Loan sharking datapoints of the day

By Felix Salmon
January 7, 2010
what happened in New Mexico, which tried to crack down on payday lenders by limiting the amount of money a company could charge in interest on a short-maturity loan. No problem, said the lenders, and just started selling a new product -- an even worse product -- which got around the law by having a maturity of over 120 days. They even provided their borrowers with Truth-in-Lending Act disclosures! Like this one:

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Are legal payday lenders a superior alternative to the loan sharks of old? Or are they they loan sharks of old? Just look at what happened in New Mexico, which tried to crack down on payday lenders by limiting the amount of money a company could charge in interest on a short-maturity loan. No problem, said the lenders, and just started selling a new product — an even worse product — which got around the law by having a maturity of over 120 days. They even provided their borrowers with Truth-in-Lending Act disclosures! Like this one:

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In case you can’t see clearly, this shows a $100 loan which is due to be repaid with 26 bi-weekly installments of $40.16 each, plus a final installment of $55.34. In total, the borrower, Oscar Wellito, has to pay not only his $100 principal back, but also $999.71 in interest, for a total APR of 1,147%.

The New Mexico attorney general is trying to get this kind of thing made illegal, but it’s still going on — and not only in New Mexico, either.

Wellito ended up making four payments on this loan, for a total of $160.64, before he complained to the New Mexico attorney general’s office and they told him to stopped making payments. If those payments had constituted payment in full on the $100 loan, they would have amounted to an APR of something over 460%. In fact, however, after paying back $160.64 on his $100 loan, Wellito had managed to reduce the principal amount outstanding by a whopping 2 cents.

Which is more than this loan would be reduced by after four payments:

loan2.tiff

Here, the APR is a mere 521%, but somehow the first half-dozen payments don’t pay down the principal at all: after paying $1,169.52 — 25% more than the total amount borrowed — the principal is completely unchanged. Eventually, on payment #7, it finally gets reduced by the princely sum of $3.32.

The first loan, here, was issued by a lender called Cash Loans Now; the second comes from Fastbucks. If both borrowers paid back twice what they originally borrowed and then defaulted, they would still owe hundreds of dollars to each lender. It’s possible that if Cash Loans Now tried to take Mr Wellito to court, the judge would just throw out the case, since the loan was so unconscionable. But if Cash Loans Now just sold its defaulted loan to Fastbucks, while Fastbucks sold its defaulted loan to Cash Loans Now, then both would have bought legitimate debts of over a thousand dollars and wouldn’t have been paid a penny on them: indeed, they would both be out of pocket. It would be very hard for a judge to throw out that kind of case.

I hope that the New Mexico attorney general does manage to get these loans deemed illegal. But in any case one look at them is enough to prove that they’re not in any way being priced off of credit risk — the lenders are likely to make a massive profit even in most cases where the borrower defaults. This is loan sharking, pure and simple — and, for the time being, it’s legal. Isn’t it about time that we have a Consumer Financial Protection Agency which could put an end to this kind of thing?

Update: The New Mexico AG clarifies that although Wellito stopped making payments on his loan after complaining to their office, they did not advise him to do so. Karen Meyers, assistant AG, writes:

Many of the consumers who submit complaints to our office stop paying on their loans because they cannot extricate themselves from the debt trap that has been set for them by the lender. The New Mexico Attorney General’s Office does not provide individual legal advice to consumers regarding their individual loans. The New Mexico Attorney General’s role is to enforce the Unfair Practices Act as we seek to do in these cases.

11 comments

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I didn’t stop to work out the details, but if this is a standard APR loan, then the APR understates the true effective rate. The reason is that APR is just periodic rate (r) times number of periods (n). So, a loan at one percent a month comes out at .01×12=0.12=12% for a year.

But to get the true rate, we should account for timing of payments and opportunity for reinvestment. This means you should take one-plus-the-periodic-rate and raise it to a POWER equal to the number of periods. So, for a loan at one percent a month, the true effective rate is (1.01)^12-1=0.1268=12.68 percent.

sixty-eight hundredths of a percent may not sound like a lot, but if you compound, say, one percent a day, you leap from 365 percent a year to 3,678 percent a year. Now we’re talkn’.

Posted by Buce | Report as abusive

What constitutes a usurious rate? If I lend someone $100 for a month, and ask for $10 interest — not much, IMO — that works out to an annual rate of about 214%. If I charge $25 interest, which is still not unreasonable, the annual rate jumps to about 1355%. Sounds awful, until you remember that the time value of money varies dramatically over different terms. Funds borrowed for a month have a very different “moneyness” than funds borrowed for a year.

And really, if you need a hundred bucks right now, borrow it from a friend and pay them back with a favor.

Posted by Mega | Report as abusive

Mega, these are 1-year loans. And, the APR calculation doesn’t compound in the way you think it does.

Megan Mcardle probably thinks they should still be paying these loans back.

Posted by Schooner | Report as abusive

What stops an enterprising bank from coming in and offering a lower interest rate?

Posted by AngryLawyer | Report as abusive

Felix,

I don’t see why a judge would care that the loans have been sold. I take it you’re arguing that they would be a holder in due course and thus immune to many defenses to the note?

You’re only a holder in due course if you took the paper without notice of the defect. The defect here is an unconscionably high interest rate. No one could plausibly buy notes without notice of the interest rate, principal balance and payment schedule.

There is also an FTC rule abrogating the holder in due course doctrine as it applies to consumer loans, but it might not apply to purely financial transactions.

(Merchants were selling loans off to their financing arms to force people to continue to repay loans for faulty products. The FTC stepped in to ban it.)

Posted by AnonymousChef | Report as abusive

If people only knew what they were getting into… for that, though, they’d have to be able to read and do mental arithmetic.

Illiteracy and innumeracy are the friends of predatory lenders. Thus it follows that those who advocate further cutbacks in education are operating hand in glove with the worst shylocks in the universe. Consequences, anyone?

Posted by HBC | Report as abusive

I am doing research in this area and would like to make contact with the person who posted this article. Please e-mail me at martin@law.unm.edu. Thanks!!

Posted by ndmartin | Report as abusive

Mega, you make a good point that for short-term loans, the ratio of interest paid to loan amount can be a better measure than the calculated APR. But that’s exactly the problem with Felix’s example loans! Their ratios are 10 to 1, and not in the good direction.

Posted by KenInIL | Report as abusive

“Isn’t it about time that we have a Consumer Financial Protection Agency which could put an end to this kind of thing?”

NOOOOOOO!!! We don’t need to create another Federal Bureaucracy to put an end to this kind of thing, we can just pass a law! It can be managed by any one of a number of organizations we already have.

Why don’t they just roll an origination fee of a point with a minimum of $25 into the principal? If this could work profitably, there’s no need to do the crazy financing and it would be easy to put these guys out of the business the capitalist way- by offering a better product to the consumer.

Posted by mattmc | Report as abusive

Absolutely amazing. Thanks for the information. Morgan at TheDebtDance.com

Posted by TheDebtDance | Report as abusive