A balanced look at payday loan interest and free market principle

 a pile of bills

Payday loans are priced based on free market principles, yet some try to make invalid comparisons between cash advance fees and interest rates for home and auto loans. Flickr photo.

Interest rates are the issue that payday loan opponents rely on most often. Anti-payday loan activists compare interest rates on payday loans with the interest rates for other financial products such as auto loans or home mortgages. Payday loan opponents make these comparisons because it’s the easiest way for them to support their arguments. The truth isn’t so obvious. Payday loans, and everything about them, are so different from loans for cars or houses that putting them in the same category as long term loans makes little sense.

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Payday loans, payday loans online and installment loans for people with bad credit fill an important role for consumers. These types of short-term financial relief are available in so many ways because there is a big market for them. During the recent, historically severe recession and what is so far a weak, jobless recovery, more people than ever need convenient access to short-term credit for money emergencies. While the market creates the environment for financial options like payday cash advances, it also determines the interest rates associated with these products.

Payday loans: value vs. price

Payday loans are like any product or service traded in a free and open market. For a product or service to be sustainable, the market creates a delicate balance between price and value. These rules apply to the interest rates applied to any financial product, from auto loans to mortgages. As long as payday loans deliver value for the price,consumers will continue to use them. As long as it’s worthwhile for payday loan companies to offer short-term cash solutions, they will continue to offer them.

Short term loans and the free market

Banks and car dealerships will set interest rates in search of optimum levels of customers and profits. If business starts falling off, their rates may be too high and they adjust accordingly. But no bank or car dealership will set interest rates that make it impossible to remain profitable. Most people would consider it outrageous if the government forced banks or auto dealerships to do that. But strangely enough, that’s what anti-payday loan activists would like the government to do to payday lenders, even though such measures were recently rejected as part of the big financial reform bill.

Right price, right now

For example, let’s say a payday loan costs about $15 to borrow $100 for two weeks. For millions of payday loan borrowers, that fee is appropriately set, based on the purpose of the transaction. A payday loan is a short term financial solution that is paid off in two weeks. For a person in a financial emergency, it’s worth it to pay $15 dollars in the short term to avoid long term financial problems such as credit damage or repossession. Responsible payday loan borrowers understand that it’s worth the cost if the payday loan is paid in full at the end of the term.

Comparing apples to oranges

Payday loan opponents use that $15 per $100 ratio and apply it to unrelated financial products like auto loans and mortgages, which use an annualized percentage rate (APR). In this case, the APR on the $100 payday loan would be in triple digits if a borrower strung it out for a whole year. Listening to these arguments, politicians are proposing that APR should apply to payday lenders, and the APR on payday loans should be capped at 36 percent. While a 36 percent interest rate would seem unusually high for a car loan or a mortgage loan lasting many years, it’s not enough to support small, short term loans lasting two weeks.

Fair market price

Direct payday lenders would not be able to make credit available to their customers if they offered 36 percent APR. The Richmond Times Dispatch reports that at 36 percent APR, the total fee charged on a $100, two-week cash advance would be $1.38. At that rate, payday advance lenders could not cover the cost of originating the instant payday loans, let alone meet employee payroll, benefits and other business expenses, like rent. The fees on payday loans are largely determined by how much they cost the lender to offer them. Like any business, profit from the transaction must be part of the equation. Millions of satisfied payday loan borrowers agree.

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