The Huffington Post recently had an article about Payday lenders leaving Arizona. In their usual left leaning slant the article was cheering about these companies leaving the state and arguing how awful they were preying on people to take out loans.Which got me thinking about what exactly is predatory lending anyway? Is the lender stalking you, forcing you to sign that loan for a paycheck you don’t have yet? Are they putting the proverbial gun to the borrower’s head making them take out the loan? Common sense says of course not. It should go without saying getting a payday loan is bad money advice! If I must resort to using payday loans to support my existing lifestyle, I need to cut back or make additional income. It’s not uncommon for a payday loan’s effective APY to be over 40%! Some people do use these loans because of emergency purposes, which in my opinion is fine, and was the original purpose of these loans. Is it the fault of the lender that the individual keeps coming back to use their service?
On a web page sponsored by the payday loan companies they discuss the myths vs. realities of payday loans. Obviously their statements are somewhat biased and should be taken with a grain of salt. Out of all of the myths, the one that caught my eye was:
Payday lenders’ high fees help the industry make billions in profits.
Small denomination, short-term loans are very expensive to originate and maintain, which is why most banks no longer offer the product. According to the Federal Reserve Banks 1999 Commercial Bank National Average Report, the cost for a small bank to originate and maintain a loan for one month is $174.
Industry critics fail to recognize that, in addition to the cost of administering the loan, payday lenders incur the normal overhead costs of running a business and paying employee salaries and benefits.
A study by the FDIC Center for Financial Research found that “operating costs lie in the range of advance fees” [collected] and that, after subtracting fixed operating costs and “unusually high rate of default losses,” payday loans “may not necessarily yield extraordinary profits. ”
Of course, government leaders and the mainstream media like to vilify these companies, when in reality they are offering service to a previously ignored market. Traditional banks stopped offering services to this group many years ago. After all, in a free market economy, who decides if a business should stay in business? The buying public at large. A business couldn’t exist if it didn’t have customers who want their service. Furthermore, if another business can offer better service (in this case a lower APY) while staying profitable, some other company will find a way to do it. This is what competition, and the free market, is all about.
Who are the customers of these payday loans, and the related industry of check cashing? Usually lower income individuals, who either do not have the documentation (remember the Patriot Act makes banks document all accounts), or people who cannot get overdraft protection or credit cards. These individuals are categorized as subprime borrowers. Just like businesses with a higher risk to default on their bonds (otherwise known as junk bonds), individuals also fall under this category. It’s interesting to note a few studies about junk bonds returns. While the rates are high with junk bonds, the effective returns have been shown to be much lower. Could the same apply to sub prime borrowers?
What’s the Purpose of Charging Interest?
I grant you 400% effective interest rate mentioned in the article is insane. I do think imposed limits of 36% are somewhat fair with no direct experience in the industry. After all, if you had a traditional bank account with overdraft or a credit card you should be able to get rates lower than 36%. In the end though, the borrower, as long as the terms are clear, should be able to charge whatever rate they deem appropriate. They are taking risk by giving out the loan, so they should be best qualified on what rate to charge.
Getting back to Puffington Post article, it’s quite interesting some of the comments made. The funniest and inane comment was:
The poorest of the poor shouldn’t pay any interest, they need every dollar. Risk could be managed the way it is now, with re-payment history and credit limits.
There are two reasons why interest exists on loans:
- Time is money
- Risk to default
That’s it. Nothing else matters. In a perfect world everyone would pay everyone back, with on-time payments and in full. If this was true, would this mean all loans would be at 0% APY? No because you as the lender have a choice over other investments that would generate higher returns.
Time Is Money
This is one of the basic laws of money. Time is money, and money is time. Having money in your hand now is worth more than in the future. If you loan money out you expect not only the principal, but also interest.
Risk To Default
We obviously know in the real word that the faith of someone paying you back in full does not always happen. Payday loans are of the unsecured type. In simple terms this means no asset, like a car or house, is tied to the loan should the borrower default. With loans tied to an asset, you as the lender at least stand a chance to recoup some or all of your principal back. If the borrower defaults on an unsecured loan, how can the lender make up for the loss? A lender has only one of three ways:
- Take a loss on your loan
- Charge you a higher interest rate based upon your risk to default
- Charge everyone else a higher rate to recoup the difference
So what is a lender to do in order to ensure they still make money lending? They do one or all of the above items. TANSTAAFL (There Ain’t No Such Thing As A Free Lunch). With my Lending Club experience, I can attest how this works. If a person asking for a loan has defaulted, has little credit history, or cannot verify income, I expect a higher interest rate on their loan.
By increasing regulation of the industry, similar to what happened during prohibition, it will go underground. The demand for these types of loans will not disappear because of increased regulation. If you cannot get a loan via traditional means, you’ll contact real loan sharks (you know the Paulie Walnuts type). With a loan shark you might even get a better rate. Getting two broken legs or cement loafers is a great incentive to ensure prompt and full payment. Bada Bing!
Readers: What do you think about payday loans? Have you ever taken one out?