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.
It is all very well saying that people should be better educated on financial matters. You are right but they are not and it would take a considerable investment to put that right even if the government decided to do it.
The problem is a symptom that people cannot live within their means and these payday loans a short term fix that risk making the problem worse once people start using them regularly. It is rather shocking that companies make profits from doing this kind of thing as well.
To say that PDLs are better than bank overdrafts is not particularly reassuring either. As you point out, banks use this facility to subsidise “free banking” in a way that is regressive.
There is something wrong about financial institutions making profits from people who are struggling with their finances. I do not know the solution, but I suspect we can learn from other countries how they regulate their financial services to stop this from happening. Even better would be to redistribute wealth better than we are at present and take away the demand for this.
We need to be very careful here not to fall into the Labour trap of trying to take run poorer people’s lives for them on the grounds that they can’t manage by themselves. Statements like “The problem is a symptom that people cannot live within their means” can lead to a very dangerous place. It is true of some people, surely, but not all, and making a working assumption that people can’t manage on their own is patronising. PDLs are open to abuse, but much better than black market lenders and even provide legitimate banks with competition. I don’t doubt that there are things the government should be doing to reduce abuse, but I’m getting fed up with the widespread assumption that all poor people are feckless and that the only reason for people to take out a PDL is their own stupidity. Cutting off poorer people from financial services will do nothing for mobility.
We also need to a lot less squeamish about people making profits. Profit-making businesses in a competitive market are far and away the best way of providing almost any service, to rich and poor alike. They have done far more to improve the lives of the poor in places like Africa, for example, than any amount of government or charitable aid. It’s not profit-making that is bad as such, it lack of competition and exploitation. Profit making companies will often push the boundaries of exploitation, of course, but we should not throw the baby out with the bathwater.
Matthew, I think you’ve misunderstood ‘payday loans’. They might be short – but the people stay indebted to the company for years. Often, the cost of the loan company are high, because they send someone round to collect the money, and more important ensure that the (sometimes vulnerable) debtor takes out more debt.
The reason that a lot of people chose these companies is not because of lack of education, but because they don’t have access to credit at more reasonable rates. Maybe they don’t have a regular income or don’t have a bank account (and the credit rating enjoyed by those of us who have had financial products for years). So having taken out one short loan (maybe to buy some Christmas presents for their children), they end up getting a regular visit from a loan shark encouraging them to stay in debt.
If we want people not to be ‘enslaved by poverty’ we need to ensure that debt is affordable and not pushed on people. This means curbing the incentives for Loan Sharks to push their products, and encouraging better access to affordable rates (eg Credit Unions). I hope you’ll look deeper into this issue.
Thanks Chris. What you describe is classic loan sharking, which is usually part of the black economy. In theory, at least, payday loans are different – often bought rather than sold (e.g. on the internet), and generally only to people who have a regular paycheck (hence the name). But I admit that it’s easy for it to tip over into something that looks very like loansharking, especially if the providers incentivise agents strongly – but even then £25 per £100 isn’t going to make anybody rich on very small loans. But your advice on looking into it further is sound – I’m running on the theory of what is supposed to happen rather than what actually does. But then again, with the largish organisations involved, it’s a bit easier to enforce the theory than with real loansharks. But institutions like credit unions are a fundamentally better way of providing credit – just very difficult to get going on the scale needed.
Thanks Matthew for the reply. While I was typing, I was thinking of exactly the sort of organisation you describe. I won’t name them, but they are a large ‘pay day loans’ company (a ‘plc’ no less) with over 2 mill customers and a glossy website. They work in exactly the way I describe – with visits to people homes for collection and encouragement of new loans.
Unfortunately, you can have a pay check, but not have a good credit rating; so you don’t have the option of normal credit channels. Though, the loans companies, I can think of, certainly don’t restrict themselves to people with a pay check, as long as they believe they’ll eventually get their money back (maybe after visits).
You are right about credit unions being difficult to scale. This is a difficult challenge – and the more interesting to solve.