Latest posts by Nikol (see all)
- How to get out of payday loan debt - October 10, 2015
- What you need to know about payday loan consolidation programs - September 2, 2015
- Payday profitability: why there is less profitability in payday loans - August 10, 2015
Usually, people tend to believe that payday loans are extremely profitable. The truth is quite different though. Payday loan lenders have ordinary profitability despite the high interest rates of their products.
A recent study found out that payday lenders’ returns don’t differ from financial returns of other lenders and their effective annualized interest rates of many thousand percent don’t change that. Data on stock returns and loan-level data from a payday lender show that payday lenders face very high loan and store fixed costs in an extremely competitive market.
The research also found that there are certain aspects of the loan terms in payday loan contracts that are very puzzling. Payday lenders charge a fixed fee that is typically around $18 per $100 to every borrower, independent of the size or the risk of the loan.
If the firms were pricing loans only according to their costs, they may charge flat fees per every loan, in addition to proportional fees. This means that despite the fact that the cost of loan losses is obviously proportional to loan size, the cost to the firm for lending and collecting is probably independent of loan size. From that point of view, loan pricing and the structure of loan contracts in the payday loan industry may be hard to understand.
Moreover, loans are approved or denied based on a credit-score rating chosen by the firm. Sometimes, the credit-score threshold for loan approval of a given firm may not vary across store locations within states, and usually changes once during a four-year sample period. This is surprising because local costs differ and one may assume that approval thresholds should also differ.
The financial aspects behind payday lending
When looking at the interest rates payday loan companies charge, it is hard to believe that there are companies that actually engage in this business. Nevertheless, there are a lot of lenders and a lot of people complaining about the industry and dangers of payday loans regarding the borrowers.
However, there are also those who defend the lending industry. If somebody borrows money only to buy beer and cigarettes, he has to pay an inflated interest rate. There is no collateral covering the loan and they’re usually directed at people who have no borrowing alternative. Such people don’t have a good credit score, so that’s why they aren’t able to get a loan at a bank. Therefore, they should pay inflated rates. It is a rational and simple industry.
Also, payday lenders are people who are aware that a customer is in a terrible financial situation. Payday lenders view that as an opportunity. But this doesn’t mean they enjoy outrageous profits. Despite the fact that customers are being overcharged, investors aren’t thrilled. Let’s take a look at some examples from American lending companies.
The largest among them booked a little over $1.8 billion in revenue in 2012. However, after it paid all the expenses, it booked only $107 million in profit which puts the net profit margin at 5.94%.
Another big lending company that has over 850 different locations has booked an $80 million net profit on $596 million of revenue. This means a net profit of 13.4%.
Another largest lending company operates financial stores in eight different countries including Canada, America, and even Ireland. The company booked $52 million in profit on $1.06 billion in revenue for a 4.91% net profit margin.
And finally, there is a payday loan company which also dabbles in car loans and made $7.9 million profit on $143 million in revenue for a 5.52% net profit margin.
These are the four largest publicly traded payday loan companies in the U.S. If we average out their profit margins, they make only 7.44%. That number is much smaller than what most people imagine.
If we compare that to some other companies, we will find out that during 2012, Apple made a net profit of $41.7 billion on a revenue of $156.5 billion. That’s a net profit margin of 26.65% and it’s twice as much as the profits of the largest payday loan lenders in the United States.
Another big company is Google that booked a net profit of $10.8 billion on $50.2 billion on a revenue with a net profit of 21.5%.
For the same time period, Coca-Cola has 18.9% net margins, IBM 15.9%, Disney 13.5%, Microsoft 28.1% and Intel 20.6%. All of them made more per dollar than even the most profitable payday loan company.
These surprising results are due to the fact that the people payday loan lenders give money to aren’t very likely to pay it back.
Some of that is actually because of the very high interest rates. But someone who needs to borrow money to make it till their next paycheque is a great credit risk. Payday loan borrowers show that they’re a credit risk by getting a payday loan in the first place. Payday loan lenders write off an enormous amount of loans every year. Because of that, it turns out that they don’t actually make a lot of money.
Even though there are a lot of problems with payday loans, they aren’t the outrageously expensive money makers people tend to believe they are. The rates are so high for the lenders to make any money at all.
How do payday loans work?
A payday loan is provided by a third-party lender. It is supposed to help consumers get out of a financial emergency by offering a cash advance on an upcoming paycheck. To get out of a financial trouble is undoubtedly a good thing but the interest charged by payday lenders typically surpasses 100%, which could make the situation even harder for the borrower. Therefore, it is arguable whether payday loans are actually a great service for those in need, or they are an example of predatory companies preying on people’s troubles.
The idea is that when the borrower is short on cash and can’t wait until his next paycheck, he turns to the local payday lender or online payday lender. The borrower then asks to set up a payday loan that is usually between $50 and $1,000. The customer writes a postdated check for that amount plus the fees he owes to the lender. He is provided with the payday loan right away and when payday rolls around, the lender will cash that check in order to collect the profit.
Typically, people who decide to use payday loans find themselves in situations where they don’t have other financial alternatives. To them, a payday loan is a way to obtain money for a short period of time without having to ask for handouts. People with a very low credit or no credit at all are ideal customers for payday lenders.
Why payday loans are not the best option?
Usually, a payday loan is not an attractive option for short-term financial problems. This is because of the following reasons: the exorbitant interest charges, the doubtful lender reliability, the small loan size, and the possible negative effects that borrowing from these lenders can have on the borrower’s credit.
The amount of interest that is charged by payday lenders is enormous. Annualized interest of between 200% and 500% are quite standard in the industry. For example, annual interest charges from an $18 fee charged on a borrowed sum of $100 drops from 821% for an 8–day loan to 365% for an 18–day loan. Payday lenders also try to get around usury laws that are government limits on the amount of interest a lender can charge, by masking their interest charges as service fees, which usually aren’t subject to the same regulations as interest fees are.
How payday loan lenders overcome law regulations?
A lot of states have usury exemptions for loans made by foreign entities. This means lenders who are based outside the borrower’s state. When a state restricts the “service charge” strategy, lenders will often overcome this by setting up shop in states without restrictions on the amount of interest they can charge. For example, a lender in South Dakota where there is no usury limit, can make a loan to a borrower in California, where usury restrictions do exist. The excessive interest charged by payday providers is illegal in many states and countries, including Canada, where usury is technically limited to 60%. Lately, many states have been taking steps to restrict payday lenders from operating within their borders. Another option for the lenders is to provide payday loans online so that the location of the shop is irrelevant.
Traditionally, payday lenders tend to be less reputable than commercial banks. In an industry where documentation is of great importance, payday lenders usually require borrowers to provide personal financial and identification information as part of the approval process. Because payday lending provide profits for lenders without almost no requirements for professional credentials, a lack of information security and potential frauds are also among the negative aspects of payday loans.
Why lenders usually provide only small amounts
When considering all the detractors from the payday loan, the usual amount of most payday loans seems of little to no consequence. However, when we take into consideration the fact that most payday lenders won’t authorize a sum amounting more than $400, their usefulness, especially if someone is concerned about keeping up with car or mortgage payments, comes into question. These small amounts are in the lenders’ favors in several ways. The smaller loan amounts mean a greater borrower diversification. This is due to the fact that spreading money over more customers means less risk. Also, when a lender limits the loans to small amounts, he can often disguise exactly how extreme the interest rates are.
How to live without payday loans
Perhaps the greatest danger of taking out a payday loan is the risk of dependency. While a payday loan may get the borrower through the end of the month, the interest charged on the loan may easily make things even more difficult for him the following month. This may lead to a cycle of dependency that can permanently cripple a person’s financial stability. If this is the case, taking out a payday loan can have a lasting negative impact on the customer’s ability to get credit in the future. As payday loans become common and are being handled more and more by reputable and established companies, some payday lenders are starting to report to credit bureaus. Given the discrediting nature of most payday borrowers’ finances, defaulting on their payday loan could mean a lasting mark on an already low credit score.
How to find better alternatives
Payday loans are definitely not the only solution for short-term financial problems. If a person needs money and he decides that collateral and credit aren’t major problems, he can always take out a conventional loan. If taking out a personal loan isn’t a realistic option, asking one’s employer for a pay advance or turning to online lending communities can be a way to avoid taking out a payday loan. There is also the possibility of borrowing from friends and family which may be a better option than payday loans.
To turn to a payday loan is usually the worst alternative, but a payday loan could be your only option. If this is the case, it’s crucial to weigh your options and consider all aspects before you enter into a financial agreement that’s favoring the lender, not you the borrower. You can also try to build an emergency fund for yourself, so that you’ll have money available in case of an emergency situation. In a worst-case scenario, having an emergency fund to draw upon could be the best solution.