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When High-Interest Payday Lending Pays

Thursday, July 19, 2012

Lenders charge high interest rates for a reason.

British payday lender Wonga recently announced that it is expanding its high interest lending from individuals to small companies. While this move has been criticized by consumer groups, who say it will hurt small business, they are wrong to oppose the expansion.

Sure, interest rates on these loans are high. Wonga, for instance, plans to charge small businesses interest rates between 0.3 and 2 percent a week.

No one wants to pay to borrow money. And most borrowers–consumers and businesses alike–would prefer to pay less than Wonga is charging. In fact, I’ll go out on a limb here and say most borrowers would prefer an interest rate of zero.

But lenders charge high interest rates for a reason. When investments are risky, rates need to be high to make up for the large number of loans that are not paid back. Consider two sets of ten borrowers. Everyone in the first group is so creditworthy that all borrowers will pay back their loans. To earn 5 percent by lending money to this set of borrowers, a lender need only charge 5 percent interest. But in the second group, which is much less creditworthy, only half of the borrowers will pay back what they owe. To earn 5 percent when lending money to this group, a lender needs to charge 10 percent.

Denying those businesses access to these loans does not solve their problems. If they can’t get access to the capital they need to operate, many of them will fail anyway.

Many of the small businesses interested in borrowing from companies like Wonga have very high loan default rates. Unless lenders can charge high interest rates to these borrowers, they won’t extend them credit, which keeps these businesses from accessing the capital they need to operate.

If payday lenders are allowed to lend money to small businesses, some of their borrowers will no doubt have trouble paying off their loans and will fail as a result. It’s not easy for businesses to generate the cash flow necessary to service high-interest-rate loans. But denying those businesses access to these loans does not solve their problems. If they can’t get access to the capital they need to operate, many of them will fail anyway.

The effort to block small business owners from taking payday loans will fail. Small business owners routinely finance their businesses by personally borrowing (rather than filing a loan application as a business) and personally guaranteeing their business loans. If small businesses are barred from taking payday loans, their owners will likely borrow the money personally and put it to work in their firms.

If small businesses are barred from taking payday loans, their owners will simply borrow the money personally and put it to work in their firms.

Trying to block payday lenders from financing small businesses is the worst kind of government paternalism–using regulation to “protect” people from themselves. We need regulation to protect people from negative externalities. Barring chemical companies from polluting our rivers, for instance, makes sense because the money that chemical companies save from dumping pollutants instead of treating them comes at the expense of everyone else’s need to cope with contaminated water.

But high interest loans don’t create negative externalities. No one else is harmed by the small business owner’s decision to try to build a business by taking out a high interest loan. Perhaps the small business owner is gambling like his neighbor who buys Powerball tickets. Why should we stop either of them from pursuing a risky dream?

Barring payday lenders from providing credit to small businesses would be costly (because the government would have to enforce the ban). It would also be a misguided attempt by policymakers to tell small business owners that the government knows better than they do what’s good for them.

Scott Shane is the A. Malachi Mixon III Professor of Entrepreneurial Studies at Case Western Reserve University.

FURTHER READING: Shane also writes “Why Small Businesses Aren’t Using the Health Insurance Tax Credit,” “When Reducing Barriers Leads to More Failed Businesses,” and “Why Aren’t Banks Lending to Small Business? Ask Bernanke.” Michael R. Strain, Donald P. Morgan, and Ihab Seblani contribute “How Payday Credit Access Affects Overdrafts and Other Outcomes.” Aparna Mathur testifies to the Small Business Committee on “The Tax Horizon.” Alan D. Viard discusses “The Misdirected Tax Debate and the Small Business Stock Exclusion.”

 

Image by Dianna Ingram / Bergman Group

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