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Uncovering Payday Lending Myths

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.

We will examine Cash Doctors' experience and empirical evidence published by the Federal Reserve Bank of New York about the more advanced US market and content from the recently released Queensland Office of Fair (QOFT) discussion paper.

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.

Moreover, the payday lending principal is in the $100's, not the $1000's or the $100,000's. Interest is calculated as a percentage, which yields a small fee if it is based on a small principal.

Examining an actual credit provider's actual figures is compelling evidence. If Cash Doctors charged a mainstream unsecured loan interest rate of 12% APR on a $200 loan over our average loan period of 24 days, $1.58 of gross revenue would be generated which results in a large loss on the given loan. In short, the credit would no longer be available to consumers.

Smaller loans cost more per dollar borrowed than larger loans even when the efficiencies of an online-only organisation like Cash Doctors are considered (Morgan, p.8, 2007). Lenders based from a physical retail style setting are likely to have a higher average cost per loan.

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 benefit from accessing 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.

Consider that 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.

The Inherent Risk Associated With Providing Unsecured Short Term Loans
The payday lending industry is riskier than most other financial ventures and entrepreneurs must recover their investments and earn a positive return. Lenders draw scarce financial resources from other lines of investment and commit these resources to the provision of unsecured loans to sub-prime clients, some of whom have damaged credit histories.

What Consumers are Prepared to Pay in a Free Market
Rational, informed households trade off the good and bad side of borrowing; they borrow until the marginal utility of consuming another unit today just equals the marginal, discounted utility of repaying the extra debt on payday (Morgan, p.7, 2007).

$200 today is often more valuable than $244 in two weeks but may not be more valuable than $288 depending on one's capacity to repay and the nature of today's need. If the value attached by the borrower to the immediate cash advance exceeds the value of the principal plus the fee of one or two weeks hence, then the borrower will undertake the transaction. Similarly, consumers take mortgages for $300,000 now and repay $500,000 over 25 years rather than waiting until they save the full price of a property, 50 years hence.

Payday loan consumers use the fee as the real price signal. They do not make decisions based on the APR which disregards the difference between a 2 week loan and a 25 year loan.

The amount a client is prepared to pay must be managed with respect to what they can afford from their upcoming payday. This 'responsibility' is firmly reinforced by the commercial incentive a lender has to repeatedly turn over given principal and minimises collections activity.

Market Immaturity in Australia
The infancy of the Australian short term lending market contributes to the prevailing payday loan interest rates. Interest rates will fall as sophisticated lenders enter the market and become more efficient and competitive.

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 heavily regulated 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, very few clients have gone bankrupt since taking a loan with Cash Doctors (from thousands of loans). In each instance, much larger sums from multiple creditors were primarily responsible. Some payday loan clients face numerous financial difficulties independent of the payday lending industry.

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. Though Cash Doctors lends only to employed clients earning more than $400/week net and approves 20% of applications, demand has been high with turnover and staff increasing monthly. 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.

Why Cash Doctors Discourages Debt Spirals and Delinquency
We now arrive at perhaps the most tantalizing section of this report. There is a belief that payday lenders profit by deliberately lending more than borrowers can afford to repay and thereby promote delinquency. But does this make sense? How can payday lenders make profits if clients cannot afford to repay? (Morgan, p.1, 2007). How can payday lenders fund operating expenses, provide additional loans and make profits if high delinquency rates are crippling cash flow? It is not in the lender's best commercial interest to lead clients into debt spirals, welfare reducing avenues and delinquency.

It's in Cash Doctors' Interests To Have Loans Repaid On Time
Cash Doctors does not allow debt spirals to occur because interest halts when the loan is 30 days overdue. 'Rollovers' or 'back-to-back' loans are also not allowed. Thus, interest is only charged for more than 60 days in exceptional cases. Any lender who continues to charge interest indefinitely and courts delinquency is very unlikely to collect and maintain viable cash flow as time progresses.

Assume Cash Doctors ignored the current policy of lending less than 30% of a client's net pay (after tax less rent or mortgage). $200 is loaned to a client for 24 days, in the knowledge that her net income expected from the next pay cannot support the repayment of $275.84. A default may occur and interest halts at 30 days overdue, as per Cash Doctors policy, giving a total outstanding amount of $370.64 at 54 days from the loan date.

Rather than being lent out again, this $370.64 becomes a part of the collections process with an affordable agreement being made to recover the amount at $50 per fortnight which takes approximately 3 months to finalise. If the client was unreceptive to an arrangement and legal action was necessary, pursuing and recovering the sum would require additional time and resources.

A predatory lender, who allows the interest to continue indefinitely, rather than halting interest when 30 days overdue as Cash Doctors does, has a debtor of $655.04 after the same 5 months (54 days + 3 months). The opportunity cost of cultivating delinquency is the gross revenue lost on additional loans plus the costs associated with collections activity plus poor cash flow. It's a formula for ruin, not profit.

Cash Doctors is far better off by lending the same $200 a few times during the 5 month period, than it is from recovering the $370.64. Interestingly, Cash Doctors is also better off lending the same $200 a few times over 5 months than our predatory lender. Not only has he created a negative experience, but he'll find it costly to recover his $655.04 thereafter.

Reputation Awareness and Repeat and Referral Business
Contrary to the suggestions of some, Cash Doctors is reputation conscious and satisfies thousands of clients by providing a positive, transparent and efficient transaction. We subsequently enjoy repeat transactions and referrals. Lending excessively and promoting delinquency will not produce satisfied clients, repeat and referral business or business growth. This is a further disincentive to engage in predatory lending.

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.

Cash Doctors' client profile is quite different from the 2002 CLCV report ($24500 average salary and many clients earning less than $401 per week) and the perception of many critics. Ordinary hard-working Australians use Cash Doctors. They tend to work in administration, accounts, sales, education, IT, recruitment, insurance, customer service and health.

Operating a Payday Lending Business Properly Requires Sophistication
Some entrants into the payday lending industry are attracted by the same misunderstandings flowing from the critics. They think it's easy money. They do not understand the cost structure, the need for high volume, the requirement for strict adherence to procedures and the costs associated with managing overdue accounts. These lenders will be filtered out by their own ineptitude and superior competition over time. Costly predation can occur only if imperfect competition enables predators to charge higher than competitive fees (Morgan, p.11.2007).

Consumers Benefit More From Competition
Some critics fail to acknowledge a fundamental aspect of economics - competition within the payday lending industry.

Competition will unquestionably bid down prices over time much as we have seen in recent years with credit cards and other financial services. This was the purpose of the financial deregulation seen in Australia during in the 1980's. Only efficient lenders can exist in a competitive environment whereas inefficient or predatory lenders survive longer than they otherwise would within an imperfect competitive environment. As competition increases and the market matures, consumers will choose professional, sophisticated credit providers offering the most favourable rates, ultimately benefiting from competition (Morgan, p.22, 2007).

The Federal Reserve Bank of New York found empirical evidence that competition led to better outcomes for consumers. "We find that payday loan rates and fees decline significantly as the number of payday lenders and pawnshops increase. Despite their alleged naivety, payday borrowers appear sophisticated enough to shop for lower prices. The problem of high prices may reflect too few payday lenders, rather than too many"(Morgan, p.22, 2007).

If the threat of or excessive regulation looms, entrepreneurs and investors will not enter the market leaving the market for underground fringe credit providers or for those who circumvent regulation, reducing competition and raising prices having the opposite of the intended effect. The industry needs to be out in the open and monitored.

Conclusion
We have demonstrated why fees are fair and reasonable when costs of credit provision are considered. Cash Doctors has used genuine figures and experience and empirical research from within the most advanced market in the world, the USA to help elucidate the issues.

The welfare benefits of payday loans to consumers are evident along with the disincentive lenders have to exploit vulnerable consumers. Finally, we've shown that a competitive environment will decrease fees, benefiting the consumer. Thus increased competition, which reinforces desired outcomes.

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