Pay day loan providers have been in the press in the UK for having interest rates which are considered to be too high. In Canada each province can make regulations to limit the interest which can be charged by a pay day loan provider. However, how high is too high when it comes to interest rates in this industry?
Most provinces have put caps on the interest rates which can be charged – However, how did the provinces come to these rates? Why do some provinces allow higher rates than others? What is a reasonable rate of interest?
For a start it is worth noting that it is the APR of a pay day loan which is often criticised. Referring to the APR immediately makes a pay day loan interest rate seem extraordinarily high when comparing it to other forms of lending.
However, the APR is not really a suitable way of expressing the interest rate on a pay day loan because by their very nature the loans are short term, usually limited to about 45 days. Pay day loans are not intended to last for anything close to a year! For instance although pay day loan provider http://www.wonga.ca has an APR of 261% this is a distortion of reality – a better way to look at things is to consider the actual amount you would pay back for your loan. A typical Wonga loan of $300 for 14 days costs $30, with simple interest of 10%. If you take the following into account is that unreasonable?
What would be a reasonable rate? The economics of business would dictate that an interest rate which allows lenders to break even would be a reasonable rate (although not necessarily make business sense!). So are pay day loan companies charging way beyond their break-even point or could other traditional credit providers break-even if they charged lower interest and fees?
When considering the above issue the following aspects of the pay day loan industry seem to be ignored. First, a pay day loan provider (like any lender) needs to cover their costs of lending. The loan revenue for a long term loan like a mortgage is far higher than the revenue produced by a pay day loan. Further, the cost of assessing an application for a pay day loan provider is also higher per dollar because the amounts borrowed are so small. It must also be kept in mind that pay day loans also have a higher default rate than traditional lending. Having borrowers default on a loan affects the break-even point. The more borrowers which default, resulting in no recovery, the more has to be recovered from other borrowers who repay their loans.
Finally, a study has also shown that if rates and caps are imposed on pay day lenders they can be forced out of business – This shows that if the rate is too low the business no longer remains viable. This then leads to a further policy debate on whether people have a right to access such loans.
Pay day loans are obviously in demand by a growing number of people. If their interest and charges are so exorbitant one has to ask why traditional lenders are not trying to compete.