Are Payday Loans as Profitable as We Think?

No. These firms have ordinary profitability despite astonishing interest rates.

My recent study with Jeremy Tobacman finds payday lenders’ firm-level returns differ little from typical financial returns, notwithstanding their effective annualized interest rates of many thousand percent. Standard financial data (on stock returns and SEC filings) and loan-level data from a payday lender are consistent with an interpretation that payday lenders face high per-loan and per-store fixed costs in a competitive market.

In researching these profitability questions, I have, however, found certain aspects of the simple loan terms in payday loan contracts as somewhat of a puzzle. Recall that payday lenders charge a fixed fee (typically around $18 per $100) to every borrower, independent of loan size or risk.

If the firms were pricing loans strictly according to their costs, they might charge flat fees per loan, in addition to (smaller) proportional fees. In other words, though the cost of loan losses is obviously proportional to loan size, the cost to the firm of loan origination and collection is probably independent of loan size. In this sense, loan pricing and the structure of loan contracts in this industry might be viewed as puzzles.

Also recall that loans are approved or denied based on a credit-score threshold chosen at the firm level. At the firm I’ve studied, the credit-score threshold for loan approval did not vary across store locations (within states), and it only changed once during the four-year sample period. One might expect that where local costs differ, approval thresholds should also perhaps differ.

I'd love to get more insight into how lenders make these types of decisions.

Comments

[source idea]

I'm surprised that you did not cite: Aaron Huckstep, Payday Lending: Do Outrageous Prices Necessarily Mean Outrageous Profits?, 12
FORDHAM J. CORP. & FIN. L. 203 (2007). Just an idea for another source to look at.

[Jake]

Perhaps the fees aren't so outrageous after all?
Advance America (AEA) recently published their 10K which you can access on Yahoo Finance under SEC filings.

[Yttrium]

Link to Huckstep paper cited above:
http://findarticles.com/p/articles/mi_qa4048/is_20070101/ai_n18781206/print

[James]

I think your conclusion does provide some defense against the charge that the services are fundamentally exploitative.

Just pulling a question out of nowhere in particular: are the default rates identical across the range of loan sizes? What about recovery rates? A larger loan might be easier to sell to a debt-collection service, or may justify a more aggressive legal pursuit that mitigates the losses.

What about regulatory issues? If the payday loan service is using the term "fee" to get around usury laws, they may be reticent about creating scalable fees that look more like interest to a regulator (or jury).

[AMC]

Why is this a surprise?

Fundamental economics dictates that this would happen.

There is no barrier to entry into the payday loan business - no special expertise needed, no costly capital requirements, no patents or intellectual property issues. Any store front will do.

So, of course, the number of payday loans operations expands until even the incredibly high margins of this type of lending are diluted by the thinner and thinner slice of the pie that each office (with fixed overhead) receives.

Take a look at this article from the Cleveland Plain Dealer - Cleveland's economy is one of the worst in the nation. The article says that there are 163 payday loan offices in Cuyahoga County (where Cleveland is located). Only Franklin County, where Columbus is located, is higher with 189 payday lenders.

http://blog.cleveland.com/business/2008/03/payday_lending_must_be_tamed.html

What appears to have been happening is that every place a new payday lender can bring in enough to make normal business profits, they build one. That dilutes the volume of each store, while cost remain fixed. At some point, it is likely that even with their outrageous interest rates, there will be too many payday lenders chasing too many customers for them to make a profit.

I fail to see how that makes what they do right, or the hamster-wheel misery they pedal of any societal benefit.

[Patches]

I like the way you put things AMC. I have never looked at it that way. You post makes a lot of logical sense.

Could there be any logic in assuming that struggling neighborhoods are targeted more frequently than affluent neighborhoods? Meaning that these loans were designed specifically to attract the destitute..??? By plain meaning they are but can we read more into that?

[AMC]

The customers of payday lenders are those who don't have any other financial reserves to fall back on - the working poor. The payday lenders are going to put their storefronts where the customers are - not the very poorest neighborhoods, where not enough residents are employed, and not the upper middle class to wealthy neighborhoods, where most people have other resources.

I don't read anything more into it than that.

Just because I was curious enough to do the math - the population of Cuyhoga County is listed at 1,393,978. So, if the article is correct, there is one payday lender for every 8,552 residents of Cuyahoga County. Franklin County has a population of 1,068,978 - so that is 5,656 Franklin County residents per payday lender.

[Patches]

Thanks AMC. Those numbers make it seem like there would be enough biz to go around. But again not everyone is getting payday loans as you said.

[Patches]

Hey, AMC checkout Reuters "Payday loans exacerbate housing crisis"

http://www.reuters.com/article/inDepthNews/idUSN1045663120080324?feedType=RSS&feedName=inDepthNews&pageNumber=1&virtualBrandChannel=0

[AMC]

Reading Patches Reuters article, above, this was a jaw-dropper:

"Bill Faith, executive director of COHHIO, an umbrella group representing some 600 nonprofit agencies in Ohio, said the state is home to some 1,650 pay day loan lenders -- more than all of Ohio's McDonald's, Burger Kings and Wendy's fast food franchises put together."

If that's true - holy crap.

[Patches]

YA! You can say that again! Faith also made a statement following the quote above, "That's saying something, as the people of Ohio really like their fast food,”

Another reason why I wanted everyone to see this article is because it confirms just about everything we have been saying about payday loans on this blog. There was a question posed sometime back on "Do payday loans cause Bankruptcies?" and my response more or less was that it was a combo effect of high interest and collection techniques leaning on collection techniques.

Also it was like they read AMC's response on deregulation, the ease of getting into the business and how the "working poor" are more susceptible. The new correlation on making the housing crisis worse follows our train of thinking on this blog subject.

Another statement in the Reuters report that caught my eye was: "The "Rust Belt" state's woes have been further compounded by the loss of 235,900 manufacturing jobs between 2000 and 2007. But while the state as a whole has not done well in recent years, pay day lenders have proliferated." THAT’S OVER 33K in job losses a year!

I had asked AMC a question: "Could there be any logic in assuming that struggling neighborhoods are targeted more frequently than affluent neighborhoods?" Although there is no obvious direct correlation supporting that assertion, the Reuters statement above kind of makes you think that there may be something to my question.

Anyhoo….. back to work. Lates.

[AMC]

There is actually a website that tracks (or, if it hasn't been updated recently, tracked) the McDonalds vs. Payday Lender ratio for the entire U.S.

Kind of interesting:

http://www.csun.edu/~sg4002/research/mcdonalds_by_state.htm

Also, some interesting color charts that show where payday lenders have their highest concentrations, by state:

http://www.csun.edu/~sg4002/research/mcdonalds.jpg

http://www.csun.edu/~sg4002/research/mcd%20vs%20pd%20per%20cap.jpg

[Christopher]

I never came before the pay day loans before. But today i have learned from this post about payday loans. This post also teaches me about the lenders who charges the pay day fee fixed to every borrower, independent of loan size or risk.

[marcy]

I like payday loans because the have same me so much money in over draft fees plus
they are convinient they dont required so much information and they are more flexible than the banks.

[payday loans]

I love payday loans. They have helped me out in the past when I wanted some last minute cash to go snowboarding. It was definitely worth the small fee. I only did the loan for a few days and only paid a few dollars. These financial institutions are very convenient and helpful.