Are Payday Loans Really That Bad?
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UPDATED: Nov 22, 2011
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There is no doubt that some suffer from the payday loan trap, and wind up getting caught on what seems like a never-ending cycle of debt. Critics of payday loans jump to these borrowers’ defense and shout about usury, short-term limits, and exorbitant annual percentage rates (APR). But are the countless others who have found much needed help in payday loans being forgotten? If the answer is yes, and if the alternatives for other forms of low-credit lending prove to be incapable, then we must ask ourselves: are payday loans really that bad?
High Interest Rates That Don’t Yield Profit
Lending is a business, and nobody enters a business to lose money. Those operating in the payday world are no different. But take a look at the service they provide: quick money to those who have good and bad credit alike. In order to give money to individuals with bad credit, there must be some kind of safety net for those operating the business. With payday loans, that safety net is high interest rates.
But with APRs upwards of 400 percent, one would expect all payday lenders to be filthy rich. However, a study done by both Vanderbilt University and the University of Oxford on the profitability of payday loans reveals payday lenders only see an average profit margin of 10.1 percent a year.
Given the high APRs, this relatively low profit margin can be explained in one of two ways: either there’s a very high default rate or borrowers pay their loan off in one term, thus substantially cutting the profit that could result from a high APR.
Defaults and Pay Offs
Any lender will charge higher interest rates to borrowers with bad credit. Private home loan lenders can get away with granting a 12 percent rate to subprime borrowers because there is a piece of real estate as collateral. Payday lenders, on the other hand, have no collateral. Consequently, they must offset defaults with the profit from those who stay current on their loans.
After all, if you loaned several hundred dollars to complete strangers, and you had the knowledge that those strangers have defaulted many times in the past given their credit score, what sort of interest rate would you charge?
That default rate combined with the fact that those who pay off their loans might be doing so in a single term-limit would also sufficiently explain the low profit margin.
Without discrediting the trouble that some get into by “rolling” over payday loans time and time again, most payday loan borrowers pay their loan off within two-terms. A payday lending report done in 2009 by the state of Washington found the average payday loan among 29 companies was 19.6 days—just longer than a single 14-day term.
That means if borrowers took a payday loan for $100 at an APR of 390 percent, they would owe $15 in two weeks. If that borrower paid his loan off just below the average lifetime of a payday loan, the payday lender would only see a 15 percent return on his money.
Couple that average with the number of borrowers who default and it’s not too difficult to imagine that 10.1 percent profit margin.
Alternative Forms of Quick Cash
There are several alternatives to payday loans: small personal loans, borrowing from friends and family, and credit card cash advances are some of the most popular. The problem with personal loans is they usually require relatively good credit. The friends and family option means borrowers loved ones must be willing and able to lend to them. That leaves credit card cash advances.
Cash advances often charge around 30 percent on the money advanced to a borrower. That interest rate equates to far less payment when compared to a payday loan that is rolled over many times.
But that 30 percent rate is quite a bit higher than a payday loan’s charge if the borrower intends to pay his debt come his next paycheck. A single term on a payday loan is minor when compared to the high rates charged by cash advances.
Credit card cash advances also require a borrower to own a credit card. Many payday customers don’t have or don’t qualify for a credit card.
The Final Verdict
Payday lending is a business that has established certain policies and measures in order to survive. They provide a service that’s sought out by millions each year, and can potentially lift borrowers out of holes and back onto their feet.
That’s not to say there aren’t nefarious lenders and victimized borrowers. The military has been targeted by a fair share of predatory lending practices, often in the form of payday loans. Other low-income individuals have found themselves drawn time and time again to the lights of the payday shop inhabiting the bottom level of their residence.
Every type of business has practitioners who try to exploit their patrons and find loop holes in the law, but the bad apples shouldn’t spoil the flavor of the batch.
Payday loans can often prove to be a cheaper alternative to other forms of short-term lending. They can also be cheaper than the fees and charges borrowers may face if unable to obtain quick money. So long as borrowers are responsible about their borrowing practices, and use pay off these lenders in one term (two at the most) then both lender and borrower can benefit from a fair and healthy partnership.