Updated: Aug 20, 2019
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"If Bernie Sanders felt the urge, he could tweet about Home Depot charging an annual interest rate of 8,100% to rent a pressure washer."
The tweet that inspired the article:
Here's the problem:
Payday loans do not have annual interest rates. The normal cost of a payday loan is a 'fee' of $15 per $100 borrowed, more commonly known as 15%. These loans are very short-term, often lasting no more than a 14-days.
Why would someone get a payday loan?
The point of a payday loan is to aid the borrower in a terrible situation as a last resort. Often times it’s to make a car payment before the car is repossessed, or keep the electricity on long enough to make it until the next payday. The borrower may be facing a costly penalty from their bank, power company, or cell phone company. It's up to the individual to decide if this penalty is better or worse than the $15 fee (per $100) for taking out the loan.
So, why is it commonly asserted that a payday loan carries an interest rate of 300, 500, or even 1,000%?
An obvious fact must be taken into account. A short-term loan is meant to be held for a very small amount of time. When you get a payday loan, you are telling the business that you get paid $500 next week, but you need the money right now. The loan is meant to be paid back in one lump-sum payment, usually within 14 days. Considering the underwriting expenses, business costs, and general risk of loaning money, the business agrees to loan you that money at a rate of 15-20%.
Now, the problem begins. What happens if you don’t pay back the loan in 14 days? Typically, these loans refresh for another 14-day loan term. This failure to pay back the lender for an entire year, compounded every two weeks, could equal anywhere from 400-1000%.
The deceitful nature of the narrative pushed by Bernie Sanders lies with using an annual percentage rate to represent something that's supposed to last no more than two weeks. An easy comparison is to think of a hotel room. A typical hotel could cost anywhere from $50-150 a night. Most people would agree, that nightly rate is not exactly “predatory.”
When you book an average hotel for the week, you might be agreeing to pay them $300-900. All well and good, right? Okay, so what happens when you decide to stay in that room for a year? Well, that could cost you $18,000-54,000 over the course of the year! "This must be stopped! Why are annual hotel rates so expensive??" - said no one.
Where’s the outrage about annual hotel room rates? After all, you'd be better off to get a home mortgage and pay $14,000 per year towards owning your own property. It must be “predatory” that a hotel can cost 300-500% more annually than owning your own home.
There’s no outrage because we all know that a hotel room is meant for short-term usage, not the entire year. In fact, if you wanted to cap hotel rates at the cost of the average mortgage, hotels would be able to charge no more than $40 a night. Subsequently, most of them would close, and we’d be left with terrible, dingy hotels as our only option.
Money as value
Perhaps the best way of the viewing the situation is by viewing money as a valued commodity. Money has a value, after all. Roughly, the value of a $100 bill is $100.
Consider the tool-rental department at The Home Depot. Let's say you're going in to rent a pressure washer to clean the exterior of your home. The standard rental for this piece of equipment is $90/day. That's not bad considering the cheapest decent pressure washer would set you back around $400, and you only need to pressure wash your home once a year.
Now we've agreed to take home a product worth $400, and return a product worth $400 the next day. In addition, we've paid a rental fee of $90 for each day we have that product.
If Bernie Sanders felt the urge, he could tweet about Home Depot charging an annual interest rate of 8,100% to rent a pressure washer.
The logic-based conclusion..
This same logic must be applied to short-term payday loans. These loans are given out at two-week rates, and every two-weeks the rate is charged again. In other words, they charged you a fee of $15 to rent $100 from them for two weeks, and every two weeks you continue to rent that same $100, they are going to charge the rental rate of $15 per $100. It’s easy to see how this $100 loan can balloon, since $15 every two weeks will cost you $390 in fees over the course of a year. This final total of $490 can now be presented by do-gooder politicians as an "annual APR" of 391%.
Here’s where legislators like Bernie Sanders and Alexandria Ocasio-Cortez arrive to save the day.
BS & AOC are now pushing to cap payday loans at 15% APR. As great as this may seem, they are failing to see the obvious results this legislation will create. If you are a lender, what is the point in loaning out $100 at an APR of 15%? Quick math will tell you that over the course of the loan you will make a whopping $15. If the borrower holds up their end of the deal, and pays within 14 days, the lender will receive a total of $.57 in interest. This means the business is loaning out $100 in hopes of ending with $100.57 in two weeks. Ask yourself a simple question. Would you loan a stranger (with a history of poor financial decisions) $100 so you could make 57 cents? Could you build a business off of doing this?
Even someone without a business degree can tell you the outcome in this scenario. The numbers you need to keep your business open won’t add up when you’re getting less than a dollar from the people that actually pay back the loan inside the agreed upon term.
What if we used math to judge a policy proposal?
Keep in mind that if you loan out $100 to 10 people, it's not a guarantee that all 10 will repay the loan (or "return the product," when using the flawless Home Depot analogy from above). If you are making a loan based on collateral using a title, a home mortgage, or anything else you might give to the lender as a guaranteed payment in the event that you fail to pay back the loan, you can afford a lower interest rate. Side note: collateral is also what separates the low interest home loan from the high interest on a credit card or student loan.
A payday loan is given with no collateral. Meaning, if even two of the borrowers fail to pay, you now have to make up that money from the remaining eight. That means (if two fail to pay) you must charge at the very least, $25 (25%) in interest to each borrower just to break-even on the entire process. If you want to make the original 15% from the $1,000 you loaned out ($100 to 10 people + 15% APR = $1,150), you now need to make $350 from the remaining eight individuals (to reach the original $1,150 return target). Already, we’ve landed at a 40% APR that must be charged to reap the original 15% return target. What happens to the interest rate when three or four of the borrowers fail to pay?
To make matters more complicated, all of those numbers were if the loans made at the proposed 15% regulation were held through the entire term. If some of the borrowers actually pay back the loan upon receipt of their next paycheck, you'd receive $.57 in interest from those individuals.
Back to our 10-loans of $100 scenario.
If the mandate is 15%, that means we are looking for $1,150 total repayment from these 10 loans. If two of the borrowers fail to pay, you're now needing $1,150 from eight borrowers. If five people pay when they get their next paycheck ($100.57 x 5 = $502.85), you now need to earn $647 from the remaining three borrowers. Divided out, we'll need $215 from each remaining borrower. That's a minimum APR of 115% necessary to actually make the mandated 15% APR on your original $1,000.
As if that wasn't head-spinning enough, we didn't even take the lenders taxes, labor costs, or legal fees into account.
The regulated results
Proposals like this will either end in the closure of short-term loan businesses, or at least a minimum amount the borrower can borrow. More than likely, the minimum would land around $1,000 so they can actually make something from the 15% annual interest rate being proposed. Remember, every loan carries with it a cost; It is a legal document, after all. So, if at the very least your cost per loan is $25, you won’t see very many short-term loans available for that person that needed $100 to pay the electric bill before the lights get shut-off.
The most obvious consequence, however, is the fact that if the interest-rate is capped, the first response is to stop lending to customers considered "high-risk." If two out of every 10 borrowers fail to repay the loan, the business model is immediately insolvent. Therefore, those deemed "too risky" at the proposed 15% rate will not be approved for the loan. This wouldn't be the first government policy that harmed the specific group it was supposed to help.
Furthermore, there may be some people that can handle the risk of losing money on these loans. You guessed it, big banks. Don't you love it when the government torpedo's a small-business industry? No? Well, the big-businesses do. A big-businesses best-friend is government regulation. That's a topic for another day.
The common message we see from today’s politicians is that individuals no longer carry within them the responsibility to make good decisions throughout their lives. Every new policy is another assertion that you, the simpleton, need the great rulers to tell you how to live your life.
Try this out as a viable socio-economic theory: "The best course for the advancement of our society is the removal of all negative consequences that follow poor decision-making."
That doesn't sound like a great long-term path to me, either.
Payday loans are dangerous, and expensive. If you are so far behind that you need a payday loan- it's on you, and only you, to understand the risks involved. But, if you sign a line promising to pay someone money within two weeks, whose responsibility is it to see things through?
Live within your means, or at the very least, don’t make promises you can’t keep.