more than 5,000 percent."

State legislators don't always agree with Webster. Nineteen states prohibit payday loans outright, while another 25 (and the District of Columbia) regulate the industry. Last year, North Carolina legislators thought they'd snuffed out the industry when they allowed the law that authorized payday lenders to sunset.

Such legislative action hasn't been able to keep up with innovation in the financial services sector. For years now, credit card companies have gotten around state-imposed interest rate ceilings by adopting a federal charter in a liberally regulated state (that's the reason why so many credit card issuers are based in Delaware). Similarly, payday lenders are teaming up with banks to offer short-term, high-interest loans in states that outlaw them. Consumer activists decry this as a "rent-a-bank" scheme and have asked federal regulators to clamp down on the practice. In late 2000 the Comptroller of the Currency, which regulates U.S. banks, put banks on notice that it would scrutinize their payday lending operations. A year later, citing regulatory violations, it forced Eagle National Bank to end its relationship with Dollar Financial Group, the country's second-largest check cashing chain.

This regulatory cat-and-mouse game also has a precedent from a century ago. "When states cracked down on salary lenders in the 1880s and 1890s," notes historian Calder, "they renamed themselves salary buyers." Critics of the practice even managed to put the largest salary buyer in prison. But 100 years later people still want small loans. And others are happy to provide them--at a price, of course.