We periodically hear calls for the state to tighten its payday loan regulations and to keep interest rates down. Such restrictive caps on interest would result in fewer people getting access to payday loans at all — or they might have to pay even higher rates of interest on the black market. Fortunately, ineffectual regulations aren’t the only answer to the problem of high interest rates. Free-market competition can give borrowers other options and better deals. For example, see this Post-Dispatch article about credit unions that offer short-term loans on better terms than the payday lenders.

Why do the credit unions offer lower interest rates? Because they’re nicer? Not quite. Actually, the credit unions have found a way to lower the risk that borrowers will default. They require borrowers to deposit their paychecks with the credit union, and to place part of their loans in a savings account there. The benefits of the practice for the credit union and its borrowers are manifold: the credit union gets to hold on to some of the cash; it establishes a relationship with the borrower; and the borrower hopefully builds up savings and reduces his dependence on payday loans.

The payday lenders offer better rates on certain loan amounts, and there will still be a place for them in the market, serving customers who can’t or won’t abide by the credit unions’ policies. But there’s now an alternative.

Besides the credit unions’ model, another way to reduce the risk of default is to ask borrowers to pay back a loan in several installments, rather than as a lump sum. I hope more lenders will enter the market, using that or other ideas to offer lower interest rates.