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High interest rates
A consumer borrowing £100 on the card would be charged £35 in interest on repayments of £5 a week over 27 weeks, giving an APR of 222.7%.
Is this for people who already have borrowed from the loan shark and must repay immediately or else? Or do the borrowers simply not understand annualized interest repayments? Of course micro-credit also involves high interest rates (in the 50-100 percent range, usually) but I can see two immediate differences. First, micro-credit is often used to take the kid to the doctor when otherwise the outcome would be grim. Second, micro-credit is usually marketed to the higher-IQ element in the village, not the lower-IQ element.
Addendum: Here is Virginia Postrel, defending consumer credit.
Posted by Tyler Cowen on October 28, 2008 at 07:46 AM in Economics | Permalink
Comments
http://www.providentpersonalcredit.com/
Posted by: at Oct 28, 2008 7:59:16 AM
Isn't 200% a fairly typical rate for a paycheck advance for a low income earner in the US?
Posted by: DDP at Oct 28, 2008 8:01:45 AM
I suppose a liberal gets mad at the lender. A conservative gets mad at the borrower. As a libertarian, I'm mad that I don't know how to get in there and charge 221%.
Posted by: Andrew at Oct 28, 2008 9:00:45 AM
It is possible that people who have really high present time-preferences need regulations (or guardians) to protect them. Children and drug addicts come to mind.
What would good alternatives be?
Posted by: matt wilbert at Oct 28, 2008 9:07:06 AM
Tyler_Cowen, you forgot to add that, despite consumers paying 221% annualized rates, it's a complete atrocity for banks to have to pay more than 4.5% on interbank loans and that if that's too inconvenient, then OBVIOUSLY they deserve government subsidized loans in order to prevent the disaster resulting from different groups being the financial intermediaries.
Posted by: Person at Oct 28, 2008 9:09:19 AM
As a libertarian, you also know there's a good reason the APR is 221%, and if you're willing to lend at that rate, you better be able to deal with all the default and debt collection you'll be faced with.
Posted by: mpkomara at Oct 28, 2008 9:12:43 AM
It is possible that people who have really high present time-preferences need regulations (or guardians) to protect them. Children and drug addicts come to mind.
What would good alternatives be?
Joining Andrew to figure out how to charge 221%.
Posted by: at Oct 28, 2008 9:13:17 AM
mpkomara, the question is not why the rate is so high, the question is why anyone pays it.
Posted by: Tyler Cowen at Oct 28, 2008 9:31:37 AM
good question. At Argos, you've got to want that vacuum cleaner in a bad way if you sign up for that card.
Posted by: mpkomara at Oct 28, 2008 9:42:04 AM
The article gives as example a Wii player costing 180 pounds, but 250 spread out over 6 months. That's a lot of interest, but nowhere near 200%. It is not entirely clear what is going on, but there is some mention of a 35 pound 'fee' you need to pay.
Presumably the high APR is calculated for small amount and repaying it fast, so that the 35 pounds result in a very high interest. But if the 35 stays constant for higher amounts and longer durations, this is a bit misleading.
Posted by: Zamfir at Oct 28, 2008 10:07:21 AM
It is possible that people who have really high present time-preferences need regulations (or guardians) to protect them. Children and drug addicts come to mind.
What would good alternatives be?
Let people "darwin" themselves out of the system, or learn how to do better.
Posted by: Jorge Landivar at Oct 28, 2008 10:10:58 AM
Tyler_Cowen: If that's the question, the answer's obvious: because they're
not actually paying 221% of anything. They're not paying "35%". They're paying
35 pounds. For having been trapped in an inconvenient spot.
I wish my annual purchases of convenience didn't exceed L35! (~$70) You purchase
convenience anytime you pay e.g. convenience store prices rather than supermarket,
restaurant prices rather than the cost of preparing it yourself, retail store
prices rather than online, etc.
You can only call it "221% interest" if you extrapolate to a circumstance that
doesn't exist.
Posted by: Person at Oct 28, 2008 10:17:44 AM
First, the cost of this loan is not exceptional. Many people in London borrow at APR of 500% or more.
Second, they do so because they tend not to think in terms of interest rates, but rather the level of the weekly repayment amount.
Third, they are also likely to be excluded from mainstream (i.e. cheaper) credit, for a whole range of reasons. Sometimes this involves having a poor credit history but often it involves the absence of any credit history.
Finally, those firms that are trying to provide cheaper loan products, with appropriate financial education at the point at which the loan is made, are still relatively small in size compared with the overall demand for credit.
http://www.fairfinance.org.uk/index.html
Posted by: Mark at Oct 28, 2008 10:27:03 AM
We need to see if Peter Thiel wants a piece of this action.
Posted by: Andrew at Oct 28, 2008 10:35:37 AM
I can think of few things less convenient than making 27 weekly payments. For me, just keeping a wad of bills and paid-off credit cards in my pocket works fine and requires few brain cells to manage.
I still don't understand most of the complicated stuff that otherwise uneducated people do every day just to buy stuff they can't afford.
Posted by: Andrew at Oct 28, 2008 11:05:04 AM
Let's not forget:
http://www.theonion.com/content/node/28387
Posted by: Gary Leff at Oct 28, 2008 12:05:33 PM
Tyler_Cowen: If that's the question, the answer's obvious: because they're
not actually paying 221% of anything. They're not paying "35%". They're paying
35 pounds. For having been trapped in an inconvenient spot.
I think Person--despite his merciless tone--is making a good point here. In my management of credit card balances I can get caught up in, "Well, should I put $x on this card with a slightly lower rate, even though it expires two months earlier..."
But then if I stepped back and realized I was stressing myself out over $65 (or whatever), I calmed down. I could just as easily go out to dinner instead of eating at home, and end up blowing more than $65, and yet I wouldn't have felt so "irresponsible" as if I didn't bother doing more research on the perfect credit card offer.
Obviously I wouldn't reason this way if I were the CFO of a major corporation, but when you're talking about relatively low balances--and especially if you pay them off within a few months--then looking just at APR can be misleading.
Posted by: Bob Murphy at Oct 28, 2008 12:59:09 PM
My other pitch to Peter Thiel streamlines microlobbying: Paypol.com
Posted by: Andrew at Oct 28, 2008 1:35:44 PM
To add two cents from the microfinance world:
1) Interest rates are typically lower than 50 - 100% p.a. - a better range would be 20 - 60% probably. There are of course outliers, but 220% is well into the money-lender universe. You can see some benchmarks for microfinance institutions online at: www.themix.org; median yield for 2007 is 29.9% globally.
2) Another difference is that microcredit interest rates are (often) high because of high operating costs (more detailed evaluation of borrowers, costs of working in rural or remote areas, etc.). Consumer credit does not incur the same types of costs since they have a much more automated approval process; probably they would claim that they are pricing primarily for risk. (I guess you could argue that high operating costs are a form of MFIs pricing that risk in up-front, rather than waiting for potential losses.)
Payday loan rates in the US can reach well over 400%, so it is also not as if this is exceptional. See some research at: http://www.law.vanderbilt.edu/faculty/faculty-personal-sites/paige-skiba/publication/index.aspx
Posted by: sbg at Oct 28, 2008 2:27:41 PM
I agree with "person". To get the "true" interest rate, you have to take the convenience factor out of the interest payment. It might be easier to pay 35 pounds than to apply for a credit card, fill out the application, wait for approval, wait for the card to arrive, then go the bank for a cash advance.
If you figure the PITA factor is 25 pounds, then the borrower is really only paying an extra 10 pounds, which is about 21%. 21% on top of credit card interest rates is only about 45%.
Another example (self-promotion: from my own post):
"I'm in line at the coffee shop at work, and realize I forgot to bring my wallet. I turn to my co-worker. If he can lend me $20, I tell him, I'll buy him a $2 coffee. He agrees. The next morning, after I've been to the bank machine, I pay him back his $20."
The interest rate on this transaction -- $2 on $20 for one day -- is about 128 quadrillion percent. But it's only $2. And having to leave the line, go get money, and get back in line, is worth a lot more than $2.
So the actual interest rate is not all that meaningful an indicator of the actual cost of the transaction.
Posted by: Phil at Oct 28, 2008 4:21:00 PM
My math is failing me. "A consumer borrowing £100 on the card would be charged £35 in interest on repayments of £5 a week over 27 weeks, giving an APR of 222.7%" I can see the £35 in interest (£5 a week over 27 weeks is £135, which could be considered £35 in interest). However, I get 78% APR for that. Even if I assume the £35 is an additional fee (so the total payment is £170) that works 178%. How do they get 222.7% for that loan?
Posted by: Blaise Pascal at Oct 28, 2008 7:59:47 PM
Blaise - it's an amortising loan, so the borrower doesn't get the use of the whole £100 for the whole 27 weeks - your calculation would be correct if the whole £135 was paid back as a balloon payment at the end of week 27.
Posted by: dsquared at Oct 29, 2008 8:07:34 AM
Phil and others are right that "convenience" needs to be taken into account when considering the attractiveness or otherwise of a loan.
However, this product is not being marketed to people for whom a few pounds is neither here nor there compared with the convenience of the product. It is being marketed to people who have little or no cash and no mainstream source of credit. They are price takers at >200% APR because that is their only offer in the market-place.
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