Payday Loan Business Model

The Payday Loan Business Model

Payday lenders depend on repeat borrowers and ‘rollover’ loan deferments for their survival.

90% of all payday loan business in the US is generated by borrowers with five or more loans a year.

Payday lenders use their internal resources to finance the main share of their business. Even if they opt to use bank finance, the banks usually stipulate that up to 20% of loans must be financed from internal resources.

This means essentially that the capital raised for payday loans is not generated ‘free of charge’ – there are costs involved.

Payday lenders still have to pay an implicit cost for their internal finance in the form of interest forgone on alternative loans or investments.

Payday lenders work with high fixed costs as the overall cost of underwriting a loan remains the same regardless of a loan’s value, and most of the costs that are faced by the providers are not dependent on the number of loans written.

The key fixed costs involved include staff costs, rents, various business overheads, and for online lenders, continued investment in online application systems and development.

Many of the initial loan costs are incurred at the application stage of the loan and have to be incurred whenever an application is made – irrespective of whether the loan is approved or denied, and irrespective of the size of the loan.

As the costs associated with a loan of say £200 are largely the same as those for a loan of £750, the profit margins on small loans is very tight.

Variable costs include credit checks obtained from specialist providers like Teletrack UK and Lend Protect. Credit reference agencies like Experian tend to be more expensive and take longer to update their records. Other variable costs are default costs and the cost of capital.

Due to the amount of high fixed costs, profits by payday lenders are largely driven by the number of loans made, given the significant economies of scale in the business.

Overall it is the number of loans granted that ultimately determines how profitable a payday lending business is – the higher the number of loans, the more profitable the business.

Profits are generated mainly the number of loans, not the number of borrowers. The lender will earn a similar amount from having say 100 loans taken by 100 people as 100 loans taken by 10 people, although the latter will be marginally more profitable.

Online Payday Lenders

Payday lenders who operate online are faced with higher costs when compared with those on the High Street.

This is mainly due to the fact that they tend to reject a higher proportion of loan applications, and also face higher rates of fraud and default.

As a consequence, the cost of obtaining a payday loan online (often £25-£30 per £100) exceeds the costs of obtaining a loan on the High Street (often £13-£18 per £100).

In order to ensure that collection costs and default rates are kept to a minimum, payday lenders require cheques and debit card details in advance so that if a borrower fails to pay off a loan the lender has a relatively low-cost method of collection.

Due to the high fixed costs of payday loans and the fixed price charged per £100 of a loan means that ultimately, borrowers of larger sums are in effect subsidising those borrowing relatively small amounts, given that a marginal cost approach to pricing would suggest much higher charges on smaller loans, and lower charges on larger loans.

However, without the fixed price method of pricing, many of these small value loans would be withdrawn from the market.

Multiple Payday Loan Applications

Payday lenders make their profit from the number of loans approved rather than the number of borrowers they have.

Research by Mark Flannery and Katherine Samolyk in the US suggests that borrowers who take out multiple loans are more preferable to the loan provider, because they contribute to overall loan volume.

Further research by the Center for Responsible Lending (CRL) shows that there is evidence of payday lenders encouraging repeat borrowing amongst customers, suggesting that they depend on it for survival.

The CRL found that in US states where a cap had been imposed on the number of loans a borrower can make in a year (limited to between 5 and 8), the payday lenders stated publicly that such limits will put them out of business.

Washington DC was the first US state to impose a cap of 8 loans per borrower a year, starting in January 2010. In response to this new legislation, a number of lenders in the state have already shut down.

Data gathered by CRL confirms that a staggering 90% of all payday loan business in the US is generated by borrowers with five or more loans a year, which may go some way to explain why payday lenders are opposed to limit the number of loans.