The Church of England's claim it will take on Wonga – and the subsequent revelation over its investments in the firm – have put the spotlight back on the payday loans industry. Wonga is the best-known firm operating in this arena, offering short-term borrowing at high interest rates. So how does it all work?
What is a payday loan?
It is a loan designed to be taken out over a short period of time. Typically they are advertised as a means to fund unexpected purchases that arise a few days before the end of the month, when you are strapped for cash and waiting for payday. Unlike traditional personal loans they are arranged over days rather than years, so can be used as a stop gap until your wages arrive.
How much can you borrow?
Typically up to £1,000, although some lenders restrict the size of the first loan they will offer. Loan periods start at less than a week and in some cases run to months. Peachy.co.uk, for example, offers borrowing over five days to five months, while Wonga's loan period starts at just a day and the maximum varies throughout the month. There are not usually early repayment charges, but there are fees for setting up the loan, as well as interest, which is usually calculated daily.
Are they expensive?
Yes, but not necessarily more so than traditional alternatives – as long as you pay them off as expected. Borrowing £90 from Wonga for three days costs £8.37, which is likely to be less than your bank charges for an unauthorised overdraft. An authorised overdraft could be better, or an interest-free credit card, but these are obviously not always options.
However, charges quickly mount if you miss the repayment or decide to extend or roll over the loan. What started as a small loan can grow rapidly once extra interest and fees start to be applied.
How quickly do they add up?
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Say you took out a £200 loan from Wonga arranged over 14 days: after that time you would owe £234.27. If Wonga is unable to retrieve that money from your account on the repayment date it will hit you with a £20 late payment charge. If, instead, you get in touch and ask to roll over the loan (effectively using another one to pay what you owe) for another 14 days, you will then owe £274.17. If, at that point, you decide you still can't pay and roll over for a month your debt will grow to £368.77. So after two months, you will have accrued interest of almost £170 on a £200 loan.
If you are unable to repay Wonga on the final agreed day, interest is added for up to 60 days at 1% a day, then frozen. In this example, that would add more than £200 to the cost before fees were frozen. After four months the debt will have grown to almost £600.
What about the massive interest rates that are quoted?
Annual percentage rates (APR) on payday loans are huge – Wonga quotes a representative APR of 5,853%, while another major player, the Money Shop, has an APR of 2,400.8%.
However, as lenders are quick to point out, the way an APR is calculated was not designed for short-term lending, and reducing the loan period means the interest rate goes up. This makes it difficult for consumers to compare the real cost of the different loans available, and has led to calls on all sides for a new "total amount repayable" figure which expresses the cost in pounds and pence.
Why are they controversial?
Campaigners against payday loan firms point to the way that borrowing can very quickly add up. They also claim lenders are targeting the most vulnerable borrowers and are not doing proper affordability checks on them before granting loans. Not all lenders co-operate with debt charities trying to help people out; costs are not always transparent; and some lenders seem to encourage consumers to take on more borrowing.
Is the criticism fair?
The Office of Fair Trading spent a year looking at the industry and found widespread evidence of irresponsible lending and breaches of the law. It said borrowers were suffering "misery and hardship" as a result of fundamental problems with the way lenders operated, putting speed ahead of everything else.
The charity Citizens Advice reported that among 2,000 loans taken out with 113 lenders, in nine out of 10 cases the borrower was not asked to provide documents to show they could afford the loan. Of those who had repayment problems, seven in 10 said they had been put under pressure to extend the loan, while 84% said they had not been offered a freeze on interest rates and charges when they said they were struggling to repay.
What is being done to protect consumers?
The OFT has shut down three lenders so far in 2013, and has referred the industry to the Competition Commission, which will be able to insist on improvements. Since it published the results of its review, 11 lenders have decided to withdraw from the market, rather than making changes.
In April 2014, regulation will pass from the OFT to the Financial Conduct Authority, and its head, Martin Wheatley, has promised to crackdown on abusive practices. In the meantime, the OFT has said payday lending would remain a top enforcement priority. In February it got the power to suspend a lender's licence immediately if it believed there was consumer detriment, and it can use this on payday loan firms if necessary.
The MP Paul Blomfield has introduced a private members bill to Parliament calling for controls on advertising and marketing, clearer information on costs, and caps on lending and charges, and the consumer minister has called an industry summit to discuss whether more regulation is needed.
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