A lot has been said about payday loan businesses charging high fees and interest rates from their customers. It has also been said that people who take these types of loans often fall into a debt trap. The press and some individuals have been lambasting them for some time now. And as a result, there is now a negative feeling about this business among a section of the population. Policy makers too try to take benefit of this situation by imposing restrictions to gain some brownie points. Are payday loans really such a sin?
The fact is that, it is actually the Merchant Cash Advance Lenders (MCAs) in America that are charging huge amounts from their clients, and not the payday loan industry. Several studies have revealed that the cost of a payday loan is at par or even less than what many other lenders are charging.
Let us investigate why the conventional Merchant Cash Advance Companies charge so high.
1. Commission – These businesses often have to pay a commission to individuals for bringing in the business. This is their acquisition cost. The commission can be quite high. Often, it comes to 10-15% and sometimes even more of the total factoring rate of the funding agency. Indeed, marketing costs have sky-rocketed in the last few years. For a $30,000 advance, the average acquisition cost can be close to $3,000. They will naturally have to cover this expense.
Payday loan companies also have to deal with acquisition costs, but it is much less, as these businesses work directly with consumers. Payday shops are located in local neighborhoods. They work with local communities. Online payday loan applications are so cheap to maintain. Any cost saving for the business is obviously good news for the consumer. It means that the benefits can be passed down.
2. Underwriting – A huge portion of the underwriting is in the operations. It comes from paying the salaries, which again can go into thousands of dollars as these businesses employ a lot of people. There are overhead expenses too, which too can be quite high. For a business that is personnel intensive, it can be anything between 5% and 10%. All this can eat away 7% to 8% of the gross profit margin easily. Obviously, these costs are passed down to the consumer, who eventually ends up paying much more than what was necessary.
Individual payday companies are small entities on the other hand. They are local players with low overhead expenses. There is hardly a lot of outflow towards salary. Sometimes, these firms don’t have any employees, or just a few.
3. The cost of capital – This is another serious issue that affects the conventional lender. Often, a loan product that was originally for a period of 6 months gets extended to 9 or 10 months because the loan could not be repaid on time. The lender’s risk level goes up drastically. Risk factors and underwriting assumptions works against this. Remember, the repayment cycle was based on 6, and not 9 or 10 months. The money that would have been paid back and re-cycled is suddenly not available any more. But the lender is still paying the cost of this capital, even while it is under-performing. This increases the potential of default. The company must cover the risk. Most of them will set up a reserve fund, which again means that this money is not in circulation, while the business is paying for its cost.
Payday loan companies are not faced with such problems. They offer the funds that they have themselves. Yes, there is a liquidity crunch if enough number of clients fails to pay back the due amount in time. But that is rarely the case, as according to statistics, more than 95% loans are paid off on the due date. And why shouldn’t the customers meet their commitments? After all, payday loans are small amount loans that run into a few hundred dollars. Its not at all difficult to pay it back. In fact most lenders get post-dated automated withdrawals forms signed up from their clients. The money gets deducted on due day automatically. This reduces the chances of default to a large extend.
4. Bad debt – This problem has plagued the banking industry since the very inception. Potentially, this can run into a huge percentage. The write-off rate for bad debt can be a whopping 8% to 20%. It depends on how well the business is managing its risks. Bad debt can arise when debtors are simply unable to repay the amount. It could also be from fraud. The bad debt can also arise from a funding program, which wasn’t all that well conceived.
The risk is considerably less for the payday loan operators from all over the United States. And of course, if the risk is less, it would naturally mean that the businesses won’t have to pass it on to its customers, which means that it would be cheaper in the end. As mentioned previously, the total loan amount runs into just a few hundred dollars. There is thus no fraud, as nobody wants to take a chance for so little money. The term is for just a couple of weeks or at most a month, which also brings down the risk by a great deal. The payday loan term cannot be extended in many states. This once again reduces their risks as well.
With all these issues, the lenders can easily lose their shirt. The cost and risk is simply too high. Naturally, most of them don’t want to offer short-term credit programs. And when they are being offered, they invariably come at a steep price for the consumer.
The FDIC recently came out with a detailed report on their “Small Dollar Loan Program“. This report revealed that most other lenders are finding it virtually impossible to compete with the payday industry. Only 31 banks agreed to participate in this program from 446 locations in 26 states. The FDIC report also noted that banks were unable to save their customers any money. In the end, they emerged as costly as the payday industry.
Payday lending has passed the test of time in the US. These loans have been around for some time, and they have helped thousands of individuals from poor and middle-income communities from around the country. It’s a vital source of credit for a lot of people. Many alternative programs have been tried. Nothing has been able to challenge these short-term loans, their rates, and the convenience they offer.
It is time the detractors, law makers and the popular media took note of this reality.
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