The true cost of payday loans is somewhat elusive because of the fee-based model. Using the example above, a two-week $100 payday loan may come with a $15 fee. Someone who isn’t savvy with finance might look at that and think the interest rate is 15%. Unfortunately, this is not how APRs work.
When translated to an annual percentage rate, this $15 fee for a two week $100 loan equates to a 390% APR. The industry average APR is 339% according to the CFPB.
A major problem that the CFPB highlights in their report is that it’s unclear whether consumers understand the costs, benefits, and risks of using these products.
Should we place rate limits on loans?
Some states have begun to push back on payday lenders. In 15 jurisdictions across the United States, payday loans are illegal or have annual percentage rates (APR) capped at 36 percent, which is in line with the interest charged by credit card companies for cash advances. These jurisdictions are: Arizona, Arkansas, Connecticut, District of Columbia, Georgia, Maryland, Massachusetts, Montana, New Hampshire, New Jersey, New York, North Carolina, Pennsylvania, Vermont, and West Virginia.
The federal government has also taken notice, with laws already in place to protect military personnel and proposed legislation to protect all consumers. The Military Lending Act places a maximum limit of 36 percent APR on loans offered to military personnel.
To achieve a 36% APR, the lender would need to limit the fee on a two-week $100 loan to $1.38 – not enough to even cover the origination cost.
Then there is the issue of covering the costs of defaults. Industry statistics indicate 6% of all payday loans default. Seems low? Well remember these are two week loans, so if you had a group of 100 two-week loans and 6 of them defaulted, you would need an annual rate of 156% just to break even on those defaults.
The bigger costs are the marketing and operations costs associated with these loans. Overhead to operate the 20,000 omnipresent storefront locations is the biggest single expense. Lets say that we go really conservative and say between all the marketing and operational expenses it cost a payday lender $5 to get that $100 loan. We would need a 130% APR to cover that cost.
If you combine default costs with your assumed marketing and operations costs we are at a 286% APR just to cover basic expenses (and that doesn’t take into account compounding). In case it’s not yet clear, lending small amounts of money to high risk borrowers for short periods of time is expensive, and therefore so is borrowing that money.
If you look at the annual reports of big payday lenders you’ll see that they actually operate at pretty low margins..
A more competitive marketplace would likely bring the price meaningfully below $15 per $100 loaned, but 36% APR would be unsustainable for the current payday lending model as we know it today.
Ultimately, this means 36% APR caps would undoubtedly push many borrowers with poor or nonexistent credit histories even further out of the credit system.
States that eliminate payday loans immediately experience a substantial rise in costly outcomes to consumers, according to research at the Federal Reserve Bank of New York and Kansas City Fed. These studies also find that more households file for bankruptcy when payday loans are no longer available.
Hence, trying to focus purely on interest rate caps is probably a short sighted way to regulate the industry. Fostering competition will introduce better alternatives, while providing access to credit to those that need it.
New and innovative lenders like LoanNow will organically drive down interest rates through more sustainable installment products, operational efficiency, better underwriting models, risk-based pricing, and improved risk management.
It’s pretty simple. If you spend less money on overhead, your underwriting is smarter and you offer loans only to those who prove creditworthy (which doesn’t necessarily mean those with a high credit score), then your default rate falls and, indirectly, so does your APR.