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Loans in small amounts are generally obtained to meet the short-term needs of consumers who often do not have access to conventional credit. Unfortunately, such loans are often mischaracterized as “predatory” by those who may not fully understand them, in part because the use of a misleading metric, the Annual Percentage Rate (APR). While an appropriate cost measure for home and car loans, applying the APR metric for small-dollar loans artificially inflates the perceived cost of such products.
Approximately 91 million consumers have subprime credit scores or lack sufficient credit file information to obtain a loan. The Federal Deposit Insurance Corporation in its latest biennial survey found that about one in four households either did not have a checking or savings account or obtained most financial services outside of the mainstream banking system.
The Federal Reserve in its latest survey found that 40 percent of adults could not cover an unexpected expense of $400 without selling something. Over one-fifth of adults report they are unable to pay all of their current month’s bills in full. The January 2019 Bankrate’s Financial Security Index reported that only 40 percent of Americans could meet an unexpected $1000 expense through savings.
Clearly, there is a large need for small dollar, short-term lending.
How to accurately and truthfully inform a person who is need of a small dollar amount of credit of the cost of such a loan is a subject of debate, but the use of APR as the preferred metric is not the answer. What are known as “payday loans” are typically $100 to $500 per loan and are borrowed for two weeks with a fee of around $15 per $100.
This works out to an APR of 390 percent, which certainly sounds high. However, in reality the consumer will not have the loan for one year. They will repay their loan in a matter of a few weeks.
Also, the fixed costs of originating and servicing a short-term loan must be spread over a much smaller amount than would be the case for a car loan or home mortgage. A lender must pay for the fixed cost of managing loans, such as rent, utilities and labor costs.
Then there is the cost of processing and administering the loan. A 2012 issue of Regulation Magazine found that the fixed and marginal costs of a $300 loan was $25. The risk of default in these loans raised the total cost to $40, or near the $15 per $100 that is being charged.
If small-dollar lenders were charging rates in excess of the actual cost of servicing and recording windfall profits we would expect credit unions and other traditional financial services firms to enter the industry. In reality, this is not happening.
The data clearly show that small-dollar lenders serve a consumer that mainstream banks are unwilling or unable to serve, and price their products commensurate with the fixed cost of operating those products, and commensurate with consumers credit risk.
An Adam Smith Institute paper makes this key point: Small-dollar lenders earn .43 cents for every dollar borrowed. In a high-risk marketplace, that’s not big money. Moreover, according to the Regulation Magazine study, credit unions simply can not make a reasonable profit by competing with small dollar lenders.
The simple fact is that small-dollar lenders serve people that mainstream lenders, for one reason or another, turn away. And by doing so, they fill an important and growing niche in the financial marketplace.
Gary Wolfram is the William Simon Professor of economics and public policy at Hillsdale College where he also serves as director of economics as well as professor of political economy.