The top story on the BBC Today programme this morning was about the expansion of so called “payday loans”, drawing attention to the shockingly high interest rates such loans entail (1,700% APR is typical). This was hooked onto some research by insolvency group R3, which thereby got massive free publicity (Christmas came early for some PR person); the BBC web story is here. Even the sober Financial Times runs the headline “‘Legal loan sharks’ target urban poor“. This coverage makes me very uncomfortable. Time and again middle-class do-gooders and commentators fail to understand the grim economics of being poor – and their interventions usually make things worse.
What are payday loans? They are short-term loans (less than a month) for smallish amounts (typically £100s). The timing and amount is related to typical paydays, hence the name. Looking at moneysupermarket.com the typical charge is £25 for a one month loan of £100. They are provided by in a reasonably transparent way by public companies, rather than in the informal economy.
How to think about this? When providing financial products (similar logic applies to savings savings) it is easiest to think about three components. The cost of the money; the risk of default; and the labour input. The first two are well understood by everybody, and are directly proportional to the amount and length of time borrowed or saved, and can be understood as a rate of interest. The third is usually ignored, because if your are well-off it doesn’t amount to very much in the scheme of things. Labour input is the cost of actually providing the product (including distribution, admin, computers, and the rest); it is not proportionate to the value of the product, but to its structure, the number of transactions, and so on. If you are dealing in millions of pounds it is negligible; but if you are borrowing (or saving) the odd £100 it is not. £25 is a massive rate of interest for a £100 borrowing, but a run of the mill cost of labour input for a single transaction. If you don’t have much money labour input is highly significant; it destroys your savings and ratchets up the cost of borrowing.
If the loan is genuinely short-term then it doesn’t look unreasonable, in fact. What are the alternatives? An unauthorised overdraft at your bank will cost way more than this, since British Banks have lighted on this as a way of cross-subsidising “free” banking. And forget trying to get an authorised overdraft, which might well come with an arrangement fee, etc. And it is a much better deal than the real loan sharks in the informal economy. Credit cards (if you can get one) may be a better deal if you are careful. In fact you could look at payday loans as welcome competition in the lending market.
Much of the criticism of this type of product centres on people who use this type of finance for longer term needs, rolling over each month. This is a very bad idea and leads to even worse hardship, but is really right to ban this sort of product on the basis that it can be misused? Cars kill hundreds (even thousands) of people each year, but this doesn’t mean we stop the public from driving them. Much of the criticism is unbearably patronising.
There are two things we must learn from this. First is that finance for the poor is more about transaction costs than interest rates and rates of return. Longer term borrowing can be extortionately expensive; savings, including most pension plans, deliver much lower returns than those for better off people. It’s part of the poverty trap that is not widely recognised. And it’s one of the reasons why the welfare state is so important in developed societies.
And the second thing is that it is vital for everybody, and especially those on lower incomes, to understand finance much better. School teaching on “financial capability” is essential. Everybody needs to be numerate.
But well-meaning regulation, such as that which has pursued payday lenders in the United States, is a likely to make matters worse. You can’t legislate away the laws of physics.