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Solving The Payday Loan Problem

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As we know there’s been rather a campaign against payday loans. The cries from the feeble minded about the excessive, totally outrageous I tell ya’, interest rates charged on them. Hundreds of percent when expressed as an APR. So, they’re being regulated out of existence. Wonga has already gone and most of the rest will follow.

As a part of the Federal Reserve has noted:

Except for the ten to twelve million people who use them every year, just about everybody hates payday loans.

Apparently for the people who actually use them the interest rates aren’t outrageous.

The essential economic problem here being that lending small sums of money for short periods of time simply is expensive. Someone, somewhere, has to process the documentation, take the decision upon whether to lend or not and that simply is some measurable amount of time, human labour and cost. There was an attempt by a part of Goodwill to do this on a non-profit basis. Their APR was still well over 200%.

The APR calculation insisting that such fees be counted as part of the interest rate being charged. And if money is being lent for a week then we must include 52 instances of the fee to give us the APR. Which is how we do get to those thousands of percent interest rates when so measured.

As the Fed goes on to point out:

Even though payday loan fees seem competitive, many reformers have advocated price caps. The Center for Responsible Lending (CRL), a nonprofit created by a credit union and a staunch foe of payday lending, has recommended capping annual rates at 36 percent “to spring the (debt) trap.” The CRL is technically correct, but only because a 36 percent cap eliminates payday loans altogether. If payday lenders earn normal profits when they charge $15 per $100 per two weeks, as the evidence suggests, they must surely lose money at $1.38 per $100 (equivalent to a 36 percent APR.)

Which is how Wonga has been regulated out of business.

So, is there a solution to this? One company is trying:

A London start-up that lets employees draw down their wages early without having to resort to risky payday loans has secured £20m from investors, including the backers of collapsed payday lender Wonga.

OK, so, what’s the trick?

Wagestream enables companies to pay their employees their wages as they earn them, rather than in an end-of-month pay packet. Billed as a workplace benefit, staff can pay a flat fee of £1.75 to secure an early payment of a percentage of their salary.

So, the credit risk is on the company paying the wages, not the employee turning up to pay back the loan. That reduces the interest rate that must be charged. Sure, they say there is no interest here, simply a fee, but when we move to APR that distinction disappears, as above. Presumably there’s also some saving by doing this in volume terms – all employees of the company can be covered for the one set of investigation into the accounts.

Looks like a useful solution. Good luck to ’em.

Except it’s not actually a solution. Because this still – potentially at least – breaches the APR cap. Or, at least, that US one of 36% and more obviously any set lower than that.

A loan of £50 paying £1.75 in fees to borrow for one month is an APR of over 40%. And it’s grossly more than that if they borrow it only for the week at the end of the pay period – because that’s just how APR works.

The problem here is the measure being used, the APR, because it always, but always, shows vast interest rates on small sums for short periods of time even when there is in fact no interest charge at all. We’d probably do better to use a different calculation method……

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9 COMMENTS

  1. Where this is going is to socialise the losses to the rest of us. Ban high street banks from not providing loans to borrowers with poor credit ratings, which will mean the APR for everyone goes up to cover the inevitable losses. I’d sell any stocks you might hold in regulated industries as these will be worthless with the government pushing social agendas onto them all.

  2. A cap of 36% would affect several (if not most) UK credit card agreements. But then UK card interest rates (like our petrol prices) will horrify the septics.

  3. If the requirement is being able to spend in week three when the income to cover the spending comes in in week four, then how about having a bank account that lets you do that. Lets you draw more money over the amount that you have on deposit in the knowledge that it will be covered in a few days. Could even think up a catchy name for it like, ooo, drawover. What would be the adjective for that? drawovering? draftover?

  4. @ jgh
    I have a bank account that will let me do just that- because I am not and never have been (or viewed as being a credit risk) .
    For those who are a credit risk, the decision whether to allow them an overdraft takes management time and costs the bank money on top of any losses that later occur because the customer get run over while drunk or whatever.
    Those who are not granted an agreed overdraft are those considered “higher risk” and the cost of agreeing not to bounce a cheque not covered by the balance in the account is an additional cost. who should pay that? CRL thinks that I should. It presumable says that bank profits exceed fees on unauthorised overdrafts – ignoring the vast increase in unauthorised overdrafts that would ensue from an abolition of fees.
    The cheapest way to borrow short-term for such people is the old-fashioned pawnbroker – because the credit risk is vastly reduced. “I haven’t got anything to pawn”? Er- not *anything* why not? Why should we think that you will pay us back?
    Wonga were scum who deserved to be canned, but those payroll lenders that are cheaper than bank overdrafts (and do not con people into loans that get rolled up instead of being fully repaid on payday) provide their customers a useful service.
    It is noteworthy that the UK’s leading pawnbroker can offer payday loans to its regular customers at a much lower APR than other lenders because it knows which ones area good credit risk (it still has much higher loan loss %ages than on its secured lending but less than ther lenders).

  5. It all boils down to the fact that borrowing is trading risk, and the do-gooders want all quantities of risk to be priced identically. Ok, I’ll have six loaves of bread, and how dare you charge me more than for one loaf of bread!

  6. @ jgh
    I take exception to your comment.
    The “do-gooders” give their own money, time and effort to help those they consider to be in need.
    CRL wants to give mine, not their own. They are pseudo-do-gooders
    If they genuinely care why don’t they support “Christians Against Poverty” or create “Atheists against poverty” (bit revealing that it hasn’t yet been created)

  7. Let’s ban businesses like Wonga from making short-term loans available. But people, many of them poor credit risks, will still sometimes need short-term loans. Where will they get that money from if there’s no legal source? Another of life’s little mysteries (if you’re in government).

  8. @Quentin Vole – ‘Atchet ‘Arry Smith will do you a nice loan of £500 for 5 points on the vig (vigorish / criminal interest) which is 5% a week interest rate or about 260% (probably less than Wonga).

    The downside is that if you don’t pay it on time the vigorish is added to the principle (to give you compounding), which can makes debts escalate rapidly into substantial sums.

    If you *STILL* don’t pay, beloved local criminal ‘Atchet ‘Arry Smith will send Bazza round to break your knees.

    On the whole, I think I’d prefer neither Wonga nor the local loan shark, but I’m white, male and privileged (so the BBC tells me), but others aren’t so lucky…

    Maybe the pawn brokers IS the best bet.

  9. Yes, the loan sharks were my implied alternative to Wonga et al. 5% a week compound is over 1,000% pa when compounded. If you take out that £500 loan and pay nothing, at the end of the year you’ll owe £6,300 (and have no kneecaps).

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