The economic and social benefits of payday lending

Introduction

A great deal of confusion and misunderstanding surrounds payday lending. From outside the industry, critics see high Annual Percentage Rates (APR's) and deduce that payday lenders profit abnormally from 'predatory' lending practices at the expense of consumer welfare. As the founders of Australia's largest and most popular online payday lender, Cash Doctors, we will share some of our experiences and insights and reveal exactly why this view has no commercial or theoretical basis.

Firstly, we will cut through the emotion and conjecture and explain exactly why the fees seem high and how much it really costs an efficient payday lender to provide credit. Then, we will defy the conventional wisdom of the critics and show why consumer welfare is enhanced within a competitive payday lending environment in accordance with the basic laws of economics and commerce.

Why are interest rates high on payday loans?

The interest rate charged for a payday loan seems ostensibly high at a typical APR of 400 - 800%. Critics compare this APR with that charged by mainstream credit providers (7-20%) and claim short-term credit providers are charging unaffordable, exorbitant interest rates and are profiting abnormally.

After all, mainstream credit providers (ie. the big four banks) are profitable and they charge much lower interest rates. So payday lenders must be doing very nicely. Well, it's not quite as simple as it appears.

The fixed cost of providing loans

The Fixed labour and operating costs associated with providing a small loan are the same as those for providing a large loan. With a larger loan principal, the lender can recover costs and earn a profit by charging a lower APR over a longer period of time. Short-term loans must however charge higher rates of interest over short payback periods in order to cover the cost of the given loan and be profitably offered.

The short term of the loan convenience and bulk discounts

A demand curve is negatively sloping meaning that as demand increases, the price of a given product falls and suppliers enjoy economies of scale. The demand for credit is no exception.

Households demanding small amounts of credit for short periods pay higher rates than households with high loan demand. High income households demanding larger quantities of credit enjoy a quantity discount while lower income households will pay a premium (Morgan, p.8, 2007).

This premium jointly reflects the lender's requirement to recoup costs and the convenient provision of small loan amounts that are accessible within hours. A convenience premium applies universally as people are increasingly 'time poor'. Clients of Cash Doctors are the only payday loan clients in Australia who enjoy the ability to access several hundred dollars within an hour or two by completing an online application form and digitally signing a contract without spending valuable time compiling application paperwork.

In a similar fashion, one might be prepared to spend $20 on an 8km taxi ride from the city to their front door, yet $38 for a bus from Brisbane to Toowoomba. A bottle of soft drink costs 88c in a supermarket but $4.95 in a 7-11 at 3am in the morning. Credit also follows this pattern.

Payday lending enhances consumer welfare

Another misunderstood aspect of payday lending is its impact on consumer welfare. Critics argue that "exorbitant" payday lending charges impoverish vulnerable households by encouraging chronic household debt, delinquency, increased bankruptcy and reduced consumer spending in the economy.

In January 2007, the Federal Reserve Bank of New York published a paper entitled "Defining and Detecting Predatory Lending". The author Donald Morgan engages empirical research in a decidedly more advanced North American market to demonstrate that people living in states with unrestricted payday lending have an increased ability to overcome financial difficulty, maintain consumption levels and service debts. (Morgan, p.18, 2007).

Let's now examine why thousands of Australians are reducing detrimental outcomes for themselves by accessing payday loan credit.

Maintaining and smoothing out consumption with credit

If the ability to consume is diminished, households will demand credit to reduce fluctuations in their standard of living and to maintain consumption. However, Households without credit must fend for themselves or seek underground credit providers, a worst-case scenario, whose prevalence would increase in a capped interest rate environment where payday loans cannot be profitably offered. 'Thus, if payday lenders raise household welfare by relaxing credit constraints, anti-predatory legislation may lower it" (Morgan, p.4, 2007).

The allegation that payday lending dampens consumer spending within the economy is without basis when considered against within the context of credit cards. Have retailers ever complained that people's credit card repayments are slowing business? The availability of credit stimulates consumption with welfare for households highest if credit is available at competitive prices (Morgan, p.22, 2007).

Ability to manage other debts and repayments

The findings of the Federal Reserve Bank of New York suggest that consumers' ability to manage finances and service debt is enhanced by a competitive payday lending market.

'Our findings seem mostly inconsistent with the hypothesis that payday lenders prey on, i.e., lower the welfare of, households with uncertain income or households with less education. Those types of households who happen to live in states that allow unlimited payday loans are less likely to report being turned down for credit, but are not more likely, by and large, to report higher debt levels, contrary to the over borrowing prediction of our model. Nor are such households more likely to have missed a debt payment in the previous year. On the contrary, households with uncertain income who live in states with unlimited payday loans are less likely to have missed a debt payment over the previous year" (Morgan, p. 3, 2007).

'Delinquency rates were not higher for prey surveyed in 2001, even those living in states with higher or unlimited payday limits. On the contrary, risky households (with uncertain income) surveyed in 2001 were nine percent less likely to have missed a payment if their state allowed unlimited payday lending" (Morgan, p.18, 2007). Perhaps legislation to cap interest rates will therefore increase incidents of bankruptcy, missed debt payments and delinquency?

There is no evidence from Cash Doctors' experience that payday lending increases cases of bankruptcy. While Cash Doctors does not lend to bankrupts and halts interest when payment is 30 days overdue, only 9 incidents of bankruptcy have occurred since taking a loan with Cash Doctors (from thousands of loans). In each instance, much larger sums from multiple creditors were responsible.

Borrowing flexibility

Payday loans allow the consumer flexibility to borrow only what they need without committing to an unnecessarily large amount over a long period. Many Cash Doctors clients have clear credit ratings and are eligible for mainstream finance and prefer this style of credit to manage their finances. Unlike a credit card or larger personal loan, the client can enter the contract, meet their objective and promptly exit the contract.

A genuine need

Payday loans help people whom seek borrowing flexibility and those without access to mainstream credit. Before the advent of payday lending, households who applied to banks for a very small, short-term loan may have been denied (Morgan, p.8, 2007).

The need for short-term credit is evident from consumers' appreciation of a transparent, comfortable transaction. The contention that payday loans are used responsibly by clients and that repayments are affordable is supported by the fact that Cash Doctors has written off very little to date.

Preying on vulnerable consumers?

Cash Doctors lends only to permanently employed Australians earning at least net $400/week and does not lend to pensioners, bankrupts, contractors or the self-employed. The average salary of a client is $38,000 net and the average age 31. Cash Doctors performs credit checks to confirm the client is not bankrupt and conforms to lending criteria. Ordinary hard-working Australians use Cash Doctors. They tend to work in administration, accounts, sales, education, IT, recruitment, insurance, customer service and health.

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