Are Payday Loan Companies Money Hungry Charlatans?

by : David Roberts

It is hard to ignore media reports that a no fax payday lender charges 1,000% for a loan. Such an eye-popping APR shocks the conscience, particularly when you consider that so many of us pay under 10% APR for most of our mortgage, car and other debt. Even credit cards typically do not charge most of us more than about 15% to 20%. So how in the world do these cash advance stores and online payday loan lenders get away with three and four digit APRs? It turns out that the story is a tad more involved that the media and some advocacy groups would have us believe.

The first problem is that an annual percentage rate is a terribly misleading measure of the cost of a 7 to 30 day loan. It would be like measuring the cost of olive oil by the gallon, which could undoubtedly exceed $100. But we do not use olive oil by the gallon, and borrowers do not have payday loans outstanding for a year. In fact, a revolving credit card charging 10% interest can cost a borrower far more than a 7-day 500% payday loan.

The second problem is that not all payday lenders are making huge profits. Imagine what goes into a $100 cash advance for which a lender charges a $15 fee. Just in overhead the lender must pay employees, lease or purchase store fronts, and if online, pay to develop and maintain an Internet presence. As for the loan, the payday lender must spend money to evaluate the borrower and make the loan, not to mention the cost of defaults. For this reason, many academic studies have found that the payday industry's costs largely justify the price of a loan.

And finally, there is significant competition within the payday loan industry. A borrower has numerous online and store front options when considering a loan. This competition naturally moves the cost of these loans to a competitive level given the costs associated with the loan.

Payday loans can be expensive, particularly for chronic borrowers. But there is good evidence that the cost of a payday loan justifies the price. Legislation that caps the interest rate a payday lender can charge, like the one in Ohio, simply drives the industry out of the state. The result will be to send many of the borrowers into the unregulated black market of loan sharking. And this is the last thing state legislatures should want.