Monday, February 18, 2008

Payday Loans - An Example of Market Failure?

Payday loans involve very short term cash loans at very high interest rates. For example, National Payday loan company offer this loan:
  • To borrow $100.00 for 7 days incurs a charge of $25.00 (25%). Therefore the customer has to repay $125.00 which works out at an APR of 1303.57%
This interest rate far exceeds any standard interest rate. For example, the interest rate on a simple bank loan could work out at around 8%. Therefore, why would anyone be wiling to pay what is effectively an interest rate of 1303.5% ?

1. Lack of Knowledge.
Someone taking out a loan may not think in terms of APR. They may not even know what APR interest rate is. A consumer may think it costs $25 to borrow the amount I need and they are willing to pay the cost to avoid other problems. To be fair, companies do publicize APR on their website but it is possible customers may not fully appreciate their significance.

2. Poor Credit History. Many people who take out pay loans, presumably are ineligible for other types of borrowing. For example, immigrants or people with poor credit may simply be refused all other types of bank loans and credit cards. The number of people in this category is much higher than we may imagine. Therefore, payday loans may be the only available option. The alternative to taking a payday loan may be either defaulting on other payments like rent or going to an underground loan shark. However, most Payday companies require customers to have an active bank account before being eligible for a payday loan

Problems of Payday Loans.

The problem with payday loans is that when you start paying fees of $25 for $100 loans, your finances deteriorate rapidly. Paying such high fees mean that in the future it will become more difficult to meet loan repayments, therefore a single payday loan can start a vicious cycle of debt that is hard to get out of.

Benefits of Payday Loans

Better than the alternative of missing payments and getting a bad credit rating (although if people already have a bad credit rating this may not be such an issue)

What should governments do about payday loans?

To overcome market failure the governments should
  • Improve personal finance education. Making people aware of a range of financial products and the implications of things like APR.
  • Consider offering government backed loans to people with poor credit histories. The government doesn't have to do this out of charity. It could charge competitive rates of say 10% APR. However, the point is the government can include people into the financial system who are currently squeezed into very poor financial deals.

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