Payday Loan Industry Defends Business Model as Feds Prepare Clampdown
Whether they offer payday loans online or through a physical store, payday lenders have been under attack for years. Many state legislators and municipal governments have enacted rules regulating the amount of interest lenders can charge for bad credit payday loans, how many loans a borrower can have at one time and how many times a borrower can renew a loan. However, the rules proposed by the Consumer Financial Protection Bureau mark the first attempt to regulate payday lenders at the federal level. Because the proposed regulations would require drastic changes to the business practices used by payday lenders, the industry has been forced to defend its business model.
Current Payday Loan Business Model that Lenders Are Defending in the Face of Federal Clampdown
Most payday lenders have a very simple business model. Borrowers must show proof of steady income and have a checking account. Based on this information, lenders agree to give the borrower cash, and borrowers agree to give the lender a postdated check for the full amount of the loan plus the lender’s fees. For online payday loans, borrowers typically authorize the lender to make an electronic withdrawal of funds from their bank accounts on the due date of the loan. If borrowers are unable to repay the loan when it is due, they can typically renew the loan by paying just the fees.
The current business model is straightforward and simple to administer. Employees who assist customers and who approve the loans require little specialized training. Borrowers typically have the opportunity to qualify for larger loans from the same lender by establishing an acceptable history of repaying previous loans.
The new regulations for storefront and online payday loans would involve many changes for payday lenders.
• Proof of income would no longer be sufficient documentation for a loan. Lenders would have to follow many of the same underwriting processes used by banks, credit card providers, mortgage companies and other traditional lenders. Before making bad credit payday loans, lenders will be required to verify the borrower’s other financial obligations, including housing and living expenses, to ensure that the borrower can repay the loan in full when it is due and still meet all other financial obligations. This will require companies that offer payday loans online or at a store to hire employees already possessing the necessary skills or undertake massive training programs for current employees.
• Lenders would not be able to make a payday loan to a borrower for at least 30 days following the borrower’s repayment of a previous loan. The only way around the prohibition is if the lender can document that the borrower’s financial condition has improved sufficiently. Like the other underwriting requirements, this will require lenders to upgrade their employees’ skills or expand their staffs.
• Unlike the current business model that may allow borrowers to qualify for larger loans, the pending regulations would have the opposite effect. If borrowers take out three sequential loans, lenders may be able to avoid some of the underwriting requirements as long as the amount of each loan is at least one-third less than the previous. Since many lenders may be forced to use this method, this could discourage borrowers from becoming loyal customers of a particular payday loan store.
The Truth About the Profitability of the Payday Loan Industry
One criticism that is frequently leveled at payday lenders is that are making huge profits from their loans. The truth is that bad credit payday loans are not as profitable as many people believe.
• In August 2013, FinancialUproar.com examined the four largest publicly traded payday loan companies operating in the United States. The profit margins ranged from 4.91 percent to 13.4 percent and averaged 7.44 percent. For comparison, during the same period, Apple’s profit margin was 26.65 percent, Google’s net profit was 21.5 percent, Microsoft’s profit margin was 28.1 percent and Coca-Cola earned 18.9 percent.
• A policy study published by Reason.org in 2013 reported even lower profit margins for payday lenders. When the profit margin for pawn shops and payday lenders was calculated, it averaged 7.6 percent, but after excluding pawn shops, the study found that payday lenders had a profit margin of approximately 3.6 percent. Commercial lenders, according to the report, averaged a profit margin of 13 percent.
• An article appearing in The Atlantic reported that the average profit before taxes for payday loan stores was less than 10 percent. The article stated that the entire consumer financial services industry had averaged a profit margin in excess of 30 percent before taxes for the previous five quarters.
• Two factors influencing the relatively low profits earned by payday lenders are the default rate and operating costs. The Pew Charitable Trusts, an organization that has been highly critical of the payday loan industry, found that payday lenders spend more than 66 percent of the fees they collect just keeping their stores open. The Atlantic article previously cited reported that loan defaults accounted for over 20 percent of the average payday loan store’s operating expensing, compared to 3 percent for small commercial banks.
Future Profitability of Lenders Offering Traditional and Online Payday Loans
Considering the relatively low profits earned by payday lenders, many people are wondering how the new federal regulations will impact the industry. There is widespread concern that payday loans will become little more than a memory. The simple truth is that lenders will not offer loans if they cannot make a profit, and the new regulations will require them to revamp their business models so drastically that profits are far from assured.
Although a number of organizations with connections to the payday loan industry have warned of the dangers represented by the federal regulations, one of the most telling warnings was issued by Moody’s Investors Services shortly after the CFPB released its proposed regulations. Moody’s report contained the following cautions.
• The proposed regulations will require dramatic changes to the business models and capital structures of payday lenders.
• Most payday lenders are not equipped to transition to lending that requires compliance with the new underwriting requirements.
• The new rules will result in a substantial reduction in revenue for payday lenders.
• New restrictions on borrowing frequency and loan size will result in reductions in both fees and volume.
• The new rules will substantially increase expenses for payday lenders.
• Branch-based payday lenders will close branches to reduce overall fixed expenses.
• Lenders will continue to expand their payday loans online operations, but these types of loans involve higher credit risks.
• Most payday lenders have limited experience with underwriting, and this could result in default rates and losses that exceed projections.
• The new regulations increase the risk of lender default, and investors could realize substantial losses if the lender files for bankruptcy.
When reviewing the points made by Moody’s, it is important to remember that Moody’s does not endorse or condemn payday lenders. Moody’s is only interested in providing professional, accurate advice to investors. Although Moody’s does not explicitly advise people not to invest in payday loan companies or to liquidate their current holdings in these companies, the implication is clear — the pending CFPB regulations mean that these companies will represent a higher risk and offer lower returns if the federal rules are finalized.
To Learn More
Payday loans can be an effective way to deal with an unexpected emergency. However, before deciding which credit product is right for your needs, it would be wise to examine all of your options. If you would like to learn more about payday loans, the pending CFPB regulations or other credit products, explore the many articles posted on the Personal Money Store.