Why payday loans are so expensive
It’s one of those things that we ask all the time. Why are payday loans so expensive? The APR rates on them are 300, 400%, surely someone must make absolute fortune out of it? You know, horrible people who take advantage of the misery of the poor?
It is not, in fact, quite simple. The point is, lending small amounts of money for short periods of time will simply be expensive. You have to have a place where the work is done, an office or a storefront. Someone must be employed to make the loans and receive the repayments. There are simply costs involved. Imagine that you were to charge $ 10 per loan just for these costs. It has nothing to do with the spirit of interest rates, it’s just what it costs for someone to walk around and say “I would like to borrow $ 200 please” and for you decide if you lend it to them or not.
They borrow it for two weeks, that $ 10 is 5% of the loan. The point is, everyone now calculates these loan fees as an annual fee, as the APR. If the money was rolled over 26 times, to make up for the 52 weeks of the year, that fee would be billed 26 times. Even ignoring the makeup, it becomes a 130% APR.
Note that so far no one has even been charged interest, but we already have an APR of 130%.
This is obvious to anyone who thinks a bit about this. Part of the very high APRs is precisely due to the fact that we add a fixed fee, billed for a short period, into an APR. It is an artefact of how APRs are calculated.
And now something that I didn’t know until today. Via CitrusNorth, what is the default rate on such loans?
Just look at the default rate of around 6%. It is quite easy to be confused by this. But that’s a 6% of all loans in default.
In fact, Felix also seems to be a little confused about this as he says “Meanwhile, the default rate on payday loans is steadily hovering in the 6% range – reaching its peak. before the financial crisis, oddly enough – and acting as a silent rebuke to anyone who dares claim that triple-digit interest rates are needed to make up for the fact that so many payday loans go wrong. (In fact, they’re reasonably safe, if only because they’re secured by a future paycheck.) “
Well, let’s think about a 6% default rate. These figures are for loans that range from 14 to 30 days. That is, if you lend $ 10,000 in accrued loans, 30 days later, $ 600 of them will be in default. Or at the shorter end, after 14 days, $ 600 will be in default. Stick to 30 days, so how much interest should you charge on the $ 10,000 to only cover your default rate?
Well you lose $ 600 by default, so at a minimum all the money you loaned must earn you $ 600 to heal you (in fact, the interest on $ 9,400 must earn you $ 600 to heal you but we didn’t need to go far, let’s stick with round numbers).
So we have to charge 6% interest per month just to cover the default rate. Without capitalization, it’s 72% per year. With composition, it’s 101% per year. So we’re really into triple-digit interest rates just to cover the default rate alone. If we consider it to be 14 days then it is 26×6% or 156% without composition and you can determine what is as complex as a little math exercise useful for the modern world.
So let’s add them together. We have, I think we would all agree, a very reasonable $ 10 fee for a $ 200 loan. It would cost quite simply to have the infrastructure capable of making the decision. And we have a default rate of 6%. If all the loans are for 30 days, we have an interest rate, unfunded, of 12×5 plus 12×6 expressed as an annual rate. 132% and reminder, this is without aggravating what the calculation of the APR insists on the fact that we should do.
If all the loans are for 14 days, we have 26×5 plus 26×6, which is 264% APR. Again, before dialing, it is therefore lower than the APR rate. And remember, no one made any money here (well, except those who defaulted on their loans) and no one even charged a profit. All we did was cover the cost of lending the money plus the default rate. There is simply no profit in it yet.
All of this is the reason that payday loans are simply very expensive. Because there are fixed costs that must be paid to make the decision to lend, to have the physical infrastructure to make the loan. There is a default rate that must be covered. Lending out small amounts 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 expensive.
And there is simply no 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, the arrangement fee becomes negligible as a percentage of the loan and the APR therefore decreases. If the loan is secured in a certain way or if these loans are only offered to creditworthy people, the default rate decreases, as does the APR.
But it just needs to be underlined. Lending small amounts of money for short periods is expensive, and so is borrowing.