Today, let's talk a bit about the economics of payday lending. We're going to cover, at a macro level:
- Where they make their money
- How they structure their terms
- Their strategy to deal with regulation
How did payday lenders originally avoid regulation?
Traditionally, the payday lending industry (estimated ~$50 BB+ size when we went to press) skirted unsecured lending regulations (think credit cards) by restructuring the terms of the agreement. Debt from payday lenders was often written to not technically be a loan or lending product but instead a cash advance or an advance on a paycheck.
These advances came at extremely high APR equivalents.
Some of this was simply due to the size of the loans. It doesn't make economic sense to service small dollar amounts without fees layered on. Also, by definition, customers seeking payday loans are higher credit risk.
In fact – very often payday lending companies do not pull the credit report of a customer. A credit pull itself is often too cost-prohibitive and does not provide much incremental value in predicting risk.
How do the economics of payday lending work?
Payday lending is a shady industry. Still, recognize that customers in the target market are extremely risky to the lender.
While I was in the auto finance industry, I saw products with marginal risk nearing 50%. For these products we expected around half of all customers to eventually default. While I served that niche, products carried APRs in the 22%-25% range.
I tell you this background because payday loans are even riskier. Of note:
- Payday loans are unsecured – there is nothing to repossess in the case of a default.
- These consumers are specifically adversely selected. No other forms of credit are available to them. (Payday lenders are the "lender of last resort", or at least the legal lender)
To handle the risks, the advance companies must be able to charge a very high rate. They don't have a choice; losses would overwhelm these lenders if the rates weren't extreme.
Here is an example of how a payday loan might be structures:
Dollar amount: $200
Payback Amount: $250
Timeline: 2 weeks from now (usually defined by the pay-cycle of the recipient)
Effective APR (250/200 - 1) * 26 = 650%(!)
If the company made 5,000 loans with these economics and perfect success, they'd receive back $1.25 million in two weeks on $1 million lent.
Effectively, in this scenario they lose money if more than 20% of loans default.
When should the Government step in on payday loans?
I'm torn between my personal and political thoughts on this matter. I gravitate towards believing that contracts must be fulfilled. So long as there's no deception in the agreement, borrowers should be repaying loans.
Even more so, this segment of the credit spectrum is so risky. There has to be a premium on these products, otherwise they couldn't stay in business.
Consider student loans, if you will.
Student loans in the US can't be discharged in bankruptcy. It's only because of this feature that they're even possible at a profit. Many students take out loans having never applied for any credit before or having a poor score.
Since paydays loans are dischargeable, they're an even riskier product than student loans.
What other options are there?
Finally – what is the other option? Payday loans are, again, in a shady niche... but they're effectively the only lenders servicing it.
These customers are simply too risky to acquire credit from other forms of unsecured lending. They aren't eligible for credit cards or personal loans.
If you push out payday lenders, the other option seems to be a loan shark. As bad as the economics are – on both sides – I prefer this escape valve to the risk of physical danger.
Payday Loans and Repeat Offenders
A populist view of Payday Lenders concentrates on yet another point. Folks seeking payday loans are particularly vulnerable to poor financial products.
Desperation and – let's face it – credit ignorance can lead these customers into a vicious cycle.
Payday lenders make the majority of their money off "repeat offenders". These folks return time and time again and take out new payday loans. Sometimes they'll take out 10+ consecutively in a hard-to-break cycle of debt servitude.
This behavior makes those on the verge of poverty even more vulnerable to expensive fees.
There must be a better way to avoid customers taking out these loans while leaving a lender of last resort in place.
Serving the Financially Underserved
We've written about how 20%+ of the population is served outside the banking system. Relatedly, we also point out that check cashing services are sometimes a better option than traditional banks.
Here's the bottom line. Banks make money off large players or small fees on large amounts of money.
The frictions and costs involved in keeping an account open (and a branch) are overcome by large account sizes.
The economics are effectively the same. Banks can't serve small accounts. Traditional lending finds these borrowers too risky. The last resort options – payday lenders and check servicers – are sometimes the only place people can turn.
And hopefully that helps you understand the terrible economics of this niche. It sucks – but these are truly the lenders of last (legal) resort.
The products they offer are wildly expensive, but by definition they are serving the underserved where others can't.