A Radical Cure for the Ills of Payday Lending: Transparency
- Companies compete for your business. In other words, there is more than one choice. (No monopolies allowed.)
- Consumers have the ability to compare, ditch and switch. They can, with a little effort, understand the true cost of competing products, make informed decisions, and change suppliers easily.
- Companies producing products that no one wants to buy can fail. They will go out of business, and the people who invested in the business will lose their investments.
Unfortunately, the forces of the market usually don't reach consumer financial products. But, when true markets are created, the results can be dramatic.
Price Comparison Sites Work Amazingly Well in U.K.
In the United Kingdom, price comparison websites have revolutionized financial services, particularly auto insurance. If you want to buy auto insurance, you can visit a website, enter a few pieces of personal information and immediately see real personalized quotes from most major auto insurance companies. These are not estimates based upon public records or reverse-engineered guesses based upon the clever work of a computer scientist. The auto insurance companies share their pricing information with the price comparison websites.
Thus, all three conditions of the market are met. Consumers can go to one website and see the cost of the products being offered. It is very easy to compare, ditch and switch online. And no auto insurance company has a handout from the government. If they don't compete for business, they will fail.
Most importantly, the price comparison websites show the cheapest products first, not the products that pay the highest commissions. To be the top recommendation, you have to be offering the best price.
Auto Insurance Premiums Have Fallen 30 Percent -- Over There
And the result? Since 2011, auto insurance premiums have dropped by more than 30 percent. In the last 12 months, auto insurance premiums dropped a staggering 19.3 percent. How can prices keep going down? The pressure of the market is forcing companies to innovate. They are improving their underwriting models. They are investing in better fraud detection and claims handling processes. But they are doing all of this to lower premiums so that they can stay alive, not because they plan on making more money. The market is forcing them to compete. And it is brutal.
Compare the U.K. market to the U.S. auto insurance market, where insurance premiums are generally increasing. One website, www.leaky.com, tried to bring transparency to the auto insurance market. Not surprisingly, the auto insurance companies were not interested in transparency. In fact, the company received a cease-and-desist order every two months of its existence from insurance companies trying to stop it. Eventually, fighting the litigation became too much, and the startup had to shut down its product. Think about what that means to you: Big insurance companies sued a tiny company into oblivion solely because they don't want you to know how much their products cost.
And the auto insurance companies are still fighting hard to ensure that it remains difficult for consumers to compare, ditch and switch.
And Now Consider Payday Loans
Thanks to true price comparison websites, the U.K. consumer has enjoyed ever-reducing insurance premiums, ever-increasing low-rate balance-transfer durations (you can now borrow at 0 percent for 34 months in the U.K.) and ever-lower personal loan interest rates (with excellent credit, it is easy to get a 5.1 percent interest rate). Regulators there have taken note and would like to unleash the power of the market on one of the worst corners of financial services: Payday loans. As the Guardian reported last week, the competition regulator is going to force payday lenders to share their pricing information with price comparison websites.
Payday lenders offer short-term loans to consumers who have no other options. On average, payday lenders charge between $15 to $20 for every $100 that you borrow for 14 days. But the real money is made when borrowers roll over the loan. When the debt comes due in 14 days, the borrower has two choices. They can pay back the $100 borrowed or pay another $15 to $20 to extend the loan for another 14 days. According the Consumer Finance Protection Bureau, 80 percent of borrowers roll over their loans.
Hidden fees can often add up to far more than amount of the loan. Short-term loans turn into long-term loans, loaded with fees, generating annual percentage rates in excess of 1,000 percent.
Payday Lenders Scheme Around the Rules
Attempts to regulate payday lending have been a complete failure, on both sides of the Atlantic. Payday lenders are clever and find ways of getting around every rule designed to hem them in. In fact, a number of U.S. payday lenders are incorporated on Indian reservations to avoid regulatory oversight completely.
The payday loan model remains:
- Hide the true cost of borrowing.
- Don't share pricing up-front, making it difficult to compare.
- Keep people in debt forever, by making it "cheaper" to extend, rather than pay off the loan.
Remember the most important part of a price comparison website: the person with the lowest price almost always wins. Financial services are a commodity. So, if payday lender A has a 1,000 percent APR, and lender B has a 990 percent APR, then all of the business would shift to lender B. Lender A would see a dramatic drop in business, and would have to respond.
Payday lenders could drop their prices by 90 percent and still make great profits. But they don't drop their prices because they don't have to. Forcing transparency on the payday lending market could drive real change.
Consumers Would Benefit on Other Products
The ability of the price comparison business model to transform financial services inspired me to leave the U.K. and move back to the U.S., where I created MagnifyMoney.com. I believe that complete price transparency quickly rewards companies with the best product, rather than the biggest marketing budget. For example, we have a balance transfer marketplace where PenFed (a credit union that anyone can join) usually takes the top spot. It is there because it has the best product (you can move your debt from other credit cards to PenFed and pay only 4.99 percent for 48 months, with no fee), not because it has the biggest marketing budget.
When banks that are too big to fail aren't forced to compete based upon price, consumers lose. We have a lot to learn from the dominance of easy-to-use price comparison websites in the U.K., and I look forward to the day when banks, payday lenders and insurers are racing to drop prices in an effort to survive.
Nick Clements is the co-founder of MagnifyMoney.com, a website that makes it easy to compare, ditch and switch financial products. He spent nearly 15 years in consumer banking, and most recently he ran the largest credit card business in the U.K.