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Judgement Day for Payday Lenders Approaches

About The Author

Edmund Day (Former Writer)

Edmund is a 3rd year student of Law with French at the University of Birmingham, currently studying towards the Certificat de Droit Français during his year abroad at l'Université Montesquieu - Bordeaux IV. Edmund aspires to be a solicitor, with a particular interest in the aviation sector.

We have all seen the laughable interest rates advertised by many payday lenders over the last few years, but for many, including some of the leading figures in politics, this situation is no laughing matter.  Ed Miliband, for one, expressed his desire to cap the cost of payday loans and even provide councils with the power to restrict the spread of high street lenders in town centres.  So who are these payday lenders and how are some of them getting away with charging over 5000% APR?

Well, payday lenders offer unsecured loans on a short-term basis, usually to be repaid when the borrower receives their next paycheck.  Because these loans are not secured against any collateral, they incur a greater risk on the part of the lender, who simply responds by increasing the APR to cover this risk - a simple risk/reward formula.  But this is only the beginning.

Payday lenders found that they could increase these rates relatively unchecked, to such an extent that the industry is now worth in excess of £2 billion annually.  Payday lenders have profited hugely, in the literal sense, from the economic downturn.  With conventional credit harder to obtain, and more and more people struggling financially, the lure of quick, easy cash proved irresistible to some, causing the market to soar.

That is not to say that everyone has a choice in the matter – bills need paying and individuals incur unforeseen expenses.  Payday lenders provide a solution for these problems.  But their popularity has extended beyond the realms of emergency short-term payments, with some borrowers turning to payday lenders for a more long-term solution to their finances without considering their ability to repay the loan – or loans.  This unsustainable approach is landing many borrowers in deep financial trouble.  Having previously deemed a cost cap unnecessary, the Financial Conduct Authority (FCA) will now be obliged to introduce a limit to the total cost of borrowing from payday lenders owing to amendments to the Banking Reform Bill, as announced by George Osbourne.  Rather than the legislative u-turn it was accused of, the Treasury insisted that this announcement came in response to a constantly evolving market and following careful monitoring of similar legislation introduced in Australia last year.

The case for or against such a cost cap boils down to two long-standing, and often contrasting, legal principles.  On one hand there are those in favour of greater consumer protection, provided by legislative intervention to render an otherwise unbalanced free market more fair for consumers.  According to these individuals, the consumer is vulnerable to exploitation from more powerful parties due to their unfavourable bargaining position, and would hence be in favour of a cost cap to extend such consumer protection.  This principle was summarised in the case of George Mitchell v Finney Lock Seeds in the final judgement of Lord Denning’s judicial career, as the “abuse of power – by the strong against the weak,” which he agreed should be curbed by the Courts.

On the other hand, there are those who argue in favour of greater freedom of contract.  This affords individuals and businesses alike the liberty to determine their contracting partner, and most importantly the content of the contract, with minimal restrictions placed on their freedom to do so.  This notion represents a 'meeting of minds' between the contracting parties, although it can leave parties open to exploitation or unfair, unjust or unreasonable dealings at the hands of a more savvy contracting party.  Supporters of greater freedom of contract would argue in opposition to a cap on the cost of borrowing from payday lenders, proposing instead that the individual is best placed to protect his or her self-interest in relation to contractual relationships rather than the legislator.

It is certainly true that in our commercialised society, there is a gulf in relative power between individuals and the corporations they often contract with, but whether this situation necessitates increasing consumer protection is open for debate.  Prior to 1800, our Courts felt obliged to ensure that contracts entered into were also fair deals.  This disregarded individuality as well as consumer freedom, and Courts would routinely undermine contracts on the objective basis that they did not equate to a fair bargain for both parties.  However, with the evolution of the doctrine of freedom of contract, Courts felt increasingly comfortable allowing the parties to protect their self-interest and establish the terms of a contract with greater freedom.  Freedom of contract continued its ascent well into the 1900s, at which point we began to see a rise in consumer protection, which as a contrasting principle, necessarily eroded the bounds of contractual freedom.  Today, the attitude of the Courts is that it is not their role to ensure a fair bargain, objectively speaking, on behalf of each party but instead to uphold contracts that are clear, unambiguous and otherwise fairly formed, respecting their binding force.

With the weight of these principles behind them, how strong are the cases both for and against the proposed payday loans cost cap?  Lenders are quick to defend their high APRs, which is the annual rate of interest a borrower has to pay back on top of the loaned amount, because payday loans are intended to be paid back over a much shorter period, typically within a matter of a few weeks.  This makes the interest rate over a whole year appear much higher, exaggerating the amount actually paid back as interest on such a short-term loan.  For example, a 31 day loan of £500 at 5000% APR would incur interest of £194, bringing the total to be repaid to £634.  However, if that loan was instead repaid over the full course of a year, the sum due would total £25,500 withinterest totalling to £25,000. (Monthly & yearly interest can be calculated with a calculator on the BBC’s website).

Wonga, one of the major players in the payday loans market, insists that 99% of its one million customers are happy with the terms of their loans, mirroring the fact that the vast majority of such services are used entirely appropriately, for example in order to meet unexpected or essential payments.  Those using payday loans in unsustainable ways are in the minority; but they are the cases causing issues.  Costs can quickly mount up, on occasion provoking a vicious cycle of continuous borrowing and debt.

One of the key issues here is that whilst it can appear risky from a consumer's point of view to engage in this kind of borrowing, it is an equally risky practice for the lenders themselves.  A main advantage of payday lenders is the ease of access to credit; credit checks are far more relaxed and loans are easier to obtain across the board than would otherwise be the case if a consumer were to turn towards conventional lenders.  These high interest rates are a product of this risk, needed to cover the losses incurred by those particularly risky borrowers who are unable to repay their loans. 

An effective solution must therefore be preventative in nature rather than reactive; it must prevent cycles of unsustainable borrowing and debt before they start, instead of limiting their damage once they are already under way.  If short-term credit from payday lenders was significantly restricted, there is always the risk of consumers going 'underground', turning to prohibition-style loan-sharks.  This type of lending, of course, is completely unregulated, not to mention illegal.  The FCA must be careful therefore to prevent overregulation from driving consumers underground.

Martin Wheatley, the FCA's Chief Executive expressed his opinion on the matter, that “payday lending has a place; many people make use of these loans and pay off their debt without a hitch, so we don't want to stop that happening.”  There is a pre-existing set of voluntary industry standards, to which 90% of lenders, including the market leaders, already conform.  On top of this, lenders are required to carry out a credit assessment on potential borrowers, and are prohibited from rolling over any loan more than three times.  The practice of rolling over a loan involves the payment of a fee by a borrower in order to delay repayment of the loan amount, which remains the same despite this payment.  The payment operates to effectively stall repayment.

It is therefore clear that lenders are able to make sizeable amounts of money from those who are struggling to meet repayments.  This is a concern to the legislator, and precisely why it is keen to tighten up the practice.  Although the substance of any future regulatory changes are merely speculation at this point, it has been suggested that the FCA is keen to make two key adaptations to current practices.  Firstly, it will reduce the number of rollovers permitted and secondly it will place an obligation on lenders to provide risk warnings prior to any borrower taking out a payday loan, in order to ensure they are fully aware of their obligations in case of delayed or failed repayment.  Certainly in the case of risk warnings, a consumer's freedom to contract is not adversely affected in any significant way.  Rather, the 'meeting of two minds' is permitted to occur between two better informed minds; the consumer retains the liberty to contract or not, on the basis of the contractual terms before them, with the freedom to choose an alternative contracting partner should he or she wish.  Thus, the essential elements of freedom of contract survive.

Whichever path the FCA chooses to go down to limit the cost of borrowing, it will have to tread carefully to ensure all bases are covered.  Fears have been expressed, for example, that any limit to APRs charged could simply lead to lenders instead introducing a fixed daily fee, which would in effect play the same role as an interest rate, without strictly falling under the same umbrella.  The Australian legislation previously mentioned took the form of a cap of 4% interest per month.  This equates to a maximum of 48% APR, a huge cut from levels currently witnessed.  One has to question whether a cut this drastic can avoid an equally drastic contraction in availability of credit.  Although conventional credit, in the form of bank loans and mortgages on a longer-term basis, is becoming more accessible, the fact remains that it is not reaching anywhere near the levels we saw prior to the economic downturn.  This, of course, leaves high consumer demand and in turn a large gap in the market for the supply of short-term credit, hence the ongoing growth and popularity of payday lenders.

There are of course many who side with arguments in favour of greater consumer protection, more specifically in the form of tough cost caps to safeguard borrowers.  Even amongst those borrowers who are aware that payday loans do not provide sustainable support to their personal finances, the ease and speed of access translates into an ever-present temptation to use these loans in an inappropriate way.  We all suffer from short-sightedness to a degree – it is an element of our human nature, and it is this short-sightedness that lenders are able to turn to their advantage both in terms of repaid loans and the spiralling charges that come with those which are not.  The cycle of debt in which borrowers finance their debts through further borrowing is particularly damaging.  This habit can rapidly overwhelm a borrower under a mountain of outstanding repayments.  This is demonstrated by the 1.2 million consumers, in 2009, who collectively took out 4.1 million payday loans.  Of those concerned, two thirds find themselves amongst the lower income bracket of less than £25,000 who, in developing these debts, not only damage their immediate finances but also obliterate their respective credit ratings, rendering it all but impossible to obtain a mortgage or other conventional credit in future.  This acts as the nail in the coffin for many trapped beneath crippling piles of debt.

George Osbourne's proposed cost cap on payday loans could mitigate a growing problem, but certainly does not solve it.  The role of the legislator is to ensure the enforcement of fair contracts, not to guarantee a fair bargain on behalf of consumers.  To do otherwise would dissolve the freedom of contract that consumers benefit from.  It is important to remember as consumers that the benefit of such a right carries with it the burden of certain responsibilities.  In this case, consumers must, where possible, commit themselves contractually in a responsible way, ensuring they are able to honour their repayments further down the line.  In an ideal world, the supply of conventional credit could be manipulated to ease the financial woes of many consumers in the medium-term.  This being said, in the absence of high levels of traditional lending, any restriction on the supply of available credit could carry damaging consequences for the majority of sustainable borrowers across the market.   We can expect to see the FCA's response as of April 2014 when it takes over from the Office of Fair Trading's mandate – addressing the issues of payday lending will certainly be high on their agenda.

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Tagged: Commercial Law, Consumer Rights, Contract Law

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