Some Thoughts on Interest and Effective Rates
We often discuss the analysis of commercial loan opportunities in this space. We have previously reviewed how interest rates and other fees charged for commercial loans should not be taken at face value when assessing either the total cost or value of any financing. What is seen as quite expensive may be less so when viewed in light of the entire transaction including loan size, time outstanding and the cost to the lender for providing the service. It can also happen that what appears to be a modest fee may in fact be very expensive.
Two examples are used for illustration. Payday loans are an example of where costs initially appear quite high. ATM fees are an example where the true cost is much greater than it initially appears.
I live in Colorado. In the last election cycle a law passed capping the combined interest rate and fees charged on Payday Loans at 36%. Is this reasonable? A quick internet search shows that the average payday loan is $355.00, is outstanding for two weeks, and earns a fee of $55.00. The effective rate on this loan is 398% given a 360 day year and repayment in 2 weeks. (Given that 80% of these loans are reported to roll over the effective rate is probably much higher than the one shown in this example.) With a 36% cap the fee is $4.97; quite the difference. This certainly is more than ok for the consumer but is the lender sufficiently compensated for the risk.
A payday loan is small which limits earnings per loan. The borrower also has a greater risk profile as evidenced by the default rate for payday loans, 6% vs 2.5% for bank consumer loans. The borrower probably has few if any other alternatives. Given these considerations is $5.00 of revenue sufficient when risking $355.00. I believe that a “fair” charge should probably be somewhere in between. It will be interesting to follow Colorado and other states that have imposed rate limits to see how many payday lenders remain viable. General consensus is there will be far fewer in the states imposing maximums with only the most efficient, cost effective providers participating in the market.
Now a closer look at ATM fees. In the past my bank did not charge a fee if I used a foreign ATM (an ATM not owned by them). The bank that did own the ATM would normally charge me a fee of around $3.00. That seemed reasonable as they serviced the machine and provided the cash. In the last six months my bank added a $3.00 fee of their own to foreign ATM transactions. What does this really cost me?
First consider the fact that this is not a loan…..I am accessing my own money. My bank has no direct costs as they do not own nor service the machine. My withdrawal is a risk free transaction as money is provided only if the account has a sufficient balance. As a way to assess the true cost I suggest that the transaction be considered as a one-day loan. Using this framework a $6.00 fee on $118, the average ATM withdrawal, for one day converts to an annualized interest rate charge of 1,831%. Now that is expensive. If one used a 36% cap on this charge it would be limited to 12 cents. Here I believe a “fair” charge is the one charged by the foreign bank. They provide the service.
The lesson here is when you assess a commercial loan for your company or a consumer transaction for yourself, your analysis must fully consider all aspects of what is received versus what is paid to really gauge the relative worth to you. It is relative worth that usually determines what a borrower does. The borrower with no options and rent to pay finds it worthwhile to use a Pay Day loan to get the money to meet their immediate need. I find it worthwhile to pay a fee to get needed cash when my bank is not available. In each case the perceived benefit exceeds the real cost.