Short-term high-interest loans have become increasingly popular for borrowers. The possibility to borrow smaller amounts for short periods of time is very attractive for those who need access to money fast and then repay the debt quickly. On Mintos, investors have the ability to invest in such loans, in fact, due to the short-repayment period, they are one of the most popular loan products on Mintos.
One frequent question we are asked here at Mintos is how do these loans work? In this blog post we will address this question and give you a deeper insight into what these loan types are and what do loan originators need to consider when determining the interest they charge to their borrowers.
What is a short-term high-interest loan?
Short-term high-interest loans, often referred to as payday loans, are typically loans with a maturity of 14 to 30 days, and generally, do not exceed EUR 500. Borrowers typically repay the loan in a single instalment. Borrowers can access these loans from non-bank lending companies, either through their branches or online, usually receiving the loan on the same day of their application.
How is the APR calculated for short-term loans?
When looking at the “price” of a short-term high-interest loan, many people look at the Annual Percentage Rate (APR). This is because using the APR allows to compare different loan types. Short-term loans usually have a higher APR than other types of loans, on average the APR for short-term loans is 400%. To compare, according to the United States Federal Reserve’s first quarter data for 2017, the average APR across all credit card accounts at all reported banks was 12.54%. However, what should be noted is that the APR does not take into account the shorter maturities of short-term loans, which on average are 14 days.
Here is why. The APR assumes the borrower is taking out a loan for one year. So if the borrower borrowed EUR 100 for one year and the APR is 400%, then the borrower would have to pay EUR 100 + EUR 400, meaning the total cost of the loan would be EUR 500. This is indeed expensive. However, for short-term loans, borrowers are only paying interest during the loan’s maturity – which is not one year. The reality is more like this. Say the borrower borrowed EUR 100 and the APR is 400%, the repayment would be EUR 100 + (400/12) which equals about EUR 133.
Why is the APR so high in the first place?
Lending small amounts of money for short periods of time is expensive. Firstly, loan originators need to consider operational costs. Staff, product, IT, legal and rent are just a few costs that need to be taken into account. As a result, the lender often includes a fixed amount per loan to cover these costs. For example, if a lender charges EUR 10 per each EUR 100 loan with a 30 day repayment period, 10% of the loan is purely to cover operational costs. If it is calculated as an annual charge, that is 120% of the loan – without compounding. So already, without taking anything into consideration except for operating costs the APR is more than 100%.
Marketing is also a costly expense for short-term non-bank lenders as costs for borrower acquisition is expensive relative to their loan size. To find a borrower there is not much difference between if the borrower is looking for a consumer loan of say EUR 3 000 or a short-term loan of EUR 100. This is because the cost of tools such as Google ads and all other advertising costs are similar irrespective of the product being marketed. This is something that must also be factored into the cost of a short-term loan.
In addition, lenders also need to cover defaults. The default rate of each loan originator depends on many factors – loan type, location, borrower segment, etc. Therefore, the cost of these defaults will vary. According to Reuters, the average payday-loan default rate is around 6% and, surprisingly, defaults in the United States were at their highest before the financial crisis – not after.
In total, default levels vary from 2-25% for payday loans. The lower default rates are reached by well-established companies with long track records and strong and efficient client assessment techniques. The client segment the company is targeting has a large impact on its default rate (prime, near prime, subprime). The riskier the borrower class, the higher the default rate. Higher default levels can be explained by inherent characteristics of the population of each country, more specifically, borrower payment discipline. Based on our observations, some of the countries with high default rates for payday loans are Denmark, Kazakhstan and Spain, on the other hand, countries like Sweden have typically low default rates.
The average 6% default rate is for loans with terms up to 30 days. Taking this into account, if a loan originator leant EUR 100 worth of loans, then after 30 days, it can be assumed that EUR 6 worth of them will have defaulted. Therefore, a loan originator will need to charge 6% per month in interest to make up for this default rate. Without compounding, that makes 72%. So if we combine this with the APR needed to cover operational costs, we are close to a 200% APR already. This figure is so far only based on operational costs and covering the default rate, the loan originator then needs to account also for a profit margin. Therefore, when considering all of the costs and risks the loan originators need to compensate for, one can see why the APR for short-term loans can get very high.
Why do investors receive smaller returns when the APR is so high?
Firstly, loan originators have many operational costs – marketing, servicing borrowers, running recoveries – and also a profit margin. Which as was previously mentioned, accounts for a large chunk of the total APR.
Secondly, short-term loans in general come with a buyback guarantee. So loan originators have to also cover the default risk. If a loan originator has an APR of 200% on its loans and subtracts the operational costs (say 120%) and adds the default costs (around 70% based on the above example), only 10% of the interest is left. This is comparable to the cost of other sources of funding available for financing short-term loans that are originated.
If it were not for a buyback guarantee investors could receive interest rates of 80-90% interest but then they would experience high levels of default (70% as in example above) and in the end, the net result would be the same, around 10%.
Short-term loans provide borrowers with quick and convenient access to funds at the time when they need it. Generally speaking, short-term loans do have higher interest rates as there are a lot of costs that must be considered when lending money to borrowers in small amounts for short period of time.
At Mintos, one of our key values is transparency, which is why we recently added a new feature which allows you to see the APR for all loans from all loan originators on the marketplace. This is to ensure you have all of the information to make an informed investment decision and streamline your strategy. You can read more about this new feature here.