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Many people want to ban payday loans altogether, but are they really so bad? What would happen if they were banned? Can regulations work instead? Discover answers to the question of why are payday loans legal.
Payday loans often receive bad press, and many people have very strong negative opinions about the industry. But if they are really so bad, then why are payday loans legal? Why not just ban payday loans UK altogether?
In this article, we’ll explore some answers to this question. We will look at whether payday loans are as unreasonable as they are often portrayed to be, and discuss whether they ever actually help people. Do payday lenders prey on the unaware? We will then tackle the question of what would happen if payday loans were banned, looking at studies from America that analysed the results of banning payday loans in certain states. The article then discusses if there are any suitable alternatives to an outright ban, discussing how successful the current FCA regulations are in protecting the safety of borrowers.
So, why are payday loans legal? Read on to find out!
The topic of payday loan bans and regulations is a controversial one, and as a payday lender, Cashfloat is in the middle of it all. As you’ll see in the article below, there are many different options, but it’s hard to find one that will benefit everyone. At Cashfloat, we’ve decided to do our part by making sure we offer safe premium payday loans in a caring and responsible manner. We try to only lend to a applicant if it’s right for them, and are happy to rearrange repayment schedules in a way that will help them the most. The regulations are just a starting point for us. At Cashfloat, we are revolutionising the payday loan market, one step at a time.
Now, back to our question: Why are payday loans legal?
Before we begin, let’s first clarify exactly what a payday loan is.
Let’s take a look at the Oxford dictionary’s definition of payday loans:
So, payday loans tend to be for small amounts (usually £100 to £1,000). The interest rate is high, but the duration of the loan is not normally longer than one month.
It is important to note that payday loans are traditionally repaid in full on the borrowers next payday. Nowadays, there is an option of spreading out repayments over two or more months. These loans are more accurately classified as short term loans. Some lenders only offer loans over 6 months, or even 12. If you do go for longer short term loans no guarantor, make sure to clarify whether you can pay back early.
Now that we’ve defined a payday loan, the next step in discussing why are payday loans legal is to look at exactly how much a payday loan costs.
At Cashfloat, the APR is 997%. Does this mean that you pay back close to ten times the amount that you borrowed? Of course not! So, we need to answer the question: what is the real cost of borrowing?
Let’s say you borrow £300.
The maximum interest rate allowed by the FCA is 0.8% per day, and this is what most lenders charge. So, for every day that you have this money, you will pay £2.40 in interest charges.
If you borrowed the money for a 30-day period, this will come to £72 in interest charges, and your total repayment will be £372.
So, are payday loans expensive? Yes, they are! So why do people want them?
If you are living on a very tight budget, any extra expenses are difficult to cover. We’re not talking only about the lowest-earning members of the population; research has shown that the majority of borrowers actually have a net household income of over £18,000.
So why would they turn to a payday loan?
Ideally, everyone should have an emergency fund, stocked with ready-to-use money that should cover most financial emergencies. It’s not for a spur of the moment holiday to the beach, it’s for car or appliance repairs, emergency medical bills, and other similar situations.
But what happens if you don’t have one, or if you’ve just used it up for something else? In that case, you don’t have many options. Most conventional loans are for large amounts and last for longer periods. If you only need a small amount for a few weeks, you may not want to go through the arduous process of applying for a bank loan. If you can borrow on your credit card, that’s great, but remember – taking out cash from a credit card account is very expensive.
But what if you don’t have a card, or it’s maxed out? If you don’t have anyone who will lend to you, you may be well and truly stuck.
There is the option of going into overdraft. However, payday loans can be cheaper, as we explored in this article about overdraft vs payday loans. But is this a reasonable option, or are payday loans legal debt traps to be avoided at all costs? Let’s see if a payday loan can help out.
Yes, but it’s easy to slip up and get into serious trouble with payday loans. However, if you are genuinely in a situation where you need a temporary cash boost, a cash advance loan may be the only answer. Let’s take a look at an example of when a payday loan was used responsibly.A payday loan is like a sharp knife; very effective but dangerous if used irresponsibly Click To Tweet
Lisa is a 25 year-old interior designer who just got her first job. She has enough money to last her until her first payday, but not much more than that. So, when a pipe bursts early Sunday morning and starts flooding the flat, she finds herself in deep water. The plumber wants £200, but Lisa only has £100 left in the bank. And that’s meant to last her until payday! He won’t accept credit card, and Lisa doesn’t have anyone she can borrow that much money from.
After some deliberation, Lisa decided that a Cashfloat payday loan would be best for her. She borrowed £200 and three weeks later, when her first paycheck arrived, she paid it all off: a total of £233.60.
There are three important points to note in this example:
As this example demonstrates, payday loans are a useful financial tool when they are used responsibly. But are they? Or are payday loans legal debt traps? Do people understand what they’re signing up for, or are they being mis-led or misusing payday loans?
When someone takes out a payday loan, do they understand what they are signing up to? Or are they then caught unaware when the payments are due? This is a key issue of the debate of why are payday loans legal. One way of investigating this is to look at whether borrowers are managing to meet the repayments.
Are payday loan borrowers mostly able to repay the loan on time, or early, or are they all just missing repayments and having the fees piled on?
To answer this question, we took a look at our own statistics. Here’s what we discovered: well over two-thirds of our borrowers repay the loan early or on time. This seems to support the view that most borrowers are aware of what they are signing up for. They have calculated exactly how much they have to repay and figured out that they will manage it, before applying for a loan.
In fact, it has been proven that people living on a very tight budget are a lot more aware of their money flow than others. They know when more money is coming in, what they will need to use it for – and when a payday loan will genuinely help. Of course, we don’t always know what’s coming around the corner. That’s why not everyone is able to meet their repayments, and we at Cashfloat do our best to help them rearrange them to suit their circumstances.
But overall, the data does not seem to support the commonly held view that payday lenders prey on the unaware. Borrowers do know what they are signing up for, and the vast majority are able to repay their loans exactly as planned, or even earlier. Why are payday loans legal? It’s the same as cigarettes – adults are trusted to make their own responsible choices, and in general, they do.
What would happen if they were banned?
It’s easy to wonder, what would happen if payday loans were banned? People would no longer be caught by these ‘debt traps’, but would there be any other consequences?
Luckily for us, there is plenty of data available on this topic. In America, payday loan regulations are different for each state. There are twelve states that ban payday loans altogether, and almost all other states have some sort of regulations on them. In fact, only six states don’t limit the interest rates or fees at all. Where are payday loans legal, and where are they banned?
These states ban payday loans:
These states do not limit payday loans:
So, are the citizens of the twelve states that ban payday loans far better off? And are those who live in the six states where payday loans are not regulated suffering?
This study on payday credit access discovered something rather startling. After payday loan bans, the numbers of returned cheques and the income banks made from overdraft fees increased. This suggests that people were formally using payday loans to prevent their account from going into overdraft, or their cheques from bouncing. Once this avenue of credit was closed to them, they could no longer avoid the often hefty charges of overdraft and bounced cheques.
However, this study on access to payday loans had very different results. The evidence revealed that access to payday loans leads to increased difficulty in paying rent or mortgage, and utilities bills.
There are many more studies. Some conclude that payday loans are bad, some say they are good, while others find that having access to them made no difference whatsoever. Each study focused on slightly different pieces of evidence, but one conclusion we can draw from all this is clear. Economists have been unable to agree on the impact of banning payday loans.
So, back to our question: would things improve for everyone if payday loans were banned? Are payday loans legal debt traps that should be banned? There is no clear answer. Clearly, while banning payday loans would have some positive effect, it would also have a negative effect, and in some areas, make no difference whatsoever.
However, there is one further aspect to consider before recommending a blanket ban on all payday loans: if people are desperate for money, what will they do instead?
What alternatives will borrowers have?
If payday loans are no longer available, many people will try to just make do without. But what will happen in situations when they really do need the money? Overdraft may be an option, albeit an expensive one. However, it is likely that many people will turn to loan sharks. Is this an answer to why are payday loans legal? Let’s take a look at what loan sharks are.
Loan sharks are infamous for extremely high interest rates and increasingly violent collection techniques. As they are illegal, they do not operate under any sort of government regulations, and will stop at nothing to get the money that’s owed to them. Sometimes, they will even threaten the borrower and their family’s safety.
Borrowing from a loan shark is never a good idea, and rarely has a happy ending – besides for the shark, that is.
Please note: Some loans sharks pose as official-looking companies offering unsecured loans online. If they are not regulated, however, you are putting yourself in danger. Click on the banner below to read Cashfloat’s guide to spotting a loan shark online. Not in the mood to read a guide? Check out our clear and easy-to-read loan shark infographic instead.
All this leaves us wondering: is there any other, possibly more effective, solution than banning payday loans? Many have suggested heavily regulating the industry. What would happen then?
What about heavily regulating them?
Many of the anti-payday loans activists were pushing for very heavy regulations. They don’t see why are payday loans legal, but instead of an outright ban, they’re pushing for extreme regulations. They wanted to implement very low price caps on the interest rates and charges allowed. Would this work?
Let’s take a look at a 2-year bank loan. One of the leading UK banks offers personal loans with a 4.9% APR representative. So, if you borrow £10,000 for 2 years, you would pay a total of £506.90 in interest. This is reasonable, both for the borrower and for the bank.
But if we would apply such a low APR to a payday loan, what would the results look like?
A typical payday loan is for £250 over 30 days. With a 4.9% APR, the borrower would pay a total of 52.8 pence.
While borrowers would love this, payday lenders would go out of business. Clearly, confining payday loans to the same interest rates as larger loans would not work.
Additionally, payday loans are a very different product to most other loans. They are unsecured, which means that you don’t need a guarantor or any assets to back up the loans. This poses a high risk to the lender, and the general rule is that the higher the risk of the loan, the higher the interest rate will be.
Payday lenders are offering financial solutions for many people who the banks have declined, but need to charge a correspondingly higher interest in order for it to work. Limiting the interest rates to what banks charge, or even slightly higher, wouldn’t work for this type of loan.
So, heavy regulations would end up having a very similar effect to banning payday loans altogether. Almost all lenders would go out of business, and people would be forced to turn to loan sharks in desperation. What about less severe regulations? Well, that’s what we have today.
Since April 1st 2013, the Financial Conduct Authority has been in charge of regulating the payday loans.
They have limited the amount of interest lenders can charge to 0.8%. In effect, this has levelled the playing field considerably. Almost every payday lender will charge 0.8%, so for small, straightforward loans, it’s not really a case of shopping around for the cheapest loan – they’re all exactly the same price. As well, the late payment fee is capped to £15, and again, almost every lender will charge this amount.
These limitations mean that, while payday loans are still expensive, they are not sky-high. A borrower will not be signing up for a loan with a ridiculous level of interest out of desperation, but rather, they are agreeing to terms that are high, but reasonable.
Another consequence of these caps is that, once the prices are all the same, lenders now have to find something else to make them stand out in this highly competitive market. Whether it is improved customer service, faster cash or more flexible loans, these are now integral parts of a lender’s marketing strategy.
What about if they can’t pay back? Are payday loans legal debt traps? After all, that’s what the majority of complaints are about. If someone can’t repay their loan, will they fall into a spiral of debt? Are payday loans nowadays a debt trap?
Once again, the FCA stepped in to provide a metaphorical safety net for borrowers. We’ve already mentioned that the late fee is capped at £15. Additionally, the FCA have allowed a maximum of two rollovers. Before, borrowers would just keep rolling over their loan, piling up the interest, month after month. For most, there was no simple way out of this situation, as the debt just kept growing. Now, however, a borrower can only roll over their loan twice. So what happens if they still can’t pay?
Well, lenders can continue charging interest of up to 0.8% per day, but only up until a certain point. The total amount a borrower has to pay in interest and charges can never exceed 100% of what they borrowed. In real terms, this means that come what may, you will never have to pay back more than double of what you borrowed. Yes, this is still a lot, but we’re talking about an extreme situation here, where the borrower is consistently not paying back the money they were lent.
This is a most effective safety net, preventing the so-called ‘spiral of debt’ from getting out of hand. Of course, it is very important to remember this rule. Pressure from the lender may push a borrower towards taking out another, bigger payday loan in order to repay the first, in which case they are suddenly left with a much bigger maximum. Never borrow to repay a loan. The only exception to this rule is a debt consolidation loan, and that should only be done after a thorough inspection of your finances. Read this article on debt consolidation loans for more information.
So, are payday loans legal debt traps? With the current FCA regulations, this does not seem to be the case.
One more rule implemented by the FCA is that all payday loan applicants must undergo thorough affordability and credit checks to ensure that they will be able to meet the repayments. The theory behind this is that these checks will prevent lenders from eagerly lending to people who will quite probably miss the repayments, and be forced to continue paying charges and interest, increasing the lender’s profits.
Whereas this may have been common practice in the past, lenders nowadays know that if they are caught offering no credit check loans or lending to people who cannot afford the repayments, they will have to forfeit any charges and interest, and may be slapped with a heavy fine.
This has indeed happened a few times over the last few years. For example, Dollar Financial (who own The Money Shop, Payday UK, Payday Express and Ladder Loans) were found to be lending to customers who could not afford the loans in October 2015. In November 2015, Cash Euro Net (Quickquid and Pounds to Pocket) were caught granting loans without appropriate affordability checks.
But we still need to wonder, is this rule helping? On the one hand, it prevents people from taking out payday loans that they won’t be able to afford, helping them avoid being trapped in debt altogether. However, it is also blocking this line of credit from those who are the most desperate for it. True, they can’t afford it – but will this encourage them to cut back more (if possible) and maybe turn to a charity such as Stepchange for financial help? Or will it push them towards illegal and unregulated loan sharks, putting them in even greater danger? This is a tricky question, and one that there is no clear-cut answer for.
Back to our original question: why are payday loans legal? In this article, we’ve seen that banning payday loans does not always have a purely positive effect. For people who need them, and use them responsibly – which, based on our own statistics, seems to be the majority of borrowers – they are a useful financial tool. Banning payday loans will remove this buffer that can help people avoid expensive overdraft or bounced cheque fees, and help them cover emergency expenses.
Without payday loans, many people may be driven to loan sharks – a far worse option than payday loans. So, instead of banning them, the Financial Conduct Authority have decided to regulate the industry. We looked at the impact of the regulations and saw that they provide quite an effective safety net for borrowers, removing the danger of them falling into an ‘unending spiral of debt’.
Is leaving payday loans legal the best option? It’s hard to tell, but banning them does not seem to be much better. Are our current regulations good enough? Again, it’s arguable in both directions.
What is certain is that the UK payday loan market today is far safer than it has ever been in history.