This won't be new to some of you, but it deserves highlighting.
Yesterday I saw a TV ad for a company called "Wonga" (a British slang term for money). This is what's called in America a payday lender.
The character in the ad needed to borrow £70 for five days. Wonga proudly announced that they can help him out - for a fee of only £9.22.
Let's look at that for just a second.
£9.22/£70 = 13.17%. For five days.
Imagine you lose your job and don't have the money to repay at the end of the five days. Maybe you'll borrow another £79.22 from Wonga (or a different lender). In another five days you still haven't found work so you roll it over again. You keep this up for a year before finally getting an inheritance from your dear great-aunt Mildred. How much would you have to inherit to pay off the bill?
Take a guess, off the top of your head, before you read further.
OK, you need to compound five days at 13.17% up to a whole year. You'll end up turning over the loan 73 times in 365 days. Total compounded annual interest...wait for it...
Eight hundred and thirty-seven...
(no, not £837. Not even 837%)
Eight hundred and thirty-seven THOUSAND percent.
And how much cash do you need - to repay your £70 payday loan?
Well, let's hope Aunt Mildred had a big house. You are now in for the flabbergasting sum of £585,982.03.
Can this possibly be correct? Remember - this number didn't come from some investigative expose of a council-estate loan shark. This is the figure the company themselves puts in their TV advert (you'll get the same figure if you go to their website and enter the figures directly).
Presumably, therefore, that's either the low end of the range of interest rates - or at least an average figure, representative of all the company's borrowers. Which would imply that there are people paying more than this. Even a single percentage point increase from 13.17% to 14.17% will almost double the cost after a year, to over £1.1 million.
So this can't be right. I found the company's website and things started to be a bit clearer. It's not quite as dreadful as it first seems, but that's not much comfort.
First, two caveats:
- Clearly a part of the £9.22 is classified as a fixed transaction fee rather than an interest payment. It doesn't make any difference to the consumer on the first loan - if they roll over the loan at a different lender, their total debt still goes up by 13% no matter how the fee is described. However, what it does mean is that the effective interest rate on a larger loan is less than on a small loan. Thus, if you have accumulated £200 of debt the interest amount on a five-day loan goes to £5.50 + (£205.50*4.92%) = £15.61 or 7.8%. A bit better, but that's still only for a FIVE DAY period.
- Clearly these loans are not designed to be rolled over (and Wonga are explicit about that on their FAQ page). But many people using payday services have little choice in the matter, and it's likely that many of them will have to roll over their loans at least once. Maybe Wonga won't allow them to roll it over directly (actually they do, but with restrictions), but I don't see that they can stop somebody borrowing from a different lender to repay their loan...and then five days later, switching back to Wonga again, £18.88 poorer.
Yep, we know. It’s huge. But there’s a simple reason for this and we’re more than happy to explain... Much like traditional lenders, we could use fixed fees, long term products and small print to dramatically shrink our annual percentage rate (APR). Yet the beauty of our short term service is its unique flexibility and complete transparency - and that's something we won't compromise... [my emphasis]But...but...that's exactly what they have done. By charging a £5.50 fee before they apply the interest rate, they are artificially reducing the component of the fee which has to be compounded under the APR regulations.
So let's look again at the amount Mildred has to leave you to get you out of this mess.
Instead of simply compounding 13.17%, we need to work through the following steps:
- Take the amount borrowed (£70)
- Add £5.50 (£75.50)
- Take 4.927% of the total (£3.72)
- Add that on (£79.22)
- Take the total as the starting amount for the next loan.
- Repeat as above, 72 more times
After a year, you'll have to repay £6,148.29.
Mildred's inheritance is relatively intact after all - but only relatively. You have paid back nearly ninety times your original loan, an APR of 8783%.
I am sure that Wonga has a very careful compliance department and is obeying the letter of the law in publishing those APR figures. But let's just say that I would not have used their calculation method myself.
I was surprised to see that Wonga is backed by some quite respectable names in venture capital. That gives me hope that they will be somewhat responsible in stopping people from running up large debts. But the very existence of a service this expensive seems to indicate either a serious market failure in the credit world, or some big gaps in financial education.
Perhaps Grameen Bank needs to set up in the UK?