A Modest Defense of Pay-day Loans

Over the weekend I had a very interesting conversation with a former commercial banker who once upon a time wrote a major loan for a pay-day loan company. Generally speaking, the pay-day loan industry is seen as the absolute bottom-feeders of the consumer credit market. These are the guys that write short term loans -- generally two weeks -- at 15% interest. In the eyes of many, this looks like legalized loan sharking, extracting huge interest payments from the weak and the desperate. My banker informant, however, told me a different story.

First, he said that the default rate on pay-day loans is quite low -- around 8%. What this means is that for the vast majority of borrowers, the interest is not compounding. Furthermore, the pay-day loan companies don't want it to compound and aggressively weed out customers who try to roll the short-term loans over from week to week. The reason for this is obvious. Even though the math of 15% interest compounded bi-weekly might look appealing on paper, in practice the debtors are likely to be judgment-proof, collection costs are high, and rolling the loan over suggests that the chances of ultimate repayment are low. In other words, contrary to the imagination of many a left-leaning consumer bankruptcy professor, pay-day loan companies are not out to pile up massive interest payments on tiny principle amounts.

The second thing that I learned was that a big part of success in the pay-day loan market comes from customer service. The folks who use pay-day loans are generally treated like crap at the bank. This is hardly surprising. After all, these are the sorts of people who bounce checks and are unlikely to qualify for a nice Fannie-Mae standard mortgage that can be immediately sold in the secondary market. On the other hand, pay-day loan centers treat their customers very nicely, although they also make sure that they get follow-up calls reminding them of repayment due dates. What this means, however, is that pay-day loans are quite labor-intensive given the amount of money involved.

The last thing I learned was the relationship between pay-day loans and checking accounts. Most pay-day loan companies require that their customers have a checking account. More interestingly, however, many people go to pay-day loans because of their checking accounts. Many of these loans are written to insure that checks written on a depleted account don't bounce if they clear before pay day. The reason that people go to the pay-day loan companies is that at many banks the penalty and service fees that one pays on a bounced check are in excess of what the pay-day loan company charges. In other words, folks turn to the pay-day loan companies to get protection from more "respectable" lenders.

Of course, to really verify these stories I would want some real data. Still, I am inclined to trust my banker informant, and at the very least the story sounds plausible. Voluntary contracts have a way of working to the advantage of both parties...

Comments

[Robert C.]

Akrasia for me too, I have way too much on my plate right now to be wasting time reading stuff like this post. But I find this very interesting, something I've wondered about but never really looked into. The logic makes sense to me.

I'm not sure if you understand enough of the fine print to answer this, or if you'll get a chance to ask someone who knows again, but I'm wondering how much the payday loan companies are actually making:

For easy math, let's suppose the average customer borrows $1000 every two weeks (I'm trying to make guesses on the high end of the spectrum to make my point). Assuming 15% is the APR, rounding to 26 two-week work periods in a year, this implies 15% / 26 = .577% interest every two weeks, which is $5.77 interest every two weeks, which amounts to 5.77 * 26 = $150 a year. Is that really all the payday loan company is making off the average customer?? If so, I'm very impressed.

I have no idea how these places work, but let's say there's 1 manager making $52K a year, and 3 other minimum wage employees making $12K a year, that implies $3.4K every two weeks in salaries, which means the first almost 600 customers every two weeks are needed (that's the first 60 customers each business day on average...) for that center just to pay the employee salaries. Rent for the building would probably erase the profits from the next 100 customers or so (every two weeks, 10 more per day). These calculations, albeit extremely crude, suggest either very tight profit margins, or some other source of revenue....

This $150 profit per year really is tiny compared to the intuition most people have about loan sharks. That is, if this same customer borrows $26,000 (the sum of borrowing $1000 every 2 weeks) at the beginning of the year on a 15% APR credit card with interest compounded daily, the interest at the end of the year would come to about $4000 (it would be $4207 not including any minimum payments paid; note the 15% APR actually implies an effective annual interest rate of [ 1 + .15/365 ]^365 - 1 = 16.18%).

[Robert C.]

Oops, I again accidentally clicked post instead of preview. Addenda:

(1) Scratch the "for easy math," I was going to try and come up with intuitive numbers, but it'd take more work.

(2) The difference between the effective annual rate of 16.18% and the APR of 15% is a difference of 1.18% and is a difference I'm guessing most people don't understand (dare I say, "esp. people who use payday loans"?). That difference of 1.18% amounts to about $300 in interest for a credit card with an average balance of $26,000 for a year at 15%--that is, about double what the pay-day loaners are making for this average customer (note that I'm assuming ALL payday loans are repaid within 2 weeks, which is a very strict interpretation of the words in the original post...).

[Robert C.]

Oh yeah, the easy math is as follows: with $1000 average balance and 15% APR with no compounding, the annual interest is $150 (I derived it the more complex way above, the benefit of advanced studies is to make easy calculations complicated...).

[Edje]

Robert C.: The interest is not an APR. You give me $1000 today; I give you $1150 two weeks from now.

Thus, in your example, to make the biweekly payroll (3.4k) requires only 2 customers per day (24 total) borrowing $1000. I assume that the typical loan is much smaller but that the traffic is much greater. Still, according to Wikipedia's article on payday loans:

"A study by the FDIC Center for Financial Research found that 'operating costs lie in the range of advance fees' [collected] and that, after subtracting fixed operating costs and 'unusually high rate of default losses,' payday loans 'may not necessarily yield extraordinary profits.'"

[Robert C.]

Oh, that makes more sense. So effectively the customers are paying 15% * 26 = 390% APR. That's a pretty steep price to pay for customer service, no matter which way you slice it....

Then I think the interesting question is whether these customers are customers out of ignorance (not understanding that they're really paying 390% APR), or if they just don't have any other options and 390% APR is just the market clearing price.

[Nate Oman]

Robert C.: Most of the loans are much much smaller than you are assuming, between $100 and $200. Furthermore, most of the loans are paid off, so you are talking about $15 to $30 per loan. Many banks -- particularlly if you have very low balances -- will hit you with $50 in fees and penalties for a bounced check. On this calculus, $15 or $30 doesn't look so bad. Of course, if you don't pay it back, then the interest starts compounding very, very rapidly. However, I suspect that what actually happens is that (1) most loans are repaid because no loan is made without proof that a paycheck is in the mail next week; and, (2) most loans that are not repaid rapidly are never repaid at all.

[Nate Oman]

One other point: As I understand it the loan contracts are very simple. For example, there is no attempt to take out any security interests, put in place garnishment rights, etc. It is just a deal whereby A gives B $200 with the understanding that B pays back $230 next week, or else faces compouding interest. This is a pretty simple transaction to understand...

[Mark B.]

It's as simple as the "six for five" private loans in the Philippines. I loan you five pesos today, and you pay me six pesos next week. Easy to understand, easy to think it's no big deal. But a sweet 20% interest rate (per week), and I don't want to do the calculations for compound interest for a year!

[Sarah]

Tax Refund Anticipation Loans work in a similar fashion -- it's basically a two week loan of something around $2000 (my limited experience as a customer service rep for an RAL lender suggests $2000 is the most typical amount) for a deposit/account fee of ~$30 and a loan fee between $6 and $120, depending on a few criteria; the most typical loan fee (again for $2000) being around $80, for a total fee (to the bank) of around $110.

If your refund is supposed to be $2000 and you're supposed to get it in ten to fifteen working days, we'll give you $1890 in two to three working days, and you'll sign your refund over to us. A lot of people find that convenient (and the ones who are denied for past bad debts are usually quite upset -- "I'm about to get evicted" type upset,) and, just as my trainer predicted, not a single customer ever asked me what their APR was. It took long enough to explain that the loan was something that needed to be repaid in the event your refund was not released to the bank; I can't imagine explaining APRs to people.

And the RAL lender I worked for never charges additional interest, even on accounts that haven't been paid in over a decade. It's the original deposit fee plus the original loan fee plus the amount of the check you got (and, if your tax preparer collects fees out of the anticipated refund amount instead of cash in advance, add those fees in, too.)

I remember saying, when my trainer asked, that these loans were a terrible deal (he DID ask, and I was only a temp.) But the customers pretty clearly disagreed, or at least, felt it was a better deal than the alternatives. Even with 400%+ APRs, apparently.

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