A free market is by definition one that is unregulated by any factors other than supply and demand, so in that sense, payday loans are indeed consistent with the free market. There is a demand for short-term loans that carry few credit restrictions; payday loan companies supply the loans to meet that demand. The implication of the question, however, is that “free market” is necessarily a good or desirable state, and that is not always the case. Things like illegal drugs and child pornography also are consistent with the free market, strictly speaking.
A payday loan is a very simple transaction. Usually, the only requirements are a job and a checking account. Once a loan-seeker’s employment is confirmed, he then writes a check payable to the loan company, post-dated for the due date of the loan. The total amount of the check is for the loan amount and the interest, which is generally very high, 25 to 30 percent or more. In other words, for a post-dated check in the amount of $200, the borrower will typically receive $150 in cash. On the date the loan is due, the loan company deposits the borrower’s check, and if everything has gone according to plan, the loan is automatically repaid when the check amount is deducted from the borrower’s account and paid to the loan company’s account.
There are obvious pitfalls in receiving a payday loan. If a person has already run short of funds between paydays, receiving an advance against the next paycheck will most likely only aggravate that deficit cycle. And even though they are loans, the manner in which payday loans are made puts them into a sort of legal gray area in case of default. The only way a payday loan can be defaulted is if there are insufficient funds in the borrower’s checking account to honor the post-dated check when it is presented to the bank. From a legal standpoint, a bad check is a bad check regardless of the reason it was written. Depending on what state the loan company is doing business in, it has wide latitude in charging additional fees in pursuit of collection, and the borrower is usually subjected to additional penalty fees from his bank. Passing a bad check is also a criminal offense. Realistically, most jurisdictions will not pursue a case against an offender for a single incident, especially if it is likely that it was an honest mistake or the result of uncontrollable circumstances. But there is nothing to prevent them from doing so if they choose, and this can be a powerful threat to use against a borrower.
Ironically, the payday loan companies can actually make more on borrowers who default than on those who do not, thanks to the civil court system. Rather than pursuing a criminal charge, the loan company can instead file a civil case in small-claims court; given the circumstances under which the loan was made, they are almost guaranteed to win the case. Typically, the borrower is ordered to repay not only the original check amount, but also a penalty to cover court costs that effectively doubles or triples the amount. And payment is guaranteed, because the court can order that the borrower’s wages be garnished to satisfy the judgment. In essence, one bad customer is worth as much as two or three good ones to the loan company.
Are payday loans a bad deal for consumers? In most cases, they probably are. Are they unethical? Perhaps, but that is a matter for debate. Are they consistent with a free market? Absolutely. Payday loan companies are free to take full advantage of the law in order to do business. And since the law prohibits the loan companies from deliberately withholding or misrepresenting the terms of the loan or its repayment, consumers are free to make a choice no matter how inadvisable it may be. A free market is not necessarily a safe or a wise market; it is up to society to decide where to find a balance.