Payday loans: the problems and solutions

payday loans©iStock.com/PeskyMonkey

In 2013, some 1.8 million people in the UK took out around 10.2 million new short term, high cost payday loans, worth £2.8 billion, according to the Competition and Markets Authority.

In December 2013, 6% of UK consumers were considering taking out a payday loan in the next six months, according to ComRes research.

As the popularity of payday loans has increased, however, so has opposition to what many see as their unfairly high interest rates, troubling marketing tactics and poor treatment of customers who default on their loans.

We don't list payday lenders... We strongly support legislation that will reform this sector. As long as they're well implemented, we believe that rate or total cost of credit caps could help to prevent the poorest people in society from falling into unmanageable debt whilst still ensuring that consumers can benefit from borrowing.
Lyndsey Burton, Founder, Choose.net

This is our guide to those problems, and to the solutions proposed by national and local Government, regulators and other lenders.

Payday loans: how they work

Payday loans are a short term, high interest borrowing option which, as the nickname suggests, are meant to tide the borrower over until they get their monthly pay packet.

Fees and interest

Payday lenders generally charge a flat fee for borrowing - usually around £5 to £10 - as well as interest, although the total cost is expressed as a set amount. So, as in the example below, a payday lender might ask for £15 for £100 lent over a week.

However, all or some of that £15 is an interest charge, which means that if the loan is not repaid within the agreed period, the cost of the borrowing will increase. This leads to some terrifying representative APRs:

Amount borrowed Over... Total to pay (no fees) Expressed as a representative APR
£100 28 days £25 1737%
£100 15 days £19.50 4214%

As of February 1st 2011, all loan providers have been required to show a representative interest rate when they advertise borrowing. However, the "representative" APR isn't particularly representative in this case.

Unlike traditional loan providers, payday lenders don't charge compound interest.

Instead, if a loan goes unpaid there'll be a fee to pay, then interest will accrue on the balance for a set period - usually around 60 days - before the lender attempts, again, to have the borrower pay back the full amount.

As of January 2015, lenders can only apply fees and interest charges of up to 100% of the original amount a customer borrows.

For most users, this will significantly limit the amount they're expected to pay back - but those who take out larger short-term loans could still face a final bill significantly higher than they first thought.

Rollovers

For these customers especially, tempting or necessary as it may seem, rolling over a payday loan - not paying the amount or not paying it off in full - is an expensive business.

Many payday lenders subtly encourage their users to roll over loans from month to month, asking only that the borrower pays the interest for that monthly period, and sometimes also a fee, to keep the debt on their books.

By rolling over the loan amount, payday loan users can end up paying hundreds of pounds more than they originally intended to.

OFT research from 2013 revealed that 28% of loans were rolled over or refinanced at least once, providing 50% of payday lenders' revenues.

So after promising tougher rules, the FCA restricted the number of times a payday loan could be rolled over to two, a change that came into force in July 2014.

Some MPs have argued for further restrictions, saying rollovers should happen just once per loan.

What's the problem?

For many, payday loans are a solution to a simple problem: a short term lack of funds needs a short term injection of funding, one that people are willing to pay for.

What worries opponents of payday lending, however, is that the sector targets the most financially vulnerable consumers, the very poor, and those already in debt, making an already precarious situation even worse.

There is considerable evidence that's the case.

The typical payday loan user has a lower income than the UK average.

Consumer Focus research carried out in 2009 found that 67% of payday loan users had an income below £25k, and were much more likely to consider themselves as having a poor credit rating.

Although there is some evidence that middle-income earners also use payday loans, they seem to prefer lenders who have stringent rules on applicant acceptance.

In addition, those who already have debts seem much more likely to use payday loans. For example, Citizens Advice report that 40% of clients who have a payday loan also have at least one other high-cost credit loan, and those with payday loans have an average of eight debts in all.

However, low income alone isn't an indicator of financial vulnerability.

The Citizens Advice data is inevitably a little biased, as by definition they see people who are struggling to cope financially - and payday loans aren't necessarily worse than mainstream short-term borrowing options.

Payday loans vs overdrafts and credit cards

For example, let's compare one of the payday lenders from above with the overdraft charges on Halifax's standard current account.

Halifax charge £1 a day for anyone who has an agreed overdraft amount, and £5 a day for those without an arranged overdraft or who go beyond their agreed amount. In comparison, then:

Amount borrowed Over... Fee
Payday lender £100 28 days £25
Overdraft: Halifax arranged £100 28 days £28
Overdraft: Halifax unarranged £100 28 days £140

In addition, Halifax charge a fee, ranging from £10 to £100, for payments made once a customer has gone into an unplanned overdraft. The calculation above assumes that they don't incur any of these charges.

Qualitative research shows that for some, it's the fear of these extra fees and charges that encourages the use of payday loans.

The same study found that fees and confusing interest rates also drew many to payday loans who would have otherwise used store or credit cards.

Like some overdrafts, cards can be just as expensive as payday loans. Just before Christmas 2008, for example, MPs said they were "disgusted" by an Argos card charging 222.7% p.a. interest, just as much as many payday lenders.

For more on how these products compare to payday loans, see our guide here.

Payday loans vs. illegal loan sharks

What payday lenders and the mainstream do agree on, however, is that payday loans are still preferable to illegal lenders.

A 2010 OFT campaign against illegal loan sharks pointed out that of the 165,000 households in the UK who use illegal money lenders, half of them are in the UK's most deprived areas.

Other research has shown that external pressures can increase the incidence of loan shark use even further.

In 2011, the Real Cost of Christmas report, from think tank the Financial Inclusion Centre, estimated that £29 million in illegal doorstep loans were taken out during the 2010 festive season.

During that period, the report said, people borrowed an average of £300 from loan sharks - and extortionate interest rates increased the amount owed to £825.

Not only do these illegal moneylenders charge far more than any regulated service - tens of thousands of percent - but their methods when people can't pay up are nasty in the extreme.

What's the solution?

If the payday loan market is failing consumers, though, what's the solution?

Cost of credit caps

For MPs like Stella Creasy there's long been a simple answer to this: a cap on interest rates or the total cost of credit.

Caps on store and credit cards were a 2010 election promise from all three main parties, while 59% of the public support an interest rate cap on payday loans, according to research from think tank Compass.

In July 2011, the Department for Business, Innovation and Skills (BIS) said further research on rate caps was needed before the Government could proceed.

France, Germany and a number of US states already impose interest rate caps and there's no consensus on whether consumers have benefited, since the cap effectively kills the market, leaving consumers in need of credit with very few options.

As a result, a cap on the total cost of credit - that's fees as well as interest - also won wide support.

Martin Lewis founder of Moneysavingexpert is another notable supporter of this solution.

"By capping APRs we'd kill the [payday loan] industry," he's written on his blog, "yet a well imposed total cost cap rather than interest rate cap wouldn't do that. It would just limit the danger these short term expensive loans have."

In November 2013 George Osborne announced he would push such "cost of credit" caps into the Banking Reform Bill, forcing the regulator to cap total costs.

Both of these features are being introduced in 2015.

The FCA's regulations mean interest rates will be capped at 0.8% every day, default fees capped at £15, and, as mentioned, the total cost of the loan won't exceed more than twice the original amount applied for.

Despite the coming change, not everyone is happy.

Credit Action, now called The Money Charity, said they feared the caps, "even if only applied to one specific section of the credit market, could create flight on the part of certain lenders which would prevent borrowers from meeting their needs and prospectively drive [illegal] loan shark activity."

Unsurprisingly, perhaps, the British Bankers Association is also, "strongly opposed to the use of price caps for consumer credit in any form" citing evidence of a "detrimental impact on consumers' abilities to access credit".

Greater regulation

In July 2011, the Consumer Finance Association (CFA), a trade body for many payday providers, released a new code of practice for the industry.

From November 2012, short term lenders who belong to the Consumer Finance Association, the Consumer Credit Trade Association, the BCCA, or the Finance & Leasing Association - which is to say, almost all of them - agreed to comply with a good practice charter overseen by independent observers.

The charter commits lenders to, for example, "set out clearly how continuous payment authority works". The full document is available to view here.

But self-regulation is generally agreed to have failed, and under considerable political pressure, the FCA has enforced tougher regulation of the market since taking over from the OFT in early 2014.

One major high street payday lender, Cheque Centre, agreed to stop offering loans altogether in May 2014, while many other small payday lenders exited the market by deciding not to renew their credit licence under the new regulator.

As well as imposing limits on rollovers, the FCA appears committed to more frequent and wide ranging market checks than the OFT. As well as calling for tighter affordability checks by lenders and looking into how they treat borrowers with payments due or in arrears, they've announced emergency regulation of credit brokers for their role in the payday industry.

In general, payday loans have become such a political hot potato that those who don't support very fierce regulation are more likely to keep schtum than not.

Boris Johnson, for example, came under fire some years ago for allowing Wonga to sponsor New Year tube travel.

Fostering alternatives

A third and increasingly popular solution to the excesses of the payday market is encouraging consumers strongly towards alternatives.

Credit unions often see themselves as a viable alternative which has led to greater support for community lenders, for example.

But we can see that many payday users do already have access to alternatives.

A 2014 study found that 60% of payday borrowers could have gone to their bank for an overdraft or credit card, for example.

Choose's view on payday loans

Choose.net covers a wide range of financial products and aims to provide information for consumers no matter what their financial situation.

However, unlike other price comparison sites, we don't list payday lenders in our comparison tables. And we never will.

"We think fair borrowing should be widely available, not just an option for those with the very best credit records. Currently, the practices of payday lenders mean that isn't the case," Lyndsey Burton, founder of Choose says.

"We strongly support legislation that will reform this sector. As long as they're well implemented, we believe that rate or total cost of credit caps could help to prevent the poorest people in society from falling into unmanageable debt whilst still ensuring that consumers can benefit from borrowing."

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