There is a lot of confusion and misunderstanding that surround payday lending. So here we will cut through the conjecture and explain exactly why the fees seem high and how much it really costs an efficient payday lender to provide credit.
Then, we will defy the conventional wisdom of the critics and show why consumer welfare is enhanced within a competitive payday lending environment in accordance with the basic laws of economics and commerce.
The interest rate charged for a payday loan seems ostensibly high at a typical APR of 400 – 800%. Critics compare this APR with that charged by mainstream credit providers (7-20%) and claim short-term credit providers are charging unaffordable, exorbitant interest rates and are profiting abnormally.
After all, mainstream credit providers are profitable and they charge much lower interest rates. So payday lenders must be doing very nicely. Well, it’s not quite as simple as it appears.
The fixed labor and operating costs associated with providing a small loan are the same as those for providing a large loan. With a larger loan principal, the lender can recover costs and earn a profit by charging a lower APR over a longer period of time.
Short-term loans must however charge higher rates of interest over short payback periods in order to cover the cost of the given loan and be profitably offered.
Another misunderstood aspect of payday lending is its impact on consumer welfare. Critics argue that “exorbitant” payday lending charges impoverish vulnerable households by encouraging chronic household debt, delinquency, increased bankruptcy and reduced consumer spending in the economy.
If the ability to consume is diminished, households will demand credit to reduce fluctuations in their standard of living and to maintain consumption.
However, households without credit must fend for themselves or seek underground credit providers, a worst-case scenario, whose prevalence would increase in a capped interest rate environment where payday loans cannot be profitably offered.
Payday loans allow the consumer flexibility to borrow only what they need without committing to an unnecessarily large amount over a long period. Unlike a credit card or larger personal loan, the client can enter the contract, meet their objective and promptly exit the contract.
Payday loans help people whom seek borrowing flexibility and those without access to mainstream credit. Before the advent of payday lending, households who applied to banks for a very small, short-term loan may have been denied.
Payday lenders require that their applicants meet certain requirements. First of all, they must have a job that nets at least $1000, or so.
Every lender is a bit different so researching each lender is crucial. Lenders do not give loans to people seeking money that they cannot pay back.
Consumers must have a valid bank account to be able to pay the loan back with either a post dated check or a post dated draft to their account. As mentioned before, the risk is quite high for payday lenders so the interest rates are a bit higher.
As long as people know what they are getting into and can adequately pay the loan back, these loans are great for stimulating the economy and bringing relief to families in need. It is sad to say that most families have little to no savings.
So when the car breaks down or the water heater goes out, it is a great way to handle such emergencies without having to jump through bank hoops. Some lenders offer a rollover plan if the consumer is not able to pay the loan back in time.
However, buyer beware that these rollover plans can come with more fees added on top of the original interest. It is not wise to fall into a trap of this kind.
It is advised that borrowers know exactly how and when they can pay the loan back. Payday lenders want to give people a chance to get money quickly when they need it, not trap people into debt. When a borrower doesn’t pay back the loan, the lender goes through a major loss.
Every person that has understood the fine print and the type of loan they are getting, end up having great experiences and would do it again if they needed it. Some people have poor credit due to divorce or medical expenses and still need a way to obtain cash when urgent situations arise.
Jack R. Landry has a PHD in financial services and has written hundreds of articles relating to consumer services and payday advance. He has been a consumer advocate for nearly 25 years.
Jack R. Landry