By: Tim Worstall
December 20, 2011
Why payday loans are so expensive
It's one of those things that gets asked all the time. Just why are payday loans so expensive? The APR rates on them are 300, 400%, surely someone must be making an absolute fortune out of them? You know, ghastly people profiteering from the misery of the poor?
It's not, actually, quite that simple. The thing is, lending small amounts of money for short periods of time is simply going to be expensive. You do have to have a place where the work is done, an office or a shopfront. Someone has to be employed to make the loans and receive the repayments. There are simply costs involved. Imagine that you need to charge $10 per loan just for these costs. This is nothing to do with the interest rate mind, this is just what it costs for someone to walk and say "I'd like to borrow $200 please" and for you to decide whether to lend it to them or not.
They borrow it for two weeks, that $10 is 5% of the loan. The thing is though, everyone now calculates that lending fee as an annual charge, as an APR. If the money were rolled over 26 times, to make up the 52 weeks of the year, that fee would be charged 26 times. Even ignoring compounding this becomes a 130% APR.
Note that so far no one has actually even been charged any interest but we've already got an APR of 130%.
This much is obvious to anyone who thinks for a bit about this subject. Part of the very high APRs is precisely because we are adding a fixed fee, charged for a short period of time, up into an APR. It's an artifact of how APRs are calculated.
And now for something I didn't know until today. Via Felix Salmon, what's the default rate on such loans?
Look just at the default rate of 6% or so. It's easy enough to get confused by this. But that is a 6% of all loans made default.
"In fact, Felix appears to get a little confused on this as well for he says "Meanwhile, the payday-loan default rate has been hovering steadily in the 6% range -- reaching its peak before the financial crisis, interestingly enough -- and acting as a silent rebuke to anybody who would dare to argue that interest rates in the triple digits are necessary to make up for the fact that so many payday loans go bad. (In fact, they're reasonably safe, if only because they're secured by a future paycheck.)"
Well, let's think a little about a 6% default rate. These figures are for loans that run from 14 to 30 days. That is, if you lend out $10,000 in accumulated loans then 30 days later $600 of them will have defaulted. Or at the shorter end, after 14 days $600 will have defaulted. Sticking with 30 days, so, how much interest do you have to charge on the $10,000 to only cover your default rate?
Well, you're losing $600 to default so at minimum all of the money loaned out must make you $600 to make you whole (actually, it's interest on $9,400 must make you $600 to make you whole but we don't need to go that far, let's stick with round numbers).
So, we've got to charge 6% per month interest just to cover the default rate. Without compounding that's 72 % a year. With compounding that's 101% a year. So we really are into triple digit interest rates just to cover the default rate alone. If we take it as being 14 days then it's 26×6% or 156% without compounding and you can work out what it is as compounding as a little exercise in math useful for the modern world.
So let's add these together. We've a, I think we'll all agree, very reasonable $10 fee for making a $200 loan. It would cost that just to have the infrastructure capable of making the decision. And we've a 6% default rate. If all loans are 30 days then we've a, without compounding, 12×5 plus 12×6 interest rate expressed as an annual rate. 132% and recall, that's without compounding which the APR calculation insists we should do.
If all loans are for 14 days then we've 26×5 plus 26×6 which is 264% as an annual rate. Again, before compounding so this is lower than the APR rate. And recall, no one has made any money here (well, except those who have defaulted on their loans) and no one has even charged any profit. All we've done is cover the cost of loaning the money plus the default rate. There simply isn't a profit in this yet.
All of which is the reason why payday lending is simply very expensive. For there are fixed costs that must be paid in making the lending decision, having the physical infrastructure to make the loan. There's a default rate that must be covered. Lending small sums of money for short periods of time is just an expensive thing to do. Therefore borrowing small amounts of money for short periods of time is an expensive thing to do.
And there just isn't any way out of this as long as it remains legal for people to lend and borrow small amounts of money for short periods of time.
If you lend or borrow large amounts or for long periods of time then the arrangement fee becomes negligible as a percentage of the loan and thus the APR falls. If the loan is secured in some manner or such loans are only offered to the creditworthy then the default rate falls and thus so does the APR.
But it just does have to be pointed out. Lending small amounts of money for short periods of time is expensive and therefore so is borrowing such.