Quick-fix loans can cost a fortune, but a rates cap may not be the answer
They've been called 'legal loan sharks', but payday lenders are thriving, and may save the desperate from real predators
Sunday 22 May 2011
Payday and other quick- fix loans may draw heavy criticism for sky-high interest rates and excessive fee structures, but they are proving popular with borrowers. New research from Moneysupermarket revealed that this month saw a 58 per cent increase in demand for payday loans compared to the same period last year.
These loans are rarely the best option, and debt charities have long been concerned about how they contribute to financial difficulties. Which raises an important question: should there be a cap on interest rates?
This is certainly a hot topic with the Department for Business, Innovation and Skills currently reviewing the findings from the Office of Fair Trading's investigation into the sector last year. Labour MP Stella Creasy and Conservative MP Justin Tomlinson also presented a Private Member's Bill calling for a cap on the cost of credit earlier this year.
Payday loans are often highlighted in any debate about capping credit interest rates. The loans are aimed at consumers needing to borrow cash quickly to tide them over until their next pay day, but due to their short-term nature they carry extremely high interest rates when converted to an annual percentage rate (APR).
"Since the credit crunch there has been massive expansion in the high-cost credit sector. Lenders charge as much as 3,000 per cent APR for small, short-term loans. We think that this is legal loan sharking, so we're calling for a cap on the total cost for credit," says Gavin Hayes, the general secretary of the think tank Compass, which is running the End Legal Loan Sharking campaign.
On the face of it, restricting interest rates could be a relatively straightforward way to reduce the cost of quick credit for borrowers. However, many groups are concerned that this would actually lead to lenders becoming less transparent, using back-end penalties and additional charges to claw back profits. At the end of a 12-month review last year, the OFT itself concluded that capping interest rates and charges imposed by doorstep and payday lenders would further reduce competition in the sector.
Crucially, some experts also say that a ceiling could cause lenders to withdraw from the market, leaving higher-risk borrowers with nowhere to turn and potentially steering them towards illegal lending.
"Where interest-rate caps have been introduced in other countries, the result was less competition and less choice for consumers. Restricting a lender's ability to price for risk will result in higher costs for all consumers, and, unlike now, there may not be an option to borrow for all categories of consumer and some may be forced to turn to loan sharks," says Russell Hamblin-Boone of the Finance & Leasing Association (FLA).
Interest rates do not necessarily paint an accurate picture when comparing different types of loan. A typical payday loan might be tagged with an APR of 1,200 per cent, for example, but this equates to a far less shocking £25 interest charged on a £100 loan.
"When you convert the interest rate of a payday loan to an APR, the costs involved can appear exorbitant. However, because of their short-term nature, expressing the rate as an APR can be misleading. For consumers who need money quickly, it can often be cheaper to borrow using a payday loan than by exceeding their overdraft limit without authorisation from their provider," says Tim Moss, the head of loans and debt at Moneysupermarket.com.
Despite the potential pitfalls from introducing a cap, however, there can be little doubt that there are areas of concern. While it may be unfair to point to interest rates as the basis of any criticism, it could be argued that the payday lending industry is taking advantage of tight lending conditions elsewhere by employing punitive repayment structures and fees.
At TxtLoan, for example, if borrowers do not pay their money back after 15 days the £100 loan rises to £117. Then on day 17 a £25 administrative fee is added and interest accrues at the rate of £1.13 per day until the loan is repaid in full. Another £25 is incurred on day 27, along with continuing interest, until a further £47 administration fee is added when the loan is passed on to a debt collector on day 46, bringing the total debt to £247.
An even bigger problem is that many payday loan providers, including Cash Genie and Uncle Buck, offer to automatically roll over the debt for those who cannot meet repayments. This rollover service enables borrowers to pay back only the interest and carry the loan amount over to the next month, adding another interest payment, which is where the high APRs will rapidly kick in.
With so much scope for spiralling debt, if a cap is to be introduced, campaigners are keen to stress that they will want this to encompass the total cost of the loan – not simply the interest rate.
"We don't want to see people being driven into the hands of illegal loan sharks, so we would set a rate that would be quite high to begin with and would therefore not put [payday lenders] out of business. We accept that some of these do have a role to play – but we want a cap to limit the excessive profiteering," says Mr Hayes.
Campaigners wary of a straightforward cap on interest rates say that the focus should also be on gaining better access to affordable alternatives, such as credit unions, which are presently limited to certain areas of the country but can offer a lifeline to lower-income families struggling to apply for low-cost credit elsewhere. In a step in this direction, the Government has announced it will invest up to £73m in credit unions, with the Post Office network set to play a central role in providing access to credit-union accounts.
"There is clearly a need for some further work to ensure that vulnerable consumers are treated fairly in how they access credit products, perhaps through the development of simple 'kite-marked' products," says Joanna Elson, the chief executive of the debt charity Money Advice Trust.
"Providing access to simple loan and banking products via Post Office banking services and credit unions is an obvious place to start."
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