Suppose you are in the lending business. Which of the following two applications would you favor?
Applicant 1 needs the cash to cover a one-time, unexpected expense. His credit history is good, and he earns more than enough money to repay the debt in full and on time. So whatever you have in mind to charge in the form of interest rate and fees, and the manner in which the loan is to be structured will have to be competitive with what the applicant can easily obtain in the open marketplace.
Applicant 2 is barely able to make ends meet each month. As such, there’s a risk that the loan may not be repaid on time, or in full. His employment situation, however, is stable, and his credit report, while not pristine, is not hateful. Add to the mix a fair amount of desperation, and it appears as if you have the latitude to charge a high rate of interest, a healthy amount of fees and, perhaps, to require a direct-debit repayment plan that coincides with the timing of the prospective borrower’s future payroll deposits, just to be sure there’s enough cash in his checking account.
That second scenario likely encapsulates the credit underwriting, pricing and structuring considerations that underlie many short-term lenders’ marketing strategies for payday, account-advance and bill-pay loans: Collateral that can be tightly controlled (payroll deposits in this instance), and a borrower who is charged as high a price as he or she can tolerate without defaulting on the loan.
In other words, let’s subvert the traditional risk versus reward trade-off by earning outsize profits while taking only moderate amounts of risk.
Of course, the added benefit of this approach is the dependency it engenders. Consumers who are compelled to take out payday, bill-pay and account-advance loans, and small businesses that sign up for merchant-advance loans — which does for small businesses what payday loans do for (or to) consumers, but this time with their accounts receivable — end up diminishing their already inadequate cash flow (hence the need for the loan in the first place). That sets the stage for them to re-borrow the same funds time and again.