Latest posts by Henry Githinji (see all)
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Payday lenders may apply high-interest rates on the loans they give out but that does mean that they are making a lot of profit? Fordham Journal of Corporate & Financial Law did a profitability analysis where it was determined that the average profit margin for seven publicly traded payday lending companies (including pawn shops) was 7.63% and for pure payday lenders it was 3.57%. When compared to other traditional lending institutions such as banks, these averages are less.
A similar study carried out at the FDCI center for Financial Research showed that operating costs were in no way different from the size of advance fees that was collected and after subtraction of fixed operating costs and high rate of defaulters, payday loans may not be profitable after all.
Why there is less profitability in payday loans
As opposed to long-term loans, the default rates on payday loans are very high. A borrower is eligible for multiple payday loans and each time he or she has not completed paying, it can roll over to a new loan. There is also no principle applied to the original loan. Traditional lending institutions, on the other hand, will impose multiple interest rates on the borrower such that the original amount borrowed continues to increase.
Payday loan companies want to save costs by not engaging in traditional forms of writing and forms which would have given them an insight of the borrowers’ financial credibility. Traditional lending institutions, on the other hand, will want to perform a thorough background check on borrowers’ financial credibility so that there can be a way of getting back their money through collaterals after the duration of payment has elapsed.
Payday lending institutions can service individuals with multiple loans as long as they are assured of getting it from the individual’s salary. However, there is no other defined way to get back the money should a borrower of multiple loans lose his or her job or migrate elsewhere. Many payday companies can attest to this scenario which occurs almost repeatedly and lead to great losses in the long run.
Most countries are placing caps on interest rates on payday loans where they feel that the poor are being taken advantage of. As much as the interest caps may seem not to be big for each borrower, when added up, it cannot miss leaving a big financial gap for the payday lenders. This has threatened to put some of them out of business which is the reason why they are increasing the amounts to be borrowed in a bid to lower the interest caps but with the high rates of defaulters, the profitability is minimal.
On the other hand, traditional lending institutions experience multiple effects when they lower their interest rates. They are able to get more borrowers who will want to take small loans which they can repay quickly so as to get access to the bigger loans. This fact alone puts traditional financial institutions at the forefront because with them, borrowers are assured of a bigger loan which is not the case as with payday loans.
Indeed, payday lenders seem to be hanging on a thread if their profit margins are taken into consideration. However, all hope is not lost for them as they are coming up with new ways to ensure that they get back the money owed to them by defaulters which are the reason why their profits may not seem to bother them.