History of Payday Lending in America

Ian Zapolsky

min read

Last week, Check announced a integration partnership that will allow any Check partner to quickly and seamlessly enable their employers to offer Earned Wage Access to their employees. I believe that Earned Wage Access is an elegant and positive sum solution to the problem of short term liquidity access for people working paycheck to paycheck.

To fully understand why, we need to dive into the history of consumer credit for hourly workers in America.

Early History

Payday loans first emerged in the U.S. in the years following the Civil War. They did so in an environment that was structurally and ideologically unfriendly to high interest rates. America’s founding fathers had established a 6% cap on the annual percentage rate (APR) for loans in the U.S., following the over 2,000-year-old practice of regulating interest rates that traces its roots all the way back to the Old Testament and before. Luckily for ancient borrowers, early luminaries of civilization such as Hammurabi (1750 BC), Plato and Aristotle (400 BC), Marcus Aurelius (180 CE), Charlemagne (800 CE), Dante (1300 CE), and Queens Mary (1550 CE) and Elizabeth (1570 CE) all shared the same view that usury was immoral and advocated for interest rate regulation.

However, by the late 1800s, the U.S. had begun to reshape itself around the innovations of the Industrial Revolution, and large urban centers appeared, with a high density of blue collar workers paid on a regular, recurring basis. Factories employing hundreds of workers started to replace the smaller-scale employment models that pervaded pre-industrial America. This was aided by the invention of the employee time clock, whose history I’ve previously written about, because it enabled employers to “automate” the data collection about hours worked each day by their many employees.

The industrial urban center was a necessary catalyst for the earliest forms of payday lenders to appear. According to Robert Mayer, author of the influential paper Loan Sharks, Interest-Rate Caps, and Deregulation, “Loan-sharking isn’t feasible in a population that ekes out a bare subsistence. It also isn’t feasible if the debtors lack a steady income stream. Only people with recurring paydays can get payday loans. The phenomenon of payday is a product of the industrial revolution and its routinization of wage-labor.”

These early payday lenders were referred to as “loan sharks” because of their predatory behavior, and they operated outside of the law to loan small sums of money to workers at APRs of up to 500%, over 80 times the legally allowed limit at the time. But why were the APRs that loan sharks offered so much higher than the 6% mandated by law at the time? Certainly part of it had to do with the fact that the customer base they served was generally less sophisticated, but primarily it was because it was simply not economically feasible to loan small sums of money at such low interest rates. A typical payday loan of $20, due in one month at an APR of 6%, would earn the lender $0.10 — not enough to pay for the amount of time it would take to process the loan. As a result, in absence of the ability to legally lend at rates higher than 6%, banks simply did not work with the blue collar workers occupying American industrial cities.

Payday lending tends to have a bad reputation, and rightfully so. Payday lenders of the early 1900s were typified by highly predatory loan terms that promoted re-borrowing to extend the payback period in a bid to entrap borrowers into a recurring revenue stream. These structures can still be seen in use today, though many states have passed payday lending reform.

And yet, despite these unfriendly terms, the black market for payday loans boomed. The reality is that for people living paycheck to paycheck, their pay schedule necessitates consumer credit. Our system of weekly, bi-weekly, or monthly payroll, combined with the inherent unpredictability of life expenses from accidents, sickness, or just a poorly timed utility or rent bill, isn't sustainable for many people. This is clearly as true today as it was 100 years ago. In the early 1900s, as many as a 25% of blue-collar workers borrowed from loan sharks every year, while today millions of Americans still take out payday loans every year — not to mention the many millions more who use credit cards on a daily basis.

Politicians in the early 1900s were alarmed by the size and velocity of the nascent payday lending market, and the fact that loan sharks operated in a black market also created negative societal externalities. Loan sharks would often use blackmail, public embarrassment, or even physical violence to extort debtors into paying back their loans. But what to do? Policymakers walked a fine line. Cap interest rate too low and you drive law-abiding lenders out of the market by making it economically infeasible to participate, thus ceding ground to loan sharks. Cap interest rates too high and you both turn your back on centuries of entrenched wisdom about usury, and also create an environment for capitalists to legally prey on low-income workers facing a short-term liquidity crunch.

Ultimately, U.S. lawmakers aimed to suppress loan sharks while also expanding consumer credit from licensed lenders. They did this by passing a targeted exception to the 6% interest rate cap for small loans specifically. The 1916 publication of the first Uniform Small Loan Law (USLL) permitted up to 3.5% monthly interest (42% APR) on loans of $300 or less. Two-thirds of states adopted some version of this law, and it was an outstanding success. Again, according to Robert Mayer, “The Uniform Small Loan Law was in fact the most successful regulatory strategy ever devised to minimize the two kinds of loan-sharking that have been the plague of payday since the birth of the credit society. In many states where this law was enacted the loan-shark debt trap that had once been so common all but disappeared by the middle of the twentieth century.”

All across America, where the usury cap had been around 6%, the USLL raised the legal interest rates offered by creditors by ~6x, drawing more participants into the market, while simultaneously cutting the exorbitant triple-digit APRs charged by loan sharks by a similar order of magnitude.

The Era of Financial Deregulation to the Present

Unfortunately, our story does not end there. Fast forward to the late 1970s, and a loophole emerged that made it possible for lenders to make loans at very high APRs to workers again.

As a result of the Supreme Court decision in Marquette National Bank v. First Omaha Service Corp in 1978, interest rates were deregulated and national banks were authorized to export whatever interest rate was operative in the state where they were chartered. Shortly thereafter, South Dakota repealed its laws protecting against high interest rates, effectively eliminating any interest rate cap, in a bid to attract business to the state to boost its struggling economy. Citibank, Wells Fargo, and other national lenders moved their charters to South Dakota and began to use this loophole to sidestep the interest rate caps on small dollar loans put into place by the USLL in other states.

Of course, there were also states in the US who had never adopted the USLL, and consumers were still unprotected there as well. States like Tennessee, where in 1993 a man named Allan Jones founded a company called Check Into Cash. Jones is frequently referred to as the “father of the payday loan industry” because Check Into Cash was the first major payday loan chain. Through lobbying efforts, including over thousands in political donations, Jones got the Tennessee state legislature to pass laws formally allowing payday lending. Then he and other payday lenders partnered with small, nationally chartered banks to open storefronts in other states that still operated under the USLL.

The rapid rise of Check Into Cash and its competitors gave birth to a second wave of payday lending in the U.S., this time supercharged by television marketing and the nascent internet. Industry analysts estimate that the number of payday loan offices nationwide increased from less than 500 in the early 1990s to approximately 12,000 in 2002.

While this backslide in progress was unfortunate, thankfully in the years since the turn of the 21st century many states have passed additional laws regulating small dollar loans, and closing the loopholes introduced in the 1980s and 1990s. Today, 21 states and the District of Columbia prohibit high cost payday lending. On the other hand, 29 states have either enacted legislation authorizing payday loans (like Tennessee), have failed to close loopholes exploited by the industry to make high-cost loans, or have deregulated small loan interest rate caps.

Non-profit organizations and activists continue to lobby at all levels to pass stricter legislation against high cost payday lending. However, it’s important to recognize that the landscape of consumer credit has also changed dramatically since the early 1900s, in ways that are nearly all beneficial for consumers, and simultaneously reduce the market share of payday lending. According to Robert Mayer, “Measured by the fraction of the population that makes use of the product, payday lending has not reached the scale of salary lending a hundred years ago and it is unlikely ever to do so. The consumer credit market has expanded enormously over the past century and it is now thickly populated with many different kinds of products. Many wage earners who might have patronized the salary lenders at the start of the twentieth century can now charge purchases on a bank card and pay the bill later or get a cash advance with a credit card. Both options will be much cheaper than a payday loan, unless late penalties are incurred.”

Earned Wage Access

So what does all of this have to do with Earned Wage Access (EWA)? Well, I believe Earned Wage Access is a rare positive sum solution to short-term emergency liquidity needs for workers, while reducing complexity for the employer.

Here’s how it works:

An EWA provider assesses an employee’s earnings data in order to offer an advance on the wages that they will earn in the current or upcoming pay period.
Once approved, the advance becomes available to the employee, who has a variety of options to access the funds (including for free in exchange for a short waiting period).
When the employee’s regular pay cycle occurs, the EWA provider will collect the corresponding amount to repay the advance, without interest.

Modern technology like smart phones, GPS, POS systems, APIs, and webhooks make tracking hours worked and wages earned in near real time feasible, and with that heightened level of data and understanding come new opportunities for workers living paycheck to paycheck to draw on their hard earned wages ahead of payday.

I’m personally excited to see the market share of payday lending decline in the coming decades, and I think the proliferation of software platforms that offer integrated payroll and EWA will be one of the primary contributors to that dynamic.

At Check, we’re on a mission to make paying people simple, whether that’s on or ahead of payday. If this resonates with you, consider joining us!