Personal Loans in a Free Market
We look at how the market for personal loans works
Personal debt is easy to come by, as is the amount of interest which can build up. Although “payday loans” to those who don’t have access to cheaper forms of finance are being more and more regulated, there is equally a belief in some quarters that a free market in loans should be allowed to operate. But just how free is the free market?
High interest loans
An inescapable feature of debt markets is that the more risky the borrower, the higher the interest rate is. This applies to national governments and it applies to individual borrowers. A secured loan to an individual with a healthy credit score will likely attract an interest rate of a few percent, as with many mortgage products currently being offered. Unsecured loans currently start at around 3.6% APR, if the bank is generally confident you can repay the loan. This rises to about 8% for smaller loans, presumably because of their administration cost is factored into the rate. Credit cards currently carry around 6.4% APR.
Not everybody will be able to get hold of these deals, though. The best rate I could find for someone with a bad credit score was 18%, but many others, presumably with fewer conditions attached, charged 47-49%.
For those unfortunate enough to have little option other than to resort to payday loans – i.e. short-term loans where the actual amount of interest paid is small – annualised interest rates work out perhaps in the 1000s of percent. The problems only really start when the loan isn’t repaid in full on “payday” but rolls over to the next week or month. Interest mounts rapidly and debts spiral out of control. Regulators are now stepping in to curtail the rates charged by payday lenders with the aim of preventing excessive customer debts.
The effect of regulation
Those affected by debt they are unable to repay will likely see regulation as too little too late. Others such as free-marketers the IEA believe that regulation is harmful, and hurts those its meant to help. Loosely speaking, that means people are better off borrowing at dazzlingly high interest rates on the high street than borrowing from lenders with less scrupulous methods of recovering assets from their debtors. Moneysavingexpert agrees with this comparison, although are eager to direct consumers to appropriate agencies who can help them in any issues against (legal) lenders.
In the UK, there are now limits imposed by the FCA on how much a lender can charge. Interest cannot be charged at higher than 0.8% per day, and the total amount owed cannot rise higher than 100% above the total amount borrowed. There is also a £15 charge cap on once-off default fees.
So whilst regulation helps those who can get payday loans, it is not help for those who perhaps could before regulations came in but are now seen by lenders as too risky. Such people are now excluded from the commercial money system.
Is all this lending sustainable?
It’s an interesting point that the whole financial system on which western banking is based centres around interest rates. And the mere existence of interest rates ensures that, unless more money is being created “out of thin air”, defaults are inevitable because more money has to be repaid than was ever created in the first place. However personal loan companies are not (necessarily) banks. They borrow money from banks and then use their expertise to lend it out again at a higher rate with, hopefully, not too high a level of default. The sustainability of the system depends on the sustainability of the personal loan companies themselves. If they cease to be viable, then commercially-backed credit for high risk individuals dries up.
It is interesting that passages found in scripture, and which are the basis of Islamic banking today, prohibit the charging of interest. Perhaps in the earliest days of of a society’s financial system, the principle of financial sustainability was understood much better than it is today. This will likely be explored in a future blog.
How free can the lending market really be?
Free marketeers might think they hold all the answers, but just how much of a free market was there before the regulator came in? Let’s look at another illustration. Let’s say I have borrowed £100 from Wonga.com (the iconic payday lender in the UK) and have defaulted so many times that they now tell me I owe £5000. I am unemployed and cannot repay them. What can Wonga do? Well, as Wonga, not a lot. But what they will do is to sell my loan to a debt collection agency (DCA). The DCA will use more direct tactics to recover the loan, including a home visit if I ignore their written advances. If the DCA is unsuccessful in persuading me to pay, a court judgement against me can result in enforcement agents (bailiffs) being appointed. They have substantially more power, and they might repossess my car and anything in my house if I let them in. And they have the law on their side, the police won’t protect me, they will protect them. Ultimately I stand to lose anything of resale value. And this is all enshrined in UK law.
The point of this illustration is that the free market as we have in the UK conspires against the borrower, so it is not really free. If the system was purely financial, I would be allowed to default, suffering no more than a punitive credit score. But it’s not purely financial. There’s a degree of coercion involved, or at least the threat of it. It might be shocking to some that a system might allow a borrower to default even though they have the means to pay, and get away with it. Indeed that’s why we have laws in place to make sure people don’t “get away with it”. But it’s clear that there is a huge power differential in the arrangement, and in favour of the side which knows the lending business the best too. I would argue that regulation as we now have it helps to redress that balance of power.
Help, I am in debt and can’t repay my loans.
Chances are, you have either fallen on hard times or you didn’t do your calculations right. And given the way some of these loans have been sold (like Wonga’s puppets), you may even have thought that taking a loan was simple and fun. Or maybe you’re just rubbish with numbers.
I don’t have the answers here, but plenty of other organisations do. This information is for UK residents, so people from other jurisdictions should search for similar organisations. Consumer website Moneysavingexpert has a friendly page with plenty of information. To speak face-to-face with someone, the Citizens Advice Bureauis usually a good place to start. Debt charity Stepchange also maintains a useful website with a helpline number.