The poorest will suffer if we ignore the real evidence on payday loans
11 December 2012
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10 December 2012
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Tax and Fiscal Policy
19 November 2024
The non-stop tide of new regulation from the government continues. It now appears to be preparing to accept an amendment to the Financial Services Bill, which will allow the Financial Conduct Authority to cap interest rates on payday loans. A recent intervention by the incoming archbishop of Canterbury (who is strongly in favour of the amendment) probably proved decisive.
Even if you have no sympathy with the argument that people may rationally use payday loans to tide them over difficult times, banning an undesirable action isn’t necessarily the right way of solving the problem itself. As we know from other prohibitions, the effect of banning something is often to make a risky situation even more risky.
But first, some context. The incredible interest rates often quoted on payday loans are not really interest rates at all. Of course, part of the interest rate is designed to compensate the lender for risk – and this is a very risky business. But, more importantly, the administration costs of these tiny loans are included in the quoted interest rate. For example, a £100 loan for two weeks. with a set-up cost of £5, would have a quoted annual percentage rate of interest (APR) of 256 per cent, even if the interest charge were zero.
Yet such a set-up cost is not interest at all. If only 5 per cent of loans default (or require additional collection costs because of late payment), you can easily see how the quoted interest costs rise, even though those costs bear little relation to the concept of interest as it is normally understood. Arguably APR should not be used at all when looking at the cost of payday loans. It is a totally misleading concept.
Proponents of a cap on interest rates often cite credit unions as providing much cheaper finance. And it’s true that they are much less expensive. But their costs are lower because they are able to use volunteers to administer the organisation, and financial regulation is much less intrusive.
Putting these points aside, the capping of interest rates on payday loans also has great risks. The Office of Fair Trading has always been reluctant to recommend this step, and with good reason.
The Department for Business, Innovation and Skills (BIS) undertook comprehensive research on interest rate caps back in 2004. Some of that research has been criticised for being incomplete. However, the critics never really provided any evidence that BIS’s conclusions were actually wrong. And those conclusions were particularly interesting.
France and Germany, which both have interest rate caps, had around five times the level of complete financial breakdown – such as bankruptcy – among people who had trouble with their debts. While the figure stood at only 4 per cent in the UK, in France and Germany it was between 20 and 25 per cent. This is a shocking statistic. Financial breakdown of this kind is often accompanied by difficulties in obtaining housing, employment and the purchase of essentials such as food.
Furthermore, the proportion of those who are credit impaired who use illegal loans was reported to be tiny in the UK – around 3 per cent. However, the use of illegal loans was much greater in France and Germany, at nearly three times the British figure. Debt collection agencies are bad enough but, when it comes to calling in loans, illegal loan sharks have very unpleasant methods indeed.
The problems do not end there. Those who cannot get credit, in markets where there are interest rate caps, tend to turn to even more expensive or less desirable sources of finance. This will include forms of finance with much higher explicit charges or the use of mail order to purchase essentials at much higher prices.
None of this should imply any lack of sympathy for those who are caught in the payday loan trap. But our experience over a wide range of issues is that banning something that people – for good reasons or ill – desperately feel they need can be very counterproductive. The most vulnerable often suffer most. Trying to simply legislate away a problem does not make it disappear.
The article was originally published in City AM.
Even if you have no sympathy with the argument that people may rationally use payday loans to tide them over difficult times, banning an undesirable action isn’t necessarily the right way of solving the problem itself. As we know from other prohibitions, the effect of banning something is often to make a risky situation even more risky.
But first, some context. The incredible interest rates often quoted on payday loans are not really interest rates at all. Of course, part of the interest rate is designed to compensate the lender for risk – and this is a very risky business. But, more importantly, the administration costs of these tiny loans are included in the quoted interest rate. For example, a £100 loan for two weeks. with a set-up cost of £5, would have a quoted annual percentage rate of interest (APR) of 256 per cent, even if the interest charge were zero.
Yet such a set-up cost is not interest at all. If only 5 per cent of loans default (or require additional collection costs because of late payment), you can easily see how the quoted interest costs rise, even though those costs bear little relation to the concept of interest as it is normally understood. Arguably APR should not be used at all when looking at the cost of payday loans. It is a totally misleading concept.
Proponents of a cap on interest rates often cite credit unions as providing much cheaper finance. And it’s true that they are much less expensive. But their costs are lower because they are able to use volunteers to administer the organisation, and financial regulation is much less intrusive.
Putting these points aside, the capping of interest rates on payday loans also has great risks. The Office of Fair Trading has always been reluctant to recommend this step, and with good reason.
The Department for Business, Innovation and Skills (BIS) undertook comprehensive research on interest rate caps back in 2004. Some of that research has been criticised for being incomplete. However, the critics never really provided any evidence that BIS’s conclusions were actually wrong. And those conclusions were particularly interesting.
France and Germany, which both have interest rate caps, had around five times the level of complete financial breakdown – such as bankruptcy – among people who had trouble with their debts. While the figure stood at only 4 per cent in the UK, in France and Germany it was between 20 and 25 per cent. This is a shocking statistic. Financial breakdown of this kind is often accompanied by difficulties in obtaining housing, employment and the purchase of essentials such as food.
Furthermore, the proportion of those who are credit impaired who use illegal loans was reported to be tiny in the UK – around 3 per cent. However, the use of illegal loans was much greater in France and Germany, at nearly three times the British figure. Debt collection agencies are bad enough but, when it comes to calling in loans, illegal loan sharks have very unpleasant methods indeed.
The problems do not end there. Those who cannot get credit, in markets where there are interest rate caps, tend to turn to even more expensive or less desirable sources of finance. This will include forms of finance with much higher explicit charges or the use of mail order to purchase essentials at much higher prices.
None of this should imply any lack of sympathy for those who are caught in the payday loan trap. But our experience over a wide range of issues is that banning something that people – for good reasons or ill – desperately feel they need can be very counterproductive. The most vulnerable often suffer most. Trying to simply legislate away a problem does not make it disappear.
The article was originally published in City AM.
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Why is that government allow legitimate loan sharks to exist. By licensing these extortionate money lenders they are condoning sheer greed on a massive scale. With interests rates of up to 4000% in some cases reported from online lenders, it makes some of the illegal lenders and criminals look actually legal. What is it with government that they are apparently a party to this terrible lending mentality that places ordinary people in even deeper and deeper debt. It is as though they want people to get into unavoidable and unrepayable debt. But why, cannot they see that the whole system is immoral and I greatly welcome the Archbishop of Canterbury’s intervention and where at least it shows that at least the Church cares for our people if our politicians seemingly do not. Actions speak greater than words and the government should take a leaf out of the archbishop’s book. It is undeniably one of the major financial elements that needs stamping out, as debt is the greatest burden on our economy and whenever debt persists and grows, an economy cannot in real terms deliver economic results to provide large growth in employment and new wealth. Apparently government and their wise advisers do not comprehend this first principal of economic recovery. No wonder the country is in such a precarious situation and where debt is our greatest threat by far. Seemingly government have learnt nothing from the financial collapse and the terrible repercussions that the people now endure for many decades to come.
Dr David Hill
Chief Executive
World Innovation Foundation