Payday Loans VS. Loan Sharks

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

A bird in the hand is worth two in the bush.

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:

  1. Take a loss on your loan
  2. Charge you a higher interest rate based upon your risk to default
  3. 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?

Comments

  1. says

    Excellent points all around, and especially pointing out some of the cream puff attitudes towards protecting the poor unwitting consumer and the Prohibition effect of going underground. But those aren't my problem.

    My beef with payday lenders is two fold:

    1) The interest rates are egregiously usurious. Without question, lending to payday lender's segment of the population comes with very high risk. However, any loan resulting in triple digit APR, regardless if that loan only encompasses a span between biweekly paychecks, is out of the question. Call it my overzealous business ethics, call it consumer protection, or call it whatever you will, I think many will agree that's above and beyond reasonable. (To be open minded, I would be interested to see any data that suggests payday lenders could not remain in business charging < 100% APR vs. > 100% APR. If so, and they're legit vs. biased industry pawns who have inflated cost of business numbers, I might change my tune.)

    2) Usury laws aren't equal across the lending business. As P2P Investors, you and I would get nailed for lending at Payday Lender interest rates. If you or I created a promissory note at the interest rates which Payday Lenders charge, we would likely have our interest rate reduced (based upon individual state usury limitations) if the borrower contacted an attorney who knew anything about usury laws or wound up in front of a judge arguing why we charged a 400% APR.

    Payday lenders spent a lot of time and money lobbying Congress to have these unique privileges put into action. Now that it's in place and it's a cash cow, any legitimate finreg will be tough, if not impossible.

    • says

      Yes I would be interested to see any legit studies. The only one I've heard of is from the FDIC mentioned, which I cannot find online. Though my theory is like junk bond studies that have shown their effective rate of return (after defaults and all) get only slightly higher returns to less riskier bonds. Could it be subprime lending leads to similar poor returns? It could be said that payday loans are the worst of the worst subprime borrowers.

      Let's also look at Propser investors. They got awful returns because many of the borrowers were sub prime and the interest rate was much too low for the risk. In addition if you study the Lending Club rates and the risk to default, some of the riskier borrowers in fact lead to lower real returns than the better credit risk borrowers.

      On either side of the fence people get too caught upon on the interest rate and aren't looking at the effective return for the lender.

  2. says

    That comment made my head hurt! People like that make me go bat sh!t crazy.

    While I have never taken out a payday loan, I don't think they are pure evil they are portrayed to be. Where else is someone going to get a couple hundred bucks cash (for whatever purpose) without a credit check? That commentor is probably the same one who villified the credit card companies and are now pissed when their APR went up 8 points.

  3. says

    I had never heard of payday lending until I got into blogging and saw how aggressively they market their services…just like banks and insurance companies now that I think of it from other ad requests. Anyway, I'd never consider taking on a loan at such exorbitant rates, but I guess you've gotta walk a mile in those moccasins. It's kind of at the nexus of regulation and free market though, right? What's reasonable and what's outrageous? The mere fact that millions of transactions occur at a 400% interest rate means that surely, perhaps thousands of transactions would occur at a 4000% rate. If someone's desperate enough, they'll pay anything (about to have the power shut off? Drugs? Bookie? You can imagine).

    It's not a business I'd want to be in, but there is a market for it. Frankly, I'm not sad to see them go, but I wish it were due to lack of demand rather than political whims. And for the commenter "they shouldn't pay interest", I'm amazed at the morons you meet on the internet, seriously.

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