Online Payday Loans Cost More Than Storefront Payday Loans And Customers Are Harassed More Egregiously

Over the last couple years, The Pew Charitable Trusts has put together a useful series of reports regarding payday lending in the United States. The fourth installment was released on October 2. Its title is quite descriptive: "Fraud and Abuse Online: Harmful Practices in Internet Payday Lending". The report documents aggressive and illegal actions taken by online payday lenders, most prominently those lenders that are not regulated by all states: harassment, threats, unauthorized dissemination of personal information and accessing of checking accounts, and automated payments that do not reduce principal loan amounts, thereby initiating an automatic renewal of the loan(!). Storefront lenders engage in some of the same tactics, but online lenders' transgressions seem to be more egregious and more frequent.

Putting these disturbing actions aside, are consumers getting a better deal online than at storefronts? Given the lower operating costs, it is logical to assume that these exorbitantly expensive loans might be just that much less expensive if purchased online? Nope. Lump-sum loans obtained online typically cost $25 per $100 borrowed, for an approximate APR of 650%. The national average APR of a store-front lump-sum loan is 391%. Why the disparity on price and severity of collection efforts?

I think the answer stems from why storefront payday lenders have been so successful. It partly is a location and relationship driven business. Payday lenders report that they do not make money off a loan until a customer has borrowed three times. As a bonus, repeat customers have lower default rates than new customers. Physical lending locations allow for peer pressure. When these people call, there is a face to put to the voice. Customers also pass by the storefront repeatedly. They took out the loan at the same strip mall where they get their nails done, where they shop for groceries, or where they do laundry. Customers also might feel a twinge of community responsibility. The result is that customers stay semi-current and keep rolling the loans over.

In contrast, getting a payday loan online requires minimal to no human interaction. I assume chit-chat on the phone while taking out the loan is more or less non-existent. And the person who spoke to the customer when the loan was given most likely is not the person calling to request repayment. Customers do not feel any social obligation to pay anything. Indeed, paying a small amount might rarely cross their minds. That is, repaying online loans may come down to remain current or pay nothing dichotomous decision. Add to this that customers do not see their obligation on a daily or weekly basis. As a result, online payday lenders have huge losses from unpaid loans. For instance, one lender reports charging off 44% of online loans. Storefront lenders report charging off a mere 17% of loans.

The threat of these huge losses, in turn, leads online lenders to use more severe collection tactics. And to make up for the losses, they have to charge all customers more, pushing up the APRs. But even that is not enough: Online lenders also report being more discriminate about who they loan to, a fact they point to as evidence that they care about customers. They reject 80% to 85% of applicants (versus 20% among storefront lenders). Those applicants they do loan to usually make more than those who get their loans from storefronts. Call me cynical, but online lenders seem to care about their customers because if they lent money indiscriminately they know they would never get it back from the cold, distant, rather uncaring land that is the Internet, even if they engage in illegal billing and collection activities.

Regardless, as Pew's study concludes, the most effective way to control online lenders' tactics is federal regulatory action. In recent years, some states have brought enforcement actions against online lenders that do not comply with state regulations. But these actions falter when lenders are incorporated overseas or claim Native American tribal immunity, and they often only cover residents of states with regulations. 

Comments

[Adam]

A few observations:

First, is the APR comparison controlling for duration? If not, it's not real meaningful.

Second, on-line payday lending has a different cost structure because of the nature of lead generation. The websites that consumers go to rarely are the actual lenders. Instead, they are lead generators that auction off the leads to the ultimate lenders. While the lenders don't have to pay for the brick and mortar structure, they do have to pay for the leads, which can cost as much as $150 (think of how many rollovers are necessary to recoup that...). The brick-and-mortar operators sometimes combine payday with other consumer financial services, like check cashing, which helps cover their operating costs.

Third, the customer base for on-line vs. store-front is likely different. The on-line borrower base might well be riskier--there is a MUCH higher denial rate for the on-line borrowers. If on-line suffers from an adverse selection problem, it would explain the higher rates (which would in turn reinforce the adverse selection).

[Pamela]

Adam, thanks for the observations. On the first, there isn't data in the study about duration. Point taken. As to the second, the study's measure of overhead costs includes marketing, which includes lead generation (which is reported as very expensive, as you state). The study finds that 42% of online lenders' revenue was spent covering overhead vs. 66% of storefront lenders' revenue. Which maybe is why online lenders can tolerate such high charge-offs? And third, the customers are different. The study reports that online customers who actually take out a loan are more likely to be younger, single, own a home, and have more education than storefront borrowers. Though with the use of leads, the initial base may be much riskier, hence the high denial rate, which maybe could lead to higher lending rates. But unless online lenders are having trouble verifying who they are lending to, I'm not sure why their ultimate pool of borrowers creates such high loan losses, particularly as compared to storefront borrowers?