Sunday, April 10, 2005
The politics of the Alternative Minimum Tax
The alternative minimum tax is similar in some ways to a flat tax that blocks people from using most of the big deductions that reduce their taxable income under the normal rules. A married couple with a gross income of $100,000, for example, must first calculate its tax bill the traditional way, then again under the A.M.T. In the alternative calculation, the couple gets to exclude $58,000 from taxation, but it must also strip out all the personal exemptions and most itemized deductions.
The prohibited deductions include those for state and local taxes, medical expenses, employee business expenses and interest on home-equity loans. The A.M.T. would then apply a flat tax of 26 percent (28 percent for couples who earn more than $175,000). The couple must pay whichever is higher, the tax calculated under the traditional method or the one under the A.M.T.
The huge looming tax increase is caused by two things. The first is that the exclusion level for the alternative minimum tax is not adjusted for inflation, so the tax affects more people each year as nominal incomes go up. The second, paradoxically, stems from Mr. Bush's tax cuts of 2001 and 2003.
Those cuts reduced regular tax rates at all income levels but did not change the alternative minimum tax. At the same time, some of the cuts came in the form of expanded deductions - the child tax credit, child care tax credits and bigger exemptions for married couples - that are not allowed under the alternative formula.
The impact of the AMT over the next few years will be considerable if the tax isn't reformed:
According to the Times, the AMT will suck up so much revenue that it will virtually replace the Bush cuts to the federal income tax:
Seen or unseen, the looming [AMT] tax increases are almost as large as the president's tax cuts. Leonard E. Burman, a senior fellow at the Urban Institute, estimated that the government would have to raise ordinary income tax rates substantially in every bracket to offset the money lost in each bracket by the elimination of the alternative minimum tax. People in today's 28 percent bracket, for example, would have to pay a top rate of 35 percent. Those who now pay a top rate of 33 percent would pay 41.4 percent.
This is obviously frustrating both to Republicans -- who actually want to cut taxes -- and to Democrats, who want to accuse Republicans of having destroyed the fiscal condition of the country. President Bush, for his part, has appointed a bipartisan advisory panel to come up with recommendations for reforming the AMT as part of a broader reform of federal taxation, but has made it clear that any proposed reform must be neutral to revenues in the aggregate.
The problem is, it is hard to see how it is to the political advantage of Republicans to reform the AMT. As I have written before, if the Republicans were to reform the AMT they would accomplish four things, none of which will obviously benefit them politically.
First, remember that the AMT was designed as a parallel tax system specifically to nail high income tax avoiders. If Republicans repeal the AMT, Democratic candidates and lefty 527s will hammer at that point in the next election campaign with all the deceptive advertising they can muster. Any repeal of the AMT, therefore, must be accompanied by other taxes elsewhere that innoculate Republican Congressmen from those advertisements. It is hard to imagine what those other taxes could be, unless they clearly land on the "rich."
Second, the AMT particularly penalizes relatively affluent people who live in states with high taxes, because it eliminates the deductions for state and local taxes. The high tax states are virtually all "blue states." Repeal of the AMT would shift wealth from low tax states -- which tend to vote Republican -- to high tax states like New York, New Jersey, Massachussets and California. Why would Republicans as a group (as opposed to the Republicans from high tax states) want to shift money from red states to blue?
Third, because the AMT eliminates the deductibility of state and local taxes, the growing application of the AMT will increase the pressure on the incumbant governments in the high tax "blue" states. Voters in New Jersey, which has high taxes, will be a lot more upset about their state and local taxes when the federal government stops paying them back for 35% of them. Since most of the incumbants in the high tax states are Democrats, the looming backlash against state and local taxes should benefit blue state Republicans.
Fourth, elimination of the AMT will make it a lot more difficult to reduce the federal budget deficit. If the Republicans try to make up for the revenue loss with spending cuts, the Democrats will attack them. If the Republicans increase other taxes to cover the difference, both other Republicans and Democrats will attack them. Finally, if the Republicans merely allow the deficit to balloon they will offend the remaining fiscal conservatives in their ranks (and there are many), and the Democats will still attack them. Some Democrats will also attack if Republicans do not repeal the AMT, but that will put Democrats in the position of arguing for more tax cuts, which will be very confusing in light of their complaints about Bush's tax cuts during the last two election cycles. In any case, the AMT was enacted in 1969 by a Democratic Congress, a point that Republicans will happily make in response.
For these reasons and perhaps others, the Republicans who control the Congress and the executive branch will not support repeal of the AMT without some change in the political calculus. That change might come from increasing awareness of the AMT among relevant voters of the AMT, but that will not happen soon because the first voters to care about it will be residents of high-tax, mostly Democratic states. The mainstream media might also make a difference -- the New York Times has run a series of stories on the AMT in the last couple of months, each with a misleading lede designed to increase pressure on Republicans. Today's story, for example, begins with this paragraph:
CYNICS have long predicted that the Bush administration, plagued by budget deficits, will eventually start raising taxes. But now it is becoming clear how it would do so: the alternative minimum tax.
Of course, the fact of revenues increasing under existing law has never before been referred to as "raising taxes," but the Times knows that if it characterizes it as such the pressure on Republicans will increase.
Finally, the President's bipartisan panel, which has some very smart people on it, may suggest changes in other taxes that so benefit Republican constituences or so innoculate Republican legislators that they will sacrifice the AMT in return. We eagerly await the panel's recommendations, since they will undoubtedly constitute an improvement to our present means of raising revenue.
10 Comments:
By 
SeekerBlog.com, at
Mon Apr 11, 01:17:00 PM:
Thanks for the AMT essay, the best I have seen on the effects - such as the red/blue distribution.
Have you any thoughts on the wisdom and political feasibility of the Optional Flat Tax?
Bush favors bold action - I'm surprised he has not proposed a Flat Tax plan. The Optional structure should make it much easier to sell and to introduce.
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A payday loan is a short-term loan that you promise to pay back from your next pay cheque. A payday loan is sometimes also called a payday advance.
Normally, you have to pay back a payday loan on or before your next payday (usually in two weeks or less). The amount you can borrow is usually limited to 30 percent of the net amount of your pay cheque. The net amount of your pay cheque is your total pay, after any deductions such as income taxes. For example, if your pay cheque is $1,000 net every two weeks, your payday loan could be for a maximum of $300 ($1,000 x 30%).
Before giving you a payday loan, lenders will ask for proof that you have a regular income, a permanent address and an active bank account. Some payday lenders also require that you be over the age of 18.
To make sure you pay back the loan, all payday lenders will ask you to provide a postdated cheque or to authorize a direct withdrawal from your bank account for the amount of the loan, plus all the different fees and interest charges that will be added to the original amount of the loan. The combination of multiple fees and interest charges are what make payday loans so expensive (Click here for an explanation of the various fees associated with these types of loans.
The lender should also ask you to sign a loan agreement. If the lender does not offer to give you a copy of the loan agreement, ask for one. Read this document carefully before signing it, and keep a copy for your records
How and when do I pay back the loan?
A payday loan agreement usually says that you must pay the total amount you owe for the loan on or before the date stated in your loan agreement. This includes the amount you borrowed, plus interest and any additional fees and charges.
Some lenders will cash your postdated cheque or process your direct withdrawal on the day the loan is due. However, some lenders may require that you pay the loan in cash, on or before the due date.
If you have not paid the loan in cash by the due date, some lenders may cash your cheque or process the direct withdrawal you signed on the day after your loan's due date, and charge you another fee. Ask the lender what the most inexpensive way is for you to repay your loan.
How does a payday loan affect my credit report?
Credit-reporting agencies collect information on whether or not you make your payments on time. This information, also called your "credit history", is part of your credit report and is used to calculate your credit score.
Making payments on time can help improve your credit score by demonstrating that you are able to manage your debt. Even if you have poor credit, you can rebuild it by using a credit card or other type of credit and paying back the money you owe on time.
This is not the case with payday loans. Since payday lenders are not currently members of the main credit-reporting agencies, getting a payday loan and paying it off on time will not improve your credit score. However, if you do not pay your loan back on time and it is sent to a collection agency, this will likely be reported to a credit-reporting agency and could have a negative impact on your credit report.
How much will a payday loan cost?
A payday loan is much more expensive than most other types of loans offered by financial institutions such as banks or credit unions. Before you apply for a payday loan, find out about all the fees and charges you will have to pay — including the fees you will be charged if you cannot repay the loan on time. The fees may not be easy to see right away, so read the agreement carefully before signing it. If you do not receive an explanation of all of the fees, charges and interest that will apply to the loan, or if you are not satisfied with the explanation you receive, do not sign the loan agreement.
How does the cost of a payday loan compare with other credit products?
Payday loans are much more expensive than other types of loans, including credit cards. But how much are you really paying? How does the cost of a payday loan compare with taking a cash advance on a credit card, using overdraft protection on your bank account or borrowing on a line of credit?
Let's compare the cost of using different types of loans. We'll assume that you borrow $300, for 14 days. Note the considerable difference in the cost of each type of loan.
Things to consider before you apply for a payday loan
Even if you think you may be turned down, ask your bank or credit union for overdraft protection on your bank account, or a line of credit. These are relatively inexpensive ways of obtaining access to extra funds, for short-term use.
If you are turned down for any of these credit options, ask why. If the reason is that you have a poor credit history, contact the three credit-reporting agencies to get a copy of your credit report. Read the reports carefully to make sure that all of the information in it is correct. If you find any errors, contact the credit-reporting agency to find out how you can have the information corrected. The three major credit-reporting agencies in Canada are Equifax Canada, TransUnion Canada and Northern Credit Bureaus. All three of these agencies will give you a copy of your credit report for free if you request that it be sent to you by regular mail.
Ask yourself if you really need to take out a loan, or whether you can get by until your next pay cheque. If you need the money immediately, try to make other arrangements. For example, you may be able to cash in vacation days. Or you might consider getting a short-term loan from a family member or a friend.
If you find that you need to apply for a payday loan because you have no alternative, only borrow an amount that you are 100 percent sure you can repay on the due date of the loan.
Don't borrow more than you need.
Things to consider if you take out a payday loan
Don't be afraid to ask a lot of questions. Read carefully — and take home with you — a copy of the loan agreement that you are being asked to sign. Don't feel pressured to sign the loan agreement right away if you have questions and want more time to read through the agreement on your own. If the lender does not want to give you a copy of the agreement, look for another lender.
Be sure to ask about all the fees, charges and interest that apply when you first get the loan, and what other charges you will owe if you can't pay the loan back on time.
If you are taking out a payday loan at another location to pay back the first payday loan, or you are extending or "rolling over" the loan that you had with the same lender, you could find yourself in serious financial difficulty. The fees, charges and interest will add up quickly on these types of loans, which can put you into serious debt.
How can I figure out the cost of each type of loan?
To estimate the total cost of a loan, including the annual cost of the loan expressed as a percentage of the amount borrowed, follow the steps below.
Step 1:
Determine how much interest you will pay. First, find out the annual interest rate that applies to the loan (if there is one). Figure out the daily interest rate by dividing the annual interest rate of the loan by 365 days. Then, multiply that rate by the length of time you are taking the loan. Finally, multiply the result by the amount you will borrow, in dollars:
Amount of interest
= Annual interest rate
--------------------------------------------------------------------------------
365 days × Length of the loan
(number of days) × Amount of the loan
Step 2:
Determine the total cost of the loan by adding any fees that may apply to the interest you will have to pay. Find out what fees apply to the loan and add them to the cost of the interest, found in Step 1:
Total cost of the loan = Amount of interest + Total fees
Step 3:
Estimate the annual cost of the loan, expressed as a percentage of the amount borrowed. First, divide the total cost of the loan, found in Step 2, by the amount of the loan. Then, divide this rate by the length of time you are taking the loan (in days) and multiply it by 365 (the number of days in the year):
Annual cost of the loan (%)
= Cost of the loan
--------------------------------------------------------------------------------
Amount of the loan ÷ Length of the loan
(number of days) × 365 days
Let's find out the cost of a $300 payday loan, taken for 14 days.
We'll assume that the lender charges you a one-time set-up fee of $10 and a service fee of $40, which includes interest on the loan.
Step 1:
Determine how much interest you will pay. In this case, there is no interest fee. The interest is therefore $0.
Step 2:
Figure out the cost of the loan by adding together any fees that apply and the interest you will have to pay. In this case, you would add the $10 set-up fee and the $40 service fee together:
$10 + $40 = $50
Step 3:
Estimate the total annual cost of the loan, expressed as a percentage of the amount borrowed:
Annual cost of the loan (%)
= Cost of the loan
--------------------------------------------------------------------------------
Amount of the loan ÷ Length of the loan
(number of days) × 365 days
= $50
———— ÷ 14 days × 365 days
$300
= 4.35 or approximately 435%
The total cost of the payday loan would be $50 with an annual cost of 435 percent of the amount borrowed.
Information asymmetries are common in credit market models, but the usual assumption,
at least in commercial lending, is that borrowers are the better informed party and that
lenders have to screen and monitor to assess whether firms are creditworthy. The opposite
asymmetry, as we assume here, does not seem implausible in the context of consumer lending.
“Fringe” borrowers are less educated than mainstream borrowers (Caskey 2003), and many
are first-time borrowers (or are rebounding from a failed first foray into credit). Lenders
know from experience with large numbers of borrowers, whereas the borrower may only have
their own experience to guide them. Credit can also be confusing; after marriage, mortgages
are probably the most complicated contract most people ever enter. Given the subtleties
involved with credit, and the supposed lack of sophistication of sub-prime borrowers, our
assumption that lenders know better seems plausible.
While lenders might deceive households about several variables that influence household
loan demand, we focus on income. We suppose that lenders exaggerate household’s future
income in order boost loan demand. Our borrowers are gullible, in the sense that they can
be fooled about their future income, but they borrow rationally given their beliefs. Fooling
borrowers is costly to lenders, where the costs could represent conscience, technological costs
(of learning the pitch), or risk of prosecution. The upside to exaggerating borrowers’ income
prospects is obvious—they borrow more. As long as the extra borrowing does not increase
default risk too much, and as long as deceiving borrowers is easy enough, income deception
and predatory—welfare reducing—lending may occur.
After defining predatory lending, we test whether payday lending fits our definition. Payday
lenders make small, short-term loans to mostly lower-middle income households. The
business is booming, but critics condemn payday lending, especially the high fees and frequent
loan rollovers, as predatory. Many states prohibit payday loans outright, or indirectly,
via usury limits.
To test whether payday lending qualifies as predatory, we compared debt and delinquency
rates for households in states that allow payday lending to those in states that do not. We
focus especially on differences across states households that, according to our model, seem
more vulnerable to predation: households with more income uncertainly or less education.
We use smoking as a third, more ambiguous, proxy for households with high, or perhaps
hyperbolic, discount rates. In general, high discounters will pay higher future costs for a
given, immediate, gain in welfare. Smokers’ seem to fit that description. What makes the
smoking proxy ambiguous is that smokers may have hyperbolic, not just high, discount rates.
Hyperbolic discount rates decline over time in a way that leads to procrastination and selfcontrol
problems (Laibson 1997). The hyperbolic discounter postpones quitting smoking,
or repaying credit. Without knowing whether smokers discount rates are merely high, or
hyperbolic, we will not be able to say whether any extra debt for smokers in payday states
is welfare reducing.2
Given those proxies, we use a difference-in-difference approach to test whether payday
lending fits our definition of predatory. First we look for differences in household debt
and delinquency across payday states and non-payday states, then we test whether those
difference are higher for potential prey. To ensure that any such differences are not merely
state effects, we difference a third time across time by comparing whether those differences
changed after the advent of payday lending circa 1995. That triple difference identifies any
difference in debt and delinquency for potential prey in payday states after payday lending
was introduced.
Our findings seem mostly inconsistent with the hypothesis that payday lenders prey on,
i.e., lower the welfare of, households with uncertain income or households with less education.
Those types of households who happen to live in states that allow unlimited payday loans
are less likely to report being turned down for credit, but are not more likely, by and large,
to report higher debt levels, contrary to the overborrowing prediction of our model. Nor are
such households more likely to have missed a debt payment in the previous year. On the
contrary, households with uncertain income who live in states with unlimited payday loans
are less likely to have missed a debt payment over the previous year. The latter result is
consistent with claims by defenders of payday lending that some households borrow from
2Consistent with a high discount rate, Munasinghe and Sicherman (2000) discover that smokers have
flatter wage profiles and they are willing to trade more future earnings for a given increase in current earnings.
Gruber and Mulainathan (2002) find that high cigarette taxes make smokers ”happier,” consistent with
hypberbolic discount rates (because taxes help smokers commit to quitting). DellaVigna and Malmendier
(2004) show how credit card lenders can manipulate hyperbolic discounters by front-loading benefits and
back-loading costs.
payday lenders to avoid missing payments on other debt. On the whole, our results seem
consistent with the hypothesis that payday lending represents a legitimate increase in the
supply of credit, not a contrived increase in credit demand.
We find some interesting differences for smokers, but those differences are harder to
interpret in relation to the predatory hypothesis without knowing apriori whether smokers
are hyperbolic, or merely high, discounters.
We also find, using a small set of data from different sources, that payday loan rates
and fees decline significantly as the number of payday lenders and pawnshops increase.
Reformers often advocate usury limits to lower payday loan fees but our evidence suggests
that competition among payday lenders (and pawnshops) works to lower payday loan prices.
Our paper has several cousins in the academic literature. Ausubel (1991) argues that
credit card lenders exploit their superior information about household credit demand in their
marketing and pricing of credit cards. The predators in our model profit from their information
advantage as well. Our concept of income delusion or deception also has a behavioral
flavor, as well, hence our use of smoking as a proxy for self-control problems. Brunnermeier
and Parker (2004), for example, imagine that households choose what to expect about future
income (or other outcomes). High hopes give households’ current “felicity,” even if it
distorts borrowing and other income-dependent decisions. Our households have high hopes
for income, and they make bad borrowing decisions, but we do not count the current felicity
from high hopes as an offset to the welfare loss from overborrowing.
Our costly falsification (of household income prospects) and costly verification (by counselors)
resemble Townsend’s (1979) costly state verification and Lacker andWeinbergs’ (1989)
costly state falsification. The main difference here is that the falsifying and verifying comes
before income is realized, not after.
More importantly, we hope our findings inform the current, very real-world debate,
around predatory lending. The stakes in that debate are high: millions of lower income
households borrow regularly from thousands of payday loan offices around the country. If
payday lenders raise household welfare by relaxing credit constraints, anti-predatory legislation
may lower it.
Payday lenders make small, short-term loans to households. The typical loan is about $300
for two weeks. The typical fee is $15 per $100 borrowed. Lenders require two recent pay
stubs (as proof of employment), and a recent bank account statement. Borrowers secure
the loan with a post-dated personal check for the loan amount plus fees. When the loan
matures, lenders deposit the check.
Payday lending evolved from check cashing much like bank lending evolved from deposit
taking. For a fee, check cashiers turn personal paychecks into cash. After cashing several
paychecks for the same customer, lending against f uture paychecks was a natural next step.
High finance charges is the main criticism against payday lenders. The typical fee of $15
per $100 per two weeks implies an annual interest rate of 15x365/14, or 390 percent. Payday
lenders are also criticize for overlending, in the sense that borrowers often refinance their
loans repeatedly, and for ”targeting” women making the transition from welfare-to-work
(Fox and Mierzewski 2001) and soldiers (Graves and Peterson 2004).
Despite their critics, payday lending has boomed. The number of payday advance offices
grew from 0 in 1990 to 14, 000 in 2003 (Stegman and Harris 2003). The industry originated
$8 to $14 billion in loans in 2000, implying 26-47 million individual loans. Rapid entry
suggests the industry is profitable.
Payday lenders present stiff competition for pawnshops, even though the internet, namely
E-bay, significantly foreclosure costs for pawnshops (Caskey 2003). The number of pawn
shops in the U.S. grew about six percent per year between 1986 and 1996, but growth
essentially stalled from 1997 to 2003. Prices of shares in EZCorp, the largest, publicly
traded pawn shop holder, were essentially flat or declining between 1994 and 2004, while
Ace Cash Express share prices, a retail financial firm selling check cashing and payday loans,
rose substantially over that period (Figure 4). EZCorp CEO, Joseph Rotunday, blamed
payday lenders for pawnshops’ dismal performance:
The company had been progressing very nicely until the late 1990s.... (when)
a new product called payroll advance/payday loans came along and provided our
customer base an alternative choice. Many of them elected the payday loan over
the traditional pawn loan. (Quoted by Caskey (2003) p.14).
Payday lending is heavily regulated (Table 1). As of 2001, eighteen states effectively
prohibited payday loans via usury limits, and most other states prices, loan size, and loan
frequency per customer (Fox and Mierzwinski 2001). Note that the payday loan limit ranges
from 0 (where payday loans are illegal) to 1250. Nine states allow unlimited payday loans.
Payday lenders have circumvented usury limits by affiliating with national or state
chartered banks, but the Comptroller of the Currency—the overseer of nationally chartered
banks–recently banned such affiliations. The Federal Deposit Insurance Corporation still
permits payday lenders to affiliate with state banks, but recently restricted those partnerships
(Graves and Peterson 2005).
Regulatory risk—the threat of costly or disabling legislation in the future—looms large for
Payday lenders. The Utah legislature is reconsidering its permissive laws governing payday
lending. North Carolina recently drove payday lenders from the state by expressly outlawing
the practice.
Heavy regulation increases the cost of payday lending. High regulatory risk increases limits
entry into the industry and increases the expected return required by industry investors.
Driving up costs and driving away investors may be exactly what regulators intended if they
view payday lending as predatory.
We define predatory lending as a welfare reducing provision of credit. Households can be
made worse off by borrowing if lenders can deceive households into borrowing more than is
optimal. Excess borrowing reduces household welfare, and may increase default risk.
We illustrate our concept of predatory lending in a standard model of household borrowing.
Before we get to predatory lending, we review basic principles about welfare improving
lending, the type that lets households maintain their consumption despite fluctuations in
their income.
The model has two periods: today (period zero) and payday (period one. Household income
goes up and down periodically, but not randomly (for now): income equals zero today
and y on payday. If households consume Ct in period t, their utility is U (Ct).Household welfare
is the sum of utility over both periods: U (C0)+δU (C1), where δ equals the household’s
time rate of discount. Households with high δ value current consumption highly relative to
future consumption. In other words, high discounters are impatient.
A digression here on discount rates serves later discussion. In classical economics δ is
constant. If δ changes over time, so does household behavior, even if nothing else changes.
If δ(t) is hyperbolic, households will postpone unpleasant tasks until current consumption
does not seem so precious relative to future consumption (Laibson 1997). With hyperbolic
discounting, that day never arrives, so hyperbolic discounters have behavioral problems: they
procrastinate. They may never repay debt, much less begin saving. Hyperbolic discounters
who start smoking may never quit.
Returning to the model, if the marginal utility of consumption (U 0) is diminishing, households
will demand credit to reduce fluctuations in their standard of living. Households
without credit, however, must fend for themselves (autarky). Welfare under autarky equals
U(0)+δU (y). The fluctuations in consumption for households without credit make autarky
a possible worst case, and hence, a good benchmark for comparing cases with credit.
If households borrow B at interest rate r, welfare equals U (B) + δU (y − (1 + r)B).
Borrowing increases utility in period zero, when the proceeds are consumed, but lowers utility
in period one, when households pay for their borrowing. Rational, informed households trade
off the good and bad side of borrowing; they borrow until the marginal utility of consuming
another unit today just equals the marginal, discounted disutility of repaying the extra debt
on payday:
U 0(B) = δ(1 + r)U 0(y − (1 + r)B). (1)
Equation (1) determines household loan demand as a function of their income, their
discount rate, and the market interest rate: B(y, δ, r). For standard utility functions,
household loan demand is increasing in income and decreasing in the discount factor and
interest rate: By > 0; Bδ < 0; Br < 0. Household welfare with optimal borrowing equals
U (B(y, r, d))+δU (y − (1+r)B(y, r, δ)). As long as households follow (1), their welfare with
positive borrowing must be higher than without (autarky).
The welfare gain from borrowing depends on the cost of credit production. Suppose the
cost of lending $B to a particular household equals (1 + ρ)B + f, where ρ represents the
opportunity cost per unit loaned and f is the fixed cost per loan. Think of f as the cost
of record-keeping and credit check required for each loan, however large or small the loan
may be. If the going price for loans is (1+r) per unit borrowed, the lenders’ profits equal
(r − ρ)B − f.
With perfect competition among lenders, the loan interest rate is competed down until
it just covers the costs of the loan: r = ρ + f /B. Equilibrium r and B are determined
where that credit supply curve equals demand (1).
Equilibrium in the payday credit market is illustrated in Figure (3). If fixed costs per loan
are prohibitively high, the market may not exist. Perhaps the payday lending technology
lowered the fixed cost per loan enough to make the business viable.3 Before the advent of
payday lending, households who applied to banks for a very small, short-term loan may have
been denied.
Fixed costs per loan imply that smaller loans will cost more per dollar borrowed than
larger loans. That means households with low credit demand will pay higher rates than
households with high loan demand. Loan demand is increasing in income, so high income
households who demand larger quantities of credit will enjoy a ”quantity” discount, while
lower income households will pay a ”small lot” premium, or penalty. That price ”discrimination”
is not invidious, however; the higher cost of smaller loans reflects the fixed costs of
lending. The high price of payday loans may partly reflect the combination of fixed costs
and small loan amounts (Flannery and Samolyk 2005).
A usury limit lowers household welfare. Suppose the maximum legal interest rate is r.
At that maximum rate, the minimum loan that lenders’ cost is f /(r− ρ) = B. Low income
households with loan demand less than B face a beggar’s choice: borrow B at r or do not
borrow at all. Such households would be willing to pay more to to avoid going without
credit, so raising the usury limit would raise welfare for those households.
Competition is another key determinant of how much households gains from borrowing.
3Alternatively, or additionaly, the demand for small, short term loans may have increased in the mid
1990s. The welfare reform then almost certainly increased demand for such credit as households who once
”worked” at home for the government were forced to go to work in the market.
Even with no competition — monopoly—households cannot be worse off than under autarky.
The monopolist raises interest rates until the marginal revenue from higher rates equals the
marginal cost from lower loan demand:
B(y, r) = −(r − ρ)Br(y, r). (2)
At that monopoly interest rate, rm, household loan demand equals B(y, rm).Household welfare
under monopoly equals U (Br(y, rm))+δU (y −(1+rm)Br(y, rm)). Welfare is lower under
monopoly because credit costs more and their standard of living fluctuates more (because
costly credit reduces their demand for credit) If households borrow from the monopolist,
however, they must better off than without credit.
In sum, welfare for rational households is highest if credit is available at competitive
prices. If households choose to borrow, they must be at least as well off as they were
without credit. Limiting loan rates cannot raise household welfare and may reduce it.
Monopoly lenders lower household welfare, but even with a monopolist, households cannot
be worse off than without credit.
The high cost of payday lending may partly reflect fixed costs per loan. Before payday
lending, those fixed costs may have been prohibitive; very small, short-term loans may not
have been worthwhile for banks. The payday lending technology may have lowered those
fixed costs, thus increasing the supply of credit to low income households demanding small
loans. That version of the genesis of payday lending suggests the innovation was welfare
improving, not predatory.
In the textbook model household welfare cannot be lower than under autarky because households
are fully informed and rational. Here we show households how can be made worse off
than without credit if predatory lenders can delude households about their (households’)
future income.
Suppose that by spending C(τ ), lenders can convince a prospective borrower that her
income on payday will be y +τ. The cost C can be interpreted variously as the cost of a guilty
By , at
Mon Oct 15, 02:42:00 AM:
A payday loan is a short-term loan that you promise to pay back from your next pay cheque. A payday loan is sometimes also called a payday advance.
Normally, you have to pay back a payday loan on or before your next payday (usually in two weeks or less). The amount you can borrow is usually limited to 30 percent of the net amount of your pay cheque. The net amount of your pay cheque is your total pay, after any deductions such as income taxes. For example, if your pay cheque is $1,000 net every two weeks, your payday loan could be for a maximum of $300 ($1,000 x 30%).
Before giving you a payday loan, lenders will ask for proof that you have a regular income, a permanent address and an active bank account. Some payday lenders also require that you be over the age of 18.
To make sure you pay back the loan, all payday lenders will ask you to provide a postdated cheque or to authorize a direct withdrawal from your bank account for the amount of the loan, plus all the different fees and interest charges that will be added to the original amount of the loan. The combination of multiple fees and interest charges are what make payday loans so expensive (Click here for an explanation of the various fees associated with these types of loans.
The lender should also ask you to sign a loan agreement. If the lender does not offer to give you a copy of the loan agreement, ask for one. Read this document carefully before signing it, and keep a copy for your records
How and when do I pay back the loan?
A payday loan agreement usually says that you must pay the total amount you owe for the loan on or before the date stated in your loan agreement. This includes the amount you borrowed, plus interest and any additional fees and charges.
Some lenders will cash your postdated cheque or process your direct withdrawal on the day the loan is due. However, some lenders may require that you pay the loan in cash, on or before the due date.
If you have not paid the loan in cash by the due date, some lenders may cash your cheque or process the direct withdrawal you signed on the day after your loan's due date, and charge you another fee. Ask the lender what the most inexpensive way is for you to repay your loan.
How does a payday loan affect my credit report?
Credit-reporting agencies collect information on whether or not you make your payments on time. This information, also called your "credit history", is part of your credit report and is used to calculate your credit score.
Making payments on time can help improve your credit score by demonstrating that you are able to manage your debt. Even if you have poor credit, you can rebuild it by using a credit card or other type of credit and paying back the money you owe on time.
This is not the case with payday loans. Since payday lenders are not currently members of the main credit-reporting agencies, getting a payday loan and paying it off on time will not improve your credit score. However, if you do not pay your loan back on time and it is sent to a collection agency, this will likely be reported to a credit-reporting agency and could have a negative impact on your credit report.
How much will a payday loan cost?
A payday loan is much more expensive than most other types of loans offered by financial institutions such as banks or credit unions. Before you apply for a payday loan, find out about all the fees and charges you will have to pay — including the fees you will be charged if you cannot repay the loan on time. The fees may not be easy to see right away, so read the agreement carefully before signing it. If you do not receive an explanation of all of the fees, charges and interest that will apply to the loan, or if you are not satisfied with the explanation you receive, do not sign the loan agreement.
How does the cost of a payday loan compare with other credit products?
Payday loans are much more expensive than other types of loans, including credit cards. But how much are you really paying? How does the cost of a payday loan compare with taking a cash advance on a credit card, using overdraft protection on your bank account or borrowing on a line of credit?
Let's compare the cost of using different types of loans. We'll assume that you borrow $300, for 14 days. Note the considerable difference in the cost of each type of loan.
Things to consider before you apply for a payday loan
Even if you think you may be turned down, ask your bank or credit union for overdraft protection on your bank account, or a line of credit. These are relatively inexpensive ways of obtaining access to extra funds, for short-term use.
If you are turned down for any of these credit options, ask why. If the reason is that you have a poor credit history, contact the three credit-reporting agencies to get a copy of your credit report. Read the reports carefully to make sure that all of the information in it is correct. If you find any errors, contact the credit-reporting agency to find out how you can have the information corrected. The three major credit-reporting agencies in Canada are Equifax Canada, TransUnion Canada and Northern Credit Bureaus. All three of these agencies will give you a copy of your credit report for free if you request that it be sent to you by regular mail.
Ask yourself if you really need to take out a loan, or whether you can get by until your next pay cheque. If you need the money immediately, try to make other arrangements. For example, you may be able to cash in vacation days. Or you might consider getting a short-term loan from a family member or a friend.
If you find that you need to apply for a payday loan because you have no alternative, only borrow an amount that you are 100 percent sure you can repay on the due date of the loan.
Don't borrow more than you need.
Things to consider if you take out a payday loan
Don't be afraid to ask a lot of questions. Read carefully — and take home with you — a copy of the loan agreement that you are being asked to sign. Don't feel pressured to sign the loan agreement right away if you have questions and want more time to read through the agreement on your own. If the lender does not want to give you a copy of the agreement, look for another lender.
Be sure to ask about all the fees, charges and interest that apply when you first get the loan, and what other charges you will owe if you can't pay the loan back on time.
If you are taking out a payday loan at another location to pay back the first payday loan, or you are extending or "rolling over" the loan that you had with the same lender, you could find yourself in serious financial difficulty. The fees, charges and interest will add up quickly on these types of loans, which can put you into serious debt.
How can I figure out the cost of each type of loan?
To estimate the total cost of a loan, including the annual cost of the loan expressed as a percentage of the amount borrowed, follow the steps below.
Step 1:
Determine how much interest you will pay. First, find out the annual interest rate that applies to the loan (if there is one). Figure out the daily interest rate by dividing the annual interest rate of the loan by 365 days. Then, multiply that rate by the length of time you are taking the loan. Finally, multiply the result by the amount you will borrow, in dollars:
Amount of interest
= Annual interest rate
--------------------------------------------------------------------------------
365 days × Length of the loan
(number of days) × Amount of the loan
Step 2:
Determine the total cost of the loan by adding any fees that may apply to the interest you will have to pay. Find out what fees apply to the loan and add them to the cost of the interest, found in Step 1:
Total cost of the loan = Amount of interest + Total fees
Step 3:
Estimate the annual cost of the loan, expressed as a percentage of the amount borrowed. First, divide the total cost of the loan, found in Step 2, by the amount of the loan. Then, divide this rate by the length of time you are taking the loan (in days) and multiply it by 365 (the number of days in the year):
Annual cost of the loan (%)
= Cost of the loan
--------------------------------------------------------------------------------
Amount of the loan ÷ Length of the loan
(number of days) × 365 days
Let's find out the cost of a $300 payday loan, taken for 14 days.
We'll assume that the lender charges you a one-time set-up fee of $10 and a service fee of $40, which includes interest on the loan.
Step 1:
Determine how much interest you will pay. In this case, there is no interest fee. The interest is therefore $0.
Step 2:
Figure out the cost of the loan by adding together any fees that apply and the interest you will have to pay. In this case, you would add the $10 set-up fee and the $40 service fee together:
$10 + $40 = $50
Step 3:
Estimate the total annual cost of the loan, expressed as a percentage of the amount borrowed:
Annual cost of the loan (%)
= Cost of the loan
--------------------------------------------------------------------------------
Amount of the loan ÷ Length of the loan
(number of days) × 365 days
= $50
———— ÷ 14 days × 365 days
$300
= 4.35 or approximately 435%
The total cost of the payday loan would be $50 with an annual cost of 435 percent of the amount borrowed.
Information asymmetries are common in credit market models, but the usual assumption,
at least in commercial lending, is that borrowers are the better informed party and that
lenders have to screen and monitor to assess whether
firms are creditworthy. The opposite
asymmetry, as we assume here, does not seem implausible in the context of consumer lending.
"Fringe" borrowers are less educated than mainstream borrowers (Caskey 2003), and many
are
first-time borrowers (or are rebounding from a failed first foray into credit). Lenders
know from experience with large numbers of borrowers, whereas the borrower may only have
their own experience to guide them. Credit can also be confusing; after marriage, mortgages
are probably the most complicated contract most people ever enter. Given the subtleties
involved with credit, and the supposed lack of sophistication of sub-prime borrowers, our
assumption that lenders know better seems plausible.
While lenders might deceive households about several variables that in
fluence household
loan demand, we focus on income. We suppose that lenders exaggerate household's future
income in order boost loan demand. Our borrowers are gullible, in the sense that they can
be fooled about their future income, but they borrow rationally given their beliefs. Fooling
borrowers is costly to lenders, where the costs could represent conscience, technological costs
(of learning the pitch), or risk of prosecution. The upside to exaggerating borrowers' income
prospects is obvious—they borrow more. As long as the extra borrowing does not increase
default risk too much, and as long as deceiving borrowers is easy enough, income deception
and predatory—welfare reducing—lending may occur.
After de
fining predatory lending, we test whether payday lending fi ts our definition. Payday
lenders make small, short-term loans to mostly lower-middle income households. The
business is booming, but critics condemn payday lending, especially the high fees and frequent
loan rollovers, as predatory. Many states prohibit payday loans outright, or
indirectly,
via
usury limits.
To test whether payday lending quali
fies as predatory, we compared debt and delinquency
rates for households in states that allow payday lending to those in states that do not. We
focus especially on di
fferences across states households that, according to our model, seem
more vulnerable to predation: households with more income uncertainly or less education.
We use smoking as a third, more ambiguous, proxy for households with high, or perhaps
hyperbolic, discount rates. In general, high discounters will pay higher future costs for a
given, immediate, gain in welfare. Smokers' seem to
fit that description. What makes the
smoking proxy ambiguous is that smokers may have hyperbolic, not just high, discount rates.
Hyperbolic discount rates decline over time in a way that leads to procrastination and selfcontrol
problems (Laibson 1997). The hyperbolic discounter postpones quitting smoking,
or repaying credit. Without knowing whether smokers discount rates are merely high, or
hyperbolic, we will not be able to say whether any extra debt for smokers in payday states
is welfare reducing.
2
Given those proxies, we use a di
fference-in-difference approach to test whether payday
lending
fits our definition of predatory. First we look for diff erences in household debt
and delinquency across payday states and non-payday states, then we test whether those
di
fference are higher for potential prey. To ensure that any such differences are not merely
state e
ffects, we difference a third time across time by comparing whether those di fferences
changed after the advent of payday lending circa 1995. That triple di
fference identifies any
di
fference in debt and delinquency for potential prey in payday states after payday lending
was introduced.
Our
findings seem mostly inconsistent with the hypothesis that payday lenders prey on,
i.e., lower the welfare of, households with uncertain income or households with less education.
Those types of households who happen to live in states that allow unlimited payday loans
are less likely to report being turned down for credit, but are
not more likely, by and large,
to report higher debt levels, contrary to the overborrowing prediction of our model. Nor are
such households more likely to have missed a debt payment in the previous year. On the
contrary, households with uncertain income who live in states with unlimited payday loans
are
less likely to have missed a debt payment over the previous year. The latter result is
consistent with claims by defenders of payday lending that some households borrow from
2
Consistent with a high discount rate, Munasinghe and Sicherman (2000) discover that smokers have
fl
atter wage profiles and they are willing to trade more future earnings for a given increase in current earnings.
Gruber and Mulainathan (2002)
find that high cigarette taxes make smokers "happier," consistent with
hypberbolic discount rates (because taxes help smokers commit to quitting). DellaVigna and Malmendier
(2004) show how credit card lenders can manipulate hyperbolic discounters by front-loading bene
fits and
back-loading costs.
payday lenders to avoid missing payments on other debt. On the whole, our results seem
consistent with the hypothesis that payday lending represents a legitimate increase in the
supply of credit, not a contrived increase in credit demand.
We
find some interesting differences for smokers, but those diff erences are harder to
interpret in relation to the predatory hypothesis without knowing
apriori whether smokers
are hyperbolic, or merely high, discounters.
We also
find, using a small set of data from different sources, that payday loan rates
and fees decline signi
ficantly as the number of payday lenders and pawnshops increase.
Reformers often advocate usury limits to lower payday loan fees but our evidence suggests
that competition among payday lenders (and pawnshops) works to lower payday loan prices.
Our paper has several cousins in the academic literature. Ausubel (1991) argues that
credit card lenders exploit their superior information about household credit demand in their
marketing and pricing of credit cards. The predators in our model pro
fit from their information
advantage as well. Our concept of income delusion or deception also has a behavioral
fl
avor, as well, hence our use of smoking as a proxy for self-control problems. Brunnermeier
and Parker (2004), for example, imagine that households
choose what to expect about future
income (or other outcomes). High hopes give households' current "felicity," even if it
distorts borrowing and other income-dependent decisions. Our households have high hopes
for income, and they make bad borrowing decisions, but we do not count the current felicity
from high hopes as an o
ffset to the welfare loss from overborrowing.
Our costly falsi
fication (of household income prospects) and costly verification (by counselors)
resemble Townsend's (1979) costly state veri
fication and Lacker andWeinbergs' (1989)
costly state falsi
fication. The main difference here is that the falsifying and verifying comes
before income is realized, not after.
More importantly, we hope our
findings inform the current, very real-world debate,
around predatory lending. The stakes in that debate are high: millions of lower income
households borrow regularly from thousands of payday loan o
ffices around the country. If
payday lenders raise household welfare by relaxing credit constraints, anti-predatory legislation
may lower it.
Payday lenders make small, short-term loans to households. The typical loan is about $300
for two weeks. The typical fee is $15 per $100 borrowed. Lenders require two recent pay
stubs (as proof of employment), and a recent bank account statement. Borrowers secure
the loan with a post-dated personal check for the loan amount plus fees. When the loan
matures, lenders deposit the check.
Payday lending evolved from check cashing much like bank lending evolved from deposit
taking. For a fee, check cashiers turn personal paychecks into cash. After cashing several
paychecks for the same customer, lending against
f uture paychecks was a natural next step.
High
finance charges is the main criticism against payday lenders. The typical fee of $15
per $100 per two weeks implies an annual interest rate of 15
x365/14, or 390 percent. Payday
lenders are also criticize for overlending, in the sense that borrowers often re
finance their
loans repeatedly, and for "targeting" women making the transition from welfare-to-work
(Fox and Mierzewski 2001) and soldiers (Graves and Peterson 2004).
Despite their critics, payday lending has boomed. The number of payday advance o
ffices
grew from 0 in 1990 to 14
, 000 in 2003 (Stegman and Harris 2003). The industry originated
$8 to $14 billion in loans in 2000, implying 26-47 million individual loans. Rapid entry
suggests the industry is pro
fitable.
Payday lenders present sti
ff competition for pawnshops, even though the internet, namely
E-bay, signi
ficantly foreclosure costs for pawnshops (Caskey 2003). The number of pawn
shops in the U.S. grew about six percent per year between 1986 and 1996, but growth
essentially stalled from 1997 to 2003. Prices of shares in EZCorp, the largest, publicly
traded pawn shop holder, were essentially
flat or declining between 1994 and 2004, while
Ace Cash Express share prices, a retail
financial firm selling check cashing and payday loans,
rose substantially over that period (Figure 4). EZCorp CEO, Joseph Rotunday, blamed
payday lenders for pawnshops' dismal performance:
The company had been progressing very nicely until the late 1990s.... (when)
a new product called payroll advance/payday loans came along and provided our
customer base an alternative choice. Many of them elected the payday loan over
the traditional pawn loan. (Quoted by Caskey (2003) p.14).
Payday lending is heavily regulated (Table 1). As of 2001, eighteen states e
ffectively
prohibited payday loans
via usury limits, and most other states prices, loan size, and loan
frequency per customer (Fox and Mierzwinski 2001). Note that the payday loan limit ranges
from 0 (where payday loans are illegal) to 1250. Nine states allow unlimited payday loans.
Payday lenders have circumvented usury limits by a
ffiliating with national or state
chartered banks, but the Comptroller of the Currency—the overseer of nationally chartered
banks–recently banned such a
ffiliations. The Federal Deposit Insurance Corporation still
permits payday lenders to a
ffiliate with state banks, but recently restricted those partnerships
(Graves and Peterson 2005).
Regulatory risk—the threat of costly or disabling legislation in the future—looms large for
Payday lenders. The Utah legislature is reconsidering its permissive laws governing payday
lending. North Carolina recently drove payday lenders from the state by expressly outlawing
the practice.
Heavy regulation increases the cost of payday lending. High regulatory risk increases limits
entry into the industry and increases the expected return required by industry investors.
Driving up costs and driving away investors may be exactly what regulators intended if they
view payday lending as predatory.
We de
fine predatory lending as a welfare reducing provision of credit. Households can be
made worse o
ff by borrowing if lenders can deceive households into borrowing more than is
optimal. Excess borrowing reduces household welfare, and may increase default risk.
We illustrate our concept of predatory lending in a standard model of household borrowing.
Before we get to predatory lending, we review basic principles about welfare
improving
lending, the type that lets households maintain their consumption despite
fluctuations in
their income.
The model has two periods: today (period zero) and payday (period one. Household income
goes up and down periodically, but not randomly (for now): income equals zero today
and
y on payday. If households consume Ct in period t, their utility is U (Ct) .Household welfare
is the sum of utility over both periods:
U (C0)+ δU (C1), where δ equals the household's
time rate of discount. Households with high
δ value current consumption highly relative to
future consumption. In other words, high discounters are impatient.
A digression here on discount rates serves later discussion. In classical economics
δ is
constant. If
δ changes over time, so does household behavior, even if nothing else changes.
If
δ(t) is hyperbolic, households will postpone unpleasant tasks until current consumption
does not seem so precious relative to future consumption (Laibson 1997). With hyperbolic
discounting, that day never arrives, so hyperbolic discounters have behavioral problems: they
procrastinate. They may never repay debt, much less begin saving. Hyperbolic discounters
who start smoking may never quit.
Returning to the model, if the marginal utility of consumption (
U 0) is diminishing, households
will demand credit to reduce
fluctuations in their standard of living. Households
without credit, however, must fend for themselves (autarky). Welfare under autarky equals
U
(0)+δU (y). The fluctuations in consumption for households without credit make autarky
a possible worst case, and hence, a good benchmark for comparing cases
with credit.
If households borrow
B at interest rate r, welfare equals U (B) + δU (y − (1 + r)B).
Borrowing increases utility in period zero, when the proceeds are consumed, but lowers utility
in period one, when households pay for their borrowing. Rational, informed households trade
o
ff the good and bad side of borrowing; they borrow until the marginal utility of consuming
another unit today just equals the marginal, discounted
disutility of repaying the extra debt
on payday:
U
0(B) = δ(1 + r)U 0(y − (1 + r)B). (1)
Equation (1) determines household loan demand as a function of their income, their
discount rate, and the market interest rate:
B(y, δ, r). For standard utility functions,
household loan demand is increasing in income and decreasing in the discount factor and
interest rate:
By > 0; B δ < 0; Br < 0. Household welfare with optimal borrowing equals
U
(B(y, r, d))+δU (y − (1+r)B( y, r, δ)). As long as households follow (1), their welfare with
positive borrowing must be higher than without (autarky).
The welfare gain from borrowing depends on the cost of credit production. Suppose the
cost of lending $
B to a particular household equals (1 + ρ)B + f, where ρ represents the
opportunity cost per unit loaned and
f is the fixed cost per loan. Think of f as the cost
of record-keeping and credit check required for each loan, however large or small the loan
may be. If the going price for loans is (1+
r) per unit borrowed, the lenders' profits equal
(
r − ρ)B − f.
With perfect competition among lenders, the loan interest rate is competed down until
it just covers the costs of the loan:
r = ρ + f /B. Equilibrium r and B are determined
where that credit supply curve equals demand (1).
Equilibrium in the payday credit market is illustrated in Figure (3). If
fixed costs per loan
are prohibitively high, the market may not exist. Perhaps the payday lending technology
lowered the
fixed cost per loan enough to make the business viable.3 Before the advent of
payday lending, households who applied to banks for a very small, short-term loan may have
been denied.
Fixed costs per loan imply that smaller loans will cost more per dollar borrowed than
larger loans. That means households with low credit demand will pay higher rates than
households with high loan demand. Loan demand is increasing in income, so high income
households who demand larger quantities of credit will enjoy a "quantity" discount, while
lower income households will pay a "small lot" premium, or penalty. That price "discrimination"
is not invidious, however; the higher cost of smaller loans re
flects the fixed costs of
lending. The high price of payday loans may partly re
flect the combination of fixed costs
and small loan amounts (Flannery and Samolyk 2005).
A usury limit lowers household welfare. Suppose the maximum legal interest rate is
r.
At that maximum rate, the minimum loan that lenders' cost is
f /(r− ρ) = B. Low income
households with loan demand less than
B face a beggar's choice: borrow B at r or do not
borrow at all. Such households would be willing to pay more to to avoid going without
credit, so raising the usury limit would raise welfare for those households.
Competition is another key determinant of how much households gains from borrowing.
3
Alternatively, or additionaly, the demand for small, short term loans may have increased in the mid
1990s. The welfare reform then almost certainly increased demand for such credit as households who once
"worked" at home for the government were forced to go to work in the market.
Even with no competition — monopoly—households cannot be worse o
ff than under autarky.
The monopolist raises interest rates until the marginal revenue from higher rates equals the
marginal cost from lower loan demand:
B
(y, r) = −(r − ρ)Br(y, r) . (2)
At that monopoly interest rate,
rm, household loan demand equals B(y, rm).Household welfare
under monopoly equals
U (Br(y, r m))+δU (y −(1+ rm)Br(y, r m)). Welfare is lower under
monopoly because credit costs more and their standard of living
fluctuates more (because
costly credit reduces their demand for credit) If households borrow from the monopolist,
however, they must better o
ff than without credit.
In sum, welfare for rational households is highest if credit is available at competitive
prices. If households choose to borrow, they must be at least as well o
ff as they were
without credit. Limiting loan rates cannot raise household welfare and may reduce it.
Monopoly lenders lower household welfare, but even with a monopolist, households cannot
be worse o
ff than without credit.
The high cost of payday lending may partly re
flect fixed costs per loan. Before payday
lending, those
fixed costs may have been prohibitive; very small, short-term loans may not
have been worthwhile for banks. The payday lending technology may have lowered those
fi
xed costs, thus increasing the supply of credit to low income households demanding small
loans. That version of the genesis of payday lending suggests the innovation was welfare
improving, not predatory.
In the textbook model household welfare cannot be lower than under autarky because households
are fully informed and rational. Here we show households how can be made worse o
ff
than without credit if predatory lenders can delude households about their (households')
future income.
Suppose that by spending
C(τ ), lenders can convince a prospective borrower that her
income on payday will be
y +τ. The cost C can be interpreted variously as the cost of a guilty
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Things To Know And FAQ's About Loan Modification
These are common questions that are asked about Loan Modifications or Mortgage Modification
1. What Is A Loan Modification?
A Loan Modification is a negotiation between a lender and a borrower that results in the terms of the existing loan being restructured without refinancing. The rate and terms of your loan are restructured to fit your current financial situation.
2. How do you do It?
In these market conditions, the banks and lenders have been mandated by the Federal government to do everything they can to work out a payment plan with their borrowers. This is great for today's borrowers, especially for those who are running late on their payments or are having trouble making them on time. The banks and lenders would rather take less money and keep you in your home making a payment that you can afford, rather than go through the expense foreclosing on the home, hiring a listing agent, rehabilitating a home, and letting it sit empty on the market for months, only to lose thousands in the process. We currently work with almost every major lender and several small lenders and banks to secure a Loan Modification to help them help you. In many cases we actually have taught smaller banks and lenders how to go about completing a Loan Modification. Within 24 hours after receiving your package, our legal team will contact your lender to notify them that they will be negotiating a Loan Modification on your behalf. From then on, they will be working with you and your lender in order to find a solution to your mortgage problems.
3. Are lenders and banks really willing to negotiate?
Definitely! Lenders do not want to foreclose on your home, unless they have no other alternative. If you can present them with a realistic professional proposal that makes sense, they are very open and receptive to the Loan Modification process.
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Basically, the bigger the hardship you are having, the more negotiating power you have with your lender. Remember, they don't want to foreclose on you. They would rather keep you in your home and create a solution that will be affordable to you rather than go through the cost and expense of foreclosing on your property.
5. Why didn't my mortgage lender tell me about this?
Your mortgage lender is in the business of originating and/or servicing loans. Modification of existing loans and foreclosures are simply a result of being in the business they are in and, as such, they aren't a priority for the mortgage lender.
This program is not that costly and quite frankly, they are so busy dealing with other homeowners who are already going through tough times, that they don't have time to deal with your situation.
6. Why should I choose a Loan Modification?
If you are having trouble and behind on your payments you have several different options to fix your problem.
Reinstatement Plan - Where your lender will reinstate the original terms of your loan once you are caught up.
Repayment Plan - Where your lender will tack on an extra amount onto each payment for a set period of time.
Loan Modification - Where you negotiate a restructure of your current loan terms without
refinancing.
Loan Refinance - Refinancing may be an option if you have the equity and credit required.
Forbearance Agreement - Where your lender negotiates a repayment plan and may force you to list your home for sale.
Short Sale - You sell your property for less than you owe but your lender accepts it as payment in full.
Pre-Foreclosure Sale - You agree to sell your property before foreclosure takes place.
(requires equity).
Deed-in-Lieu of Foreclosure - You agree to sign your property back over to your bank and walk away.
Bankruptcy - You have to file bankruptcy to protect yourself, but if you miss one payment you will be right back in foreclosure.
A Loan Modification is a good solution if you cannot refinance, are behind on your payment or struggling to make your payments, have experienced a genuine hardship, and you want to stay in your home.
A Loan Modification is a permanent solution to your situation and is not meant to be used as a temporary stop to the foreclosure process.
7. Can I negotiate a Loan Modification myself?
In short, yes you can. You can contact your lender or your bank and see about going through the process of Loan Modification.
But, keep in mind that your bank has their best interest at heart. They neither have the time nor the inclination to hear about what troubles you might be experiencing. What usually occurs is that the bank will negotiate an agreement that helps them, but still leaves you with only a temporary solution.
This also takes many hours of communication and back and forth information exchanges in order to accomplish. It is not easy to complete on your own and the outcome may not be favorable to you. When you contact the bank, they will ask for a "hardship letter" from you. When they receive that letter, they will usually tell you that they will get back to you in about 8 weeks. By the time you get back with them, or if you are lucky enough to get a call from them, you're already in worse shape than when you first started negotiation.
8. How Come You Have More Success?
Our attorneys have been doing hundreds of Loan Modifications every month, working with virtually every bank and lender. They have open lines of communication with most lenders, which gives them the ability to negotiate directly with the person who is in charge of making a decision on your loan.
We also create a professional legal file on your behalf which includes all of your financial data such as income, assets, expenses, and unexpected intangible expenses. They couple this with a full property analysis and package this together in a file that makes it easy for the lender to read and understand, allowing for a more comprehensive and quicker response than you would get through other forms of negotiation.
9. How much does it cost?
The costs associated with an attorney based Loan Modification will vary depending on the value of your property, the type of loan, the lender, and the number of loans held against our property.
The modification cost usually comes close to equaling the same as about one month's mortgage payment. Since every Loan Modification is different, it requires a varied amount of negotiation. After your initial application is reviewed and if the attorneys accept your case, your Loan Modification representative can help determine what the exact cost of your Loan Modification will be.
Our primary goal is helping homeowners who want to keep their homes, find a beneficial solution for their situation. We will work with you to ensure that we can obtain an affordable solution for your Loan Modification needs.
10. What do you need from me to get started?
If our attorneys believe they can help you and accept your case, then we will need to submit a complete Loan Modification file that outlines your current financial situation.
They will contact you directly if other paperwork is required by the lender in order to negotiate a successful Loan Modification. They will also determine the current value of your property and put together a professional proposal for your lender.
11. What makes you different from other companies?
We are not a store front Loan Modification company, but a service provider helping you find the right legal representation needed to negotiate on your behalf. Loss mitigation departments at major banks and lenders give much more credence to modification proposals submitted by attorneys. Maybe it is fear of a lawsuit if they do not negotiate in good faith, but banks and lenders are much more responsive to attorneys than they would be with the actual homeowner or other third party negotiator.
12. Will I have to meet with my lender or deal with any of their paperwork?
Absolutely not. We take care of all the paperwork and all of the negotiating on your behalf.
13. How long does the process usually take?
It can be completed in as little as five days but usually takes from 5 - 12 weeks depending on the lender, type of loan, and individual situation.
14. What paperwork do I need to complete the process?
We provide you with a complete list of the documents the attorney will need in the file to complete the process and will help prepare the file. Of course, no legal representation can begin until counsel has been properly retained and you have given written authorization to proceed.
After we receive these items from you, we can begin your Loan Modification process.
Please contact us with any other questions or concerns. Remember that time is not on your side, so if you are having problems or struggling to keep up with rising mortgage payments, don't delay and call us immediately for a free and confidential consultation.
We want to help you keep your home, period.
15. By utilizing the Loan Modification option to bring an asset current, can the mortgagee include all fees and corporate advances?
Mortgagee Letter 00-05, page 21, paragraph F, "Allowable Provisions" states: "All or a portion of the PITI arrearage (principle, interest, Taxes and Insurance) may be capitalized to the mortgage balance. Foreclosure costs, late fees and other administrative expenses may not be capitalized.
16. Does the repayment plan have to be completed prior to completing the Loan Modification documents, or can the mortgagee attach the plan once the option has been completed?
It is a mortgagee decision as to when to complete the repayment plan for outstanding fees, costs and administrative expenses.
17. When utilizing a Loan Modification option, can a mortgagee capitalize an escrow advance for Homeowner's Association fees?
HUD Handbook 4330.1 REV-5, Paragraph 2-1, Section B, Escrow Obligations states:
Mortgagees must also escrow funds for those items which, if not paid, would create liens on the property positioned ahead of the FHA-insured mortgage.
18. Will HUD subordinate a Partial Claim, should a mortgagor subsequently default and qualify for a Loan Modification?
If a mortgagor subsequently defaults and qualifies for a Loan Modification, HUD will
subordinate the Partial Claim.
19. When an asset is modified is the homeowner eligible for the upfront premium refund at payoff of the loan?
It depends upon when the closing date occurred. For assets closed: After July 1, 1991 but before January 1, 2001, the 7-year unearned premium refund schedule shown in Mortgagee Letter 1994-1 remains in effect. On or after January 1, 2001 that are subsequently refinanced, the 5-year refund schedule shown in the attachment of Mortgagee Letter 2000-46 applies. On or after December 8, 2004, refunds of upfront MIP are eliminated except, when the mortgagor refinances to another FHA insured mortgage. The refund schedule attached to Mortgagee Letter 2005-03 has been modified to a 3-year period.
20. Can a mortgagee qualify an asset for the Loan Modification option when the mortgagor is unemployed, the spouse is employed, but the spouse name is not on the mortgage?
The mortgagee should consult with their legal counsel to determine the legality and validity of such a mortgage instrument.
21. I'm unemployed. My spouse does have a job, but her name isn't on the mortgage. Can I qualify for a Loan Modification?
This isn't a simple question that can be answered "yes" or "no". What typically happens in situations like this is that the mortgagee - your lender - will conduct a financial review of your household income and expenses to determine if the spouse's income is sufficient to meet the new modified mortgage payment, but insufficient to pay back the arrears. Once this process has been completed your lender will then get together with their legal counsel to determine if you're eligible for a Loan Modification, since the spouse is not on the original mortgage.
22. Are there any guarantees on the outcome of my Loan Modification?
It would be impossible for us to guarantee that some other entity (the lender) will do what we suggest that they do. We can say we have a VERY high success rate in obtaining
modifications for our past clients. If no modification is achieved, then you get some or all of your retainer back.
23. How does Loan Modification affect my credit?
If we are successful in obtaining a modification for you, the loan will, from that point forward, be reported as being paid as agreed. Assuming you make all of your payments on time, you may see your credit begin to get better over time. Obtaining a Loan Modification is the least damaging to your credit when compared with a short sale or a foreclosure.
24. Will having a Loan Modification affect my taxes?
We are not CPA's or enrolled agents and therefore can't offer you tax advice. We suggest
you check with your tax professional.
25. Do I have to be behind on my mortgage to qualify?
No. Although falling behind on your mortgage payments is an obvious indicator of financial hardship. Some clients are forced use reserves or credit cards to keep there mortgage payments current. In this situation it is only a matter of time before they fall behind. If an obvious fanatical hardship exists a modification may be possible although the payments are current.
26. Do I have to owe more than my house is worth to qualify?
No. The basic formula is to have less than 20% equity in your home. The less equity you have in your home, the more the investor stands to lose in a foreclosure situation. If you
have negative equity, that is even more incentive for your lender to work with us.
27. Can I have my 1st and 2nd mortgage combined?
Yes. In some cases where the first and seconded mortgage are with the same investor that investor may elect to combine both mortgages into one. Keep in mind if the investors are
different a combined mortgage outcome is VERY unlikely.
28. I'm about to or already filed for bankruptcy, is it too late?
No. If you are currently in bankruptcy and your property is not included in your bankruptcy and you meet all other qualifications you are eligible immediately. If your property is included in your bankruptcy you may be able to ask your bankruptcy attorney to remove it from the bankruptcy. Keep in mind your bankruptcy attorney may charge an additional fee for service to pull the property out of your bankruptcy.
29. I already have a sale date for my home, can I still save my home?
Yes. Traditionally we need a minimum of ten days prior to the sale date to be able to achieve a postponement of the sale. In some cases we are able to postpone the sale as late
as the day before.
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