Payday lending – Helpful or harmful?

29 July 2016
Author: Maya Ramchandani
How informed are you on payday lending? The industry has been under intense scrutiny for its predatory lending practices, particularly in the past few months with increased media attention highlighting changes in laws and regulations.  
  • In June 2016, Alberta passed a by-law requiring payday lenders to provide borrowers with debt and money management resources, stipulating that failure to do so will result in a $1,000 fine.
The payday lending industry has surfaced as a hot-topic but does everyone know what all the fuss is about?
 
What’s a payday loan and how does it work?
 
A payday loan is a cash advance with fees associated with borrowing. In accordance with federal law, a payday loan must not exceed $1,500 or span a period exceeding 62 days.   
 
Figure 1 compares the differences in costs associated with various types of credit sources. Credit cards can often have high interest rates, however when compared to payday loans, credit cards are much cheaper. The difference between a credit card and a payday loan is the cost of borrowing.

Figure 1
Figure 1
Credit Card vs Payday Loan
 
A consumer using a payday lender in New Brunswick pays $63 to borrow $300 over a period of 10 days. Under those same conditions using a credit card costs only $1.65. That’s drastic – $63 compared to $1.65. The highest interest credit cards have an annual interest rate of 21 per cent - therefore $300 borrowed for 10 days out of 365 days will only incur $1.65 in interest (the cost of borrowing). When the payday lending “fee” is treated as interest, a $63 cost to borrow over a 10 day period translates into an annual interest rate of 766%! Figure 2 illustrates the annual interest rate of payday lending services across Canada.  

Figure 2
Why are payday loans harmful to consumers?
 
1. Borrowers are forced to pay unfair interest rates. Whenever you request a payday loan, you must repay the loan on your next pay day. Whether you borrow $300 for a period of seven days or 28 days, you are obliged to pay the same interest cost of $63. So one borrower might pay 21 per cent weekly interest while another ends up paying 5.25 per cent weekly interest. 

2. Payday lenders do not help customers build their credit. Payday lenders issue loans without a credit check. Credit checks are used to measure your ability to repay the loan you are issued. People with poor credit scores have fewer options for borrowing and are therefore more prone to resorting to a payday lender. In fact, individuals who have been declined a credit card are 3.6 times more likely to resort to a payday lender (1). Since payday lenders do not report borrower compliance to the credit bureaus their customers cannot build credit or improve their credit score. As a result, they remain ineligible for cheaper and safer loans such as a line of credit. 

3. Payday lenders target people living on low incomes often leading them into a cycle of debt and dependency. Fifty per cent of payday users fall within the bottom 20 per cent of net-worth distribution in Canada (1). According to the 2005 Survey of Financial Security conducted by Statistics Canada, “households with less than $500 in the bank were 2.6 times more likely to have used a payday lending service than those with over $2,000 in the bank”(1). Many payday users are on a tight budget living from paycheque to paycheque and can’t afford the $63 interest cost of borrowing from payday lenders. This leaves them short at the end of the month requiring another loan to be taken out to meet their expenses and the costs associated with the first loan. That is where consumers fall into a debt cycle. 

4. Failure to repay your payday loan can have disastrous consequences. If you cannot repay your borrowed loan on your next pay day, you are subject to a penalty fee which ranges from $25 in Ontario to $40 in Nova Scotia (2). Let us look at one example of a British Columbian who decides to borrow $300. They will be charged the borrowing cost of $69, however missing their repayment on the agreed upon date would subject them to a penalty fee of $20. This hikes their debt to the lender up to $389 ($300 + $69 + $20). The $389 is then subject to an additional annual interest rate of 60 per cent - the maximum allowable rate by Canadian federal law. 

The reality is that many Canadians on low incomes have nowhere else to turn
 
Despite the impact of payday lending practices on consumers, the industry occupies an important niche. In fact, sometimes using a payday lender is a more rational choice than the alternative. For example, if an individual in Ontario is at risk of having their electricity shut off due to an outstanding bill and reactivating their electricity costs $90, it is technically more economical to pay the $63 interest fee for a payday loan. 
 
Quebec uses a unique model that’s worth exploring. Payday lending practices are illegal in the province of Quebec. However, a different system was developed to occupy the niche of payday lenders. The Option Consmmateurs program provides loans up to $800 for one year with an annual interest rate of five per cent (3). To obtain this loan, one must prove they are “low income, face an unforeseen expense, have an ability to repay, and live within a certain geographical area in Montreal” (3). Completely eradicating the industry is not necessarily the solution as it may leave many well worse off. 
 
What do you think is an effective solution to address the issue of payday lending?

Citations
1. Brian Dijkema and Rhys McKendry, “Banking on the Margins- Finding Ways to Build an Enabling Small-Dollar Credit Market”, Cardus, February 2016. Accessed June 2016.
2. Payday Loans: An expensive way to borrow”, FCAC, February 2016. Accessed June 2016.
3. The Real Cost of Payday Lending”, Momentum, June 2014. Accessed June 2016.

Figure 1. Image obtained from Brian Dijkema and Rhys McKendry, “Banking on the Margins- Finding Ways to Build an Enabling Small-Dollar Credit Market”, Cardus, February 2016. Accessed June 2016

Figure 2. Image obtained from Brian Dijkema and Rhys McKendry, “Banking on the Margins- Finding Ways to Build an Enabling Small-Dollar Credit Market”, Cardus, February 2016. Accessed June 2016.

THE AUTHOR

Maya Ramchandani is a former Intern for the Marketing and Communications department at Prosper Canada. She recently graduated receiving an Honours Bachelor of Science degree at the University of Toronto. She began her Master of Public Policy and Global Affairs degree at the University of British Columbia in the fall of 2016.

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