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Why Are Annual Interest Rates So High For Payday Loans?

Payday lending is surrounded by confusion and misunderstanding.

Critics see high Annual Percentage Rates (APR’s) and deduce that payday lenders are profiting abnormally at the expense of consumers.

As a co-founder of Australia’s largest online payday lender, I’ll share some of our experiences and show exactly why this view has no theoretical basis.

Cash Doctors do things a little differently from other players in the industry, so I can only talk from our perspective.

The interest rates for payday loans seem high with APR’s of 400 – 800%. Critic’s contrast this APR with that charged by mainstream credit providers (7-20%) and accuse short-term credit providers of robbing consumers.

After all, mainstream credit providers are quite profitable and they charge less interest. So payday lenders must be making an absolute killing.

I’ll show you why this isn’t the case. It’s not as simple as it appears.

The Fixed Cost of Providing Credit

The cost of inputs for a provider of small loan is the same as those incurred by the provider of large loans. With large principals, the lender recovers costs and derives income by charging a much lower APR over a much longer time frame. Short-term lenders must charge higher interest over short time frames to cover expenses and offer their products profitably.

Bear in mind a typical payday-lending principal is in the $100’s, not the $100,000’s and the loan is taken out for 10-20 days not 10-20 years. Interest is calculated as a percentage, which yields a small fee if it is based on a small principal over a short time (i.e. If you borrow $200 for 2 weeks, you’d repay Cash Doctors $244 – this seems reasonable for getting cash in les than 30 minutes without leaving your PC).

The Short Term of the Loan and Convenience

A demand curve is downward sloping. Thus as demand rises, price falls and suppliers enjoy economies of scale. Unsurprisingly, the demand for credit also follows this pattern.

Households demanding very little credit for very little time, pay more than households with high demand for credit. Thus high-income households demanding lots of credit will receive a quantity discount. Lower income households will pay a premium.

This premium reflects both the lender’s need to cover expenses and the convenient provision of small loans that are accessible within minutes. A convenience premium applies universally. Consider that one might be prepared to spend $25 on an 10km taxi ride from the city centre to their home, yet $36 for a bus from Brisbane to Rockhampton.

What Consumers are Willing to Pay in a Free Market

$100 today is sometimes more valuable than $122 in two weeks but may not be more valuable than $144, depending on one’s ability to repay and the strength of today’s need. If the value attached by the borrower to having the funds today exceeds the value of the principal plus the interest one or two weeks hence, the borrower will undertake the loan.

Consider that consumers take mortgages for $400,000 today and repay $650,000 over 30 years rather than waiting forever until they save the full price of a property.

Payday loan consumers use the fee when forming their decisions.

They do not make decisions based on the APR, which disregards the difference between a one week loan and a twenty year loan.