Monday, March 24, 2008

Would you pay 61,000,000,000,000% interest on a loan?

Every so often, "payday loan" operators come under attack for the high-fees they charge to their customers, most of whom are not well off. A couple of years ago, one of the local papers, the Ottawa Citizen, ran a bunch of stories on the issue. If I recall (the articles are not online), they sent a reporter out to get a loan, and it wound up costing \$75 for a three-day loan of \$300.

What's the annual compound interest rate on the loan? The charge was 25% of the principal; to get an annual rate, you'd figure there are 121.667 three-day periods in a year, and calculate

Interest Rate in % = 100 * [ (1.25)^(121.667) – 1 ]

Do that arithmetic, and you get an annual interest rate of over 61 trillion percent.

The Citizen took this number and went to town with it. The legal limit on interest in Ontario is 60%, and 61,000,000,000,000% is higher than that. The payday loan people actually charge 60% interest plus a fixed service charge, and argue that the service charge shouldn't count as interest. Advocates opposed to payday loans, of course, argue that it should.

Anyway, after a couple of days of this, I wrote the following and sent it to the editor of the paper's Op-Ed page. They didn't run it.

-----

In his breathless expose of the payday loan industry [Dec. 3, 2005], the Citizen asks, "would you pay 61 trillion percent interest on a loan?" Well, in some cases, yes, I would, and you probably would too.

I'm in line at the coffee shop at work, and realize I forgot to bring my wallet. I turn to my co-worker. If he can lend me \$20, I tell him, I'll buy him a \$2 coffee. He agrees. The next morning, after I've been to the bank machine, I pay him back his \$20.

Clearly, my friend is an exploitative loan shark. With compounding, the twenty-four-hour loan cost me an annual interest rate of about 128 quadrillion percent -- 128,330,558,031,335,269, to be more exact. That's 2,000 times higher than even the payday loan operators.

And it's a good thing I didn't stop by the bank machine until the next day. There's a bank machine between the coffee shop and my desk. If I had paid back the loan in five minutes, rather than 24 hours, the effective interest rate would be much higher. Much, much higher -- it would have 4,354 digits!

Here's a real-life example. Most of the major banks charge a service fee of \$2.50 for a credit card cash advance (in addition to the annual interest of 21% or so). Having forgotten my cash at home, I stop at the bank for an advance of \$50. I pay it back the next day. My total cost is \$2.50 for the service fee, and three cents in interest, for a 24-hour total of \$2.53. Compounded, that's an annual rate of 6,678,050,678 percent.

Should I feel ripped off that the bank charged me over six billion percent on my loan? Actually, it was worth it! The total cost to get my \$50 was only \$2.53. Had I used the same bank machine to draw money from my savings account, it would have cost me \$3 in ATM fees. Accepting an interest rate in the billions actually saved me 47 cents!

The moral: when loan periods are very short, and compounding does not actually occur, the astronomically high compound rates are grossly misleading of the nature of the actual transaction. Reasonable people should agree that both my transactions were quite acceptable – when you come down to it, they cost me only around \$2 each.

Which brings us to the payday loan services.

In their calculations, the Citizen assumes that service charges must legally be included in the interest rate charged. (The payday services disagree on this legal question, and it will be up to the courts to decide, of course.) But it must be noted, first, that the actual service does have a real cost, and, second, that including those costs in the interest rate cap would make it impossible to provide these services without going bankrupt.

The Citizen's experience was a charge of \$75 on a three-day loan of \$300, which worked out to 61 trillion percent annually. At a capped annual rate of only 60 percent, the lender could have charged no more than about \$1.50 (including both interest and service charges) for that same loan.

But there's no way \$1.50 will cover costs. It probably costs more than that in wages just to process the loan, or even just to pay the teller to help the borrower fill out the form. Add the cost of storefront rent, advertising, credit checking, and security (these stores are open 24 hours), and it becomes overwhelmingly obvious that it is not possible to provide short term loans at \$1.50 each. The banks, with full credit checks, preprocessed applications, and automated machines, charge \$2.50. How can a small storefront operator lend to total strangers, in cash and in person, at 3 am, for only \$1.50?

Now, an alternative argument could be made that even if \$1.50 is too low, \$75 is too high. Suppose we can agree that \$10 is a reasonable profit on a loan of this type. A \$10 charge on a three-day loan still works out to an interest rate of 5,402 percent, which is obviously much higher than the limit. This \$10 doesn't even include the overhead cost of bad loans – and when you lend to strangers in the middle of the night on the basis of a pay stub, there is bound to be a lot of fraud.

Every loan requires some administrative overhead. For long-term loans, like mortgages, the administrative cost is trivial compared to the interest on the transaction. But for short-term loans, administration is the lion's share of the cost. In these cases, to lump administration in with interest is disingenuous. More importantly, to insist on enforcement of the 60-percent limit is dishonest. For three-day loans, a 60% limit is the equivalent of a ban.

If a ban is what advocates want, they should come right out and say so -- instead of pretending the limit is workable, running scary but irrelevant numbers, and insisting that willing customers are being "exploited."

Labels:

At Monday, March 24, 2008 12:26:00 AM,  Phil Birnbaum said...

By the way, I just noticed an error in my original calculation.

In the coffee examples, I calculated interest as \$2 on \$20. But, since I'm buying my co-worker the coffee immediately, it's actually \$2 on \$18.

That increases the interest rates substantially: the 24-hour rate goes from 128 quadrillion to 5 sextillion, if I've done the math right.

At Monday, March 24, 2008 9:44:00 AM,  Brian Burke said...

If someone is so upset at the high interest and fees for payday loans, the solution isn't government regulation. The solution is more loan shops (as tacky as they are).

With full competition in the market economic rent will be eliminated, and an honest equilibrium interest rate/fee would prevail.

To regulate the market guarantees three things. First, the true market price of payday loans will never be known. And second, there will be a stiff barrier to market entry from competition.

Lastly, the lucky few shops that survive the regulation will forever be gouging customers. The regulated rates and fees guarantees a supplier surplus. In other words, the privileged shops will be conducting business at a price higher than necessary for them to be willing to conduct business. (Someone's going to be getting rich.)

This also creates strong incentives for businesses to continually lobby (bribe) government officials to adjust the regulations favorably.

Regulation chokes markets, reduces competition, and creates strong incentives for rent-seeking and corrupting behavior.

Who wins? Established, powerful businesses and government officials. Who loses? Consumers.

But as an O's fan, I want MLB to regulate the heck out of the Yankees and Red Sox payrolls!

At Thursday, March 27, 2008 2:14:00 AM,  Tony said...

Excelent example provided...
When you are in need of immediate money, at that time you don't want to get through the lengthy process of loan approval. We provide same day payday loans in UK, these are small loans that you can apply for fast approval. The main benefit of the same day payday loans are for those who have bad credit history, can also apply for cash.

At Monday, April 20, 2009 4:13:00 AM,  cvxv said...