I’ve just read the Telegraph’s article on Bishop Justin adding his weight behind a bill to restrict charges on payday loans. At the end of the article there is a quote from a Wonga.com spokesman saying that their loans only cost 1% per day. This is already extortionate when you consider the Bank of England charges only 0.5% per year! However, as we’ll see, the true cost makes 1% per day look very generous. The spokesman goes on to say, “It would be brilliant to sit down with our critics and explain how it works.”
So, let’s actually do that, then. I visited Wonga.com‘s web site, which quotes an APR (annualised percentage rate) of 4214%. Yes, you read that correctly, when forced by law to tell the truth, their interest rate is equivalent to thousands of percent per year. Most banks and credit cards charge single or low double figure percentages. So 4214% is a lot. And it looks bad. Which is why Wonga.com’s website then explains that things are not really as bad as they seem, that they are forced by law to quote APR and that APR is not actually an appropriate way of representing their products.
Why is APR not appropriate? Their answer is that, firstly, their interest is not compounded, and, secondly, APR is an annual rate whereas loans from Wonga.com cannot last anywhere near as long as a year. In other words, APR is not comparing apples with apples. This is deeply disingenuous – APR is specifically required by law so that there is a way of comparing apples with apples, regardless of details like compounding and term. It also conceals the fact that, owing to some playing about with definitions, the 1% per day does not actually include the entire cost of the loan. There is also a “transmission charge” of £5.50 – which is effectively an interest by another name.
So what is APR? I’ll give two definitions, both of which are correct and both of which allow us to explore Wonga.com’s offering. Firstly, APR is a way of comparing loan products in terms of how much extra I pay back over and above what I borrowed. In Wonga.com’s example which gave the 4214% APR, £207 is borrowed for 20 days and the total to pay back is £254.42. For me to have the same experience with my bank account overdraft, my bank would also have to be charging 4214% interest. This is an exact like for like comparison for anyone who has a bank overdraft facility that is at least as large as £207. It cuts away all the dissembling: the fact is I could borrow the same about of money for the same time period for about a 20th of what Wonga.com charges.
The second way to look at APR is to ask how much it would cost me over the period of a whole year if I borrowed money for that length of time without making any interest payments. In the case of Wonga.com, the way to do this is to roll credit. That is, to pay off one loan with another. And because we are not making interest payments, it means we have to add the accrued interest of the previous loans to every new loan we take out. Which means, contrary to what Wonga.com claim, interest is compounded. It’s just that it isn’t Wonga.com who are compounding it, but the customer. Given this definition, to borrow £100 for a year would cost a customer several thousand pounds overall! (Although, technically the customer would be bankrupt long before then because Wonga.com won’t lend you more than £400).
So, APR turns out to be an excellent way of showing just how expensive a loan product is. It sweeps away word games that call some of the expenditure “interest” and some of it “transfer fees”. And it forces one to be honest about this being a loan that can only ever make sense over a short period and as a one-off. Any kind of habitual use of this kind of product is deadly. To be fair, Wonga.com are also upfront about this: they advise people not to use their service if it is too expensive. But one must ask who would ever chose a loan product that is twenty times as expensive as credit cards or bank overdrafts. The answer, of course, is those who are utterly desperate and have no other recourse. It is exactly such people who will not suddenly after pay day have enough to pay back the original loan plus the extortionate costs and somehow be sufficiently in the black next month not to need another loan.
I’ll finish off with a worked example, just to illustrate in real terms what I have discussed above. We’ll start with a £100 loan, just to tide us over until pay day, a week hence – because it has been an expensive month. The front page of Wonga.com’s website calculates that we will have to pay £112.78 out of next month’s pay-cheque to cover the loan. (That’s £5.50 trasfer fee plus £100 plus interest on both amounts). Sounds good, only costs us £12ish, let’s do it. Towards the end of the next month we realise this has also been an expensive month – after all, there was £112.78 less to go around off an income which was already stretched. We borrow £113 (rounding off), making the next repayment 126.68. As this continues, the loan progresses as follows:
|142||8||159.14||Cash is now so short, we have to borrow a day earlier.|
|197||9||220.48||Borrowing even earlier in the month.|
|220||10||247.74||Even earlier – it’s escalating.|
|358||13||410.11||A year has now passed.|
After a year we are in debt by more than four times the initial amount (i.e. more than 400% in a year where most days we were not actually in debt to Wonga.com). Wonga.com will no longer lend us enough to cover last month’s debt – their cap is £400. So the children are beginning to go hungry. But the real evil is only just beginning. As you will have noticed we’re having to take the loan out earlier and earlier each month at an increasing rate and we’re having to borrow more each month at an increasing rate. Very soon we’ll be borrowing £400 all the time. Every month we’ll have to pay over £125 in costs. The only thing saving us from spiralling completely out of control is that Wonga.com won’t lend us more than £400 or for more than 43 days. And that is why they claim that APR is not appropriate – because you’ll never get to paying 4214% interest – you’ll starve first.