Payday Loan Rollover
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UPDATED: Feb 7, 2012
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No, it’s not mans’ best friend performing a trick for us—but some would still call it a trick nonetheless. The payday loan rollover is, among other things, what causes critics of the industry to mount such vehemently hostile attacks against these loans. The rollover is unlike any other mechanism found in different types of loans, and acts like a trap door that is all too easy to pass through, but very difficult to open back up to return from. It’s the rollover that births the heart wrenching stories we all hear regarding people who borrow several hundred dollars only to owe thousands upon thousands several years later.
The Anatomy of a Rollover
The rollover is a device used by payday lenders in order to ensure profitability. It’s a way to collect additional fees, and truth be told, the success of the industry in its current form relies heavily upon the rollover. Here’s how it works:
Imagine a payday loan that carries a $15 per $100 fee—an approximate annual percentage rate (APR) of 390 percent.
In order to acquire that loan, a borrower must write a check (or allow the lender access to the borrower’s bank account, as is more common today) for $115 dollars. That check is understood to be cashed on the borrower’s next payday, hence the name of this type of financing.
So ultimately this borrower pays $15 to receive a $100 cash advance. That’s not too bad, right? It definitely isn’t when one considers the fact that payday loan borrowers are not subject to or judged by a credit check, they don’t need to prove employment, and any outstanding debts are ignored. If somebody needs money—and has to have it now—payday loans are available and they’re a much better alternative to illegal loan sharks.
However, their biggest strength is also their biggest weakness.
Because the demographic that is inherently drawn to the mechanics of payday loans tend to be of the lower income bracket, they are subject to falling into a financial trap. That’s where the “rollover!” trick comes to play.
When the borrower’s next paycheck comes about and they see bills piling up, some aren’t able to afford the $115 to pay off their lender, so they approach the lender for an extension of their payday loan—an extension that requires yet another fee.
That’s a rollover: extending a loan by agreeing to pay another fee.
If the borrower rolls the loan over again, they must now write a check for $145. After just two rollovers, the borrower effectively paid $45 for a mere $100 loan—nearly 50 percent interest. Now just imagine if a borrower continues to roll this loan over again and again. After four more rollovers, the borrower would be pushing $105 in interest on his or her initial loan of $100.
Flattened by this Rolling Torrent
Take this real life example into consideration: a woman named Sandra, whose story was told by Responsiblelending.org, is a single mother who sought a payday loan in order to pay off her utility bill.
Sandra took a cash advance of $300 at an APR of 342 percent. After struggling to make ends meet, she approached a financial confidant who quickly went from simply giving Sandra advice to becoming her support advocate. When all was said and done, that $300 payday loan rolled over so many times that Sandra wound up shelling out $1,080 to finally pay it off.
But as Sister Berta Sailer of Operation Breakthrough told Responsible Lending, “If you were choosing between taking a loan out of a place you knew was going to rip you off or having your kid homeless, what would you do?”
This evident problem with payday loans is, however, much more difficult to fix than one might initially think. It is one thing to say, “Charge less interest,” or, “Put restrictions on the APR.” But ultimately, the industry has such standards not because it’s full of money-sucking leeches (not to say they’re all benevolent beings either), but instead to ensure survivability.
Because payday lenders don’t have any credit score requirements or collateral (save a check or access to one’s wages), and because they lend to a demographic that is often inherently in financial trouble, they run a very high risk of default. That risk of default sits at approximately 6 percent.
This means if a payday lender lent 10 loans of the type described above ($100 with a $15 charge), he can expect to make $150 in interest. But with a 6 percent default rate, that lender will lose approximately $60 of his $1,000 lent out. The total amount of money he will make on his initial $1,000 investment is his $150 profit less the $60 lost in defaults, for a total of $80.
If that same lender decided to go the route of self-immolation and offer these short-term, high-risk loans for a smaller interest rate—let’s say $8 per $100 lent—he would make a meager $20 profit on his $1,000 lent. And that’s assuming he hits the average default rate of 6 percent. If that’s any higher, this lender would fall underwater.
That’s the unfortunate paradox: payday loans are risky endeavors for both borrower and lender—but at the same time, they’re a necessary safety net for the financial strugglers in society. Otherwise, borrowers wouldn’t pay for their loans with stress and financial hardship, but rather with limbs and lives as less-than-understanding loan sharks would fill the demand for such a service.
While this double edged sword draws blood from both parties, there may (hopefully) be a fix on the horizon.
The Consumer Financial Protection Bureau (CFPB) has taken off at a powerful speed, and seems to be adamant about taking both consumers’ and lenders’ concerns into consideration. Now that this government-sponsored oversight agency is up and running, perhaps they can prove to be the whetstone strong enough to dull this blade, and create policies that will be mutually beneficial for both providers and users of payday loans.