Bankruptcy

Are Payday Loans as Profitable as We Think?

By Paige Marta Skiba

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.

Full post as published by Credit Slips on March 20, 2008 (boomark / email).