Payday loans are an often criticized means of obtaining short-term financing with no credit check. Used by millions each year, payday loans are thought by some to be financial blessings since they are often the only method of financing for those with poor borrowing histories. But despite their demand, consumer advocate groups often vehemently speak out against this type of financing, largely due to a mechanism inherently built into these loans: the rollover.
What is a Rollover?
Imagine a borrower who approaches a payday lender for a loan and takes out an initial two-week line of credit for $100 with a $15 dollar fee-an annual percentage rate (APR) of roughly 390 percent. As that two-week deadline approaches, the borrower finds he has other debt obligations to fulfill with this upcoming paycheck, so he strolls back into the street-corner lending office and asks to extend his loan term.
The lender explains to him that he can extend his term by taking out an additional loan to cover the original loan’s amount. So the borrower finances another payday loan, but this time it’s for $115 with a $17 fee-again an APR of 390 percent, but this time it’s higher due to the new principal covering the cost of the original loan.
The borrower just practiced what is called a payday loan rollover. A rollover is the name given to a subsequent loan taken out to pay off an existing loan.
If the borrower rolls over that second cash advance again, he would be expected to finance $132 with a fee of $19.75.
As the rollover process continues, our borrower would find himself on an ever quickening “debt treadmill.” Like an accelerating treadmill where one is constantly being forced to run quicker and quicker just to stay in place, a debt treadmill forces a borrower to consistently pay increasing sums of money just to make good on an original payday loan.
Assuming our fictitious borrower was able to payback his third rollover and escape this debt treadmill, he would ultimately pay the lender $151.75 for his original $100 loan-more than 50 percent in interest.
Why do Rollovers Exist?
The unfortunate existence of rollovers is actually a side effect from the risk that payday lenders subject themselves to by being a part of the short-term lending industry. Since these lenders grant their financing indiscriminately to borrowers regardless of credit score, they naturally encounter a high rate of default.
In fact, the default rate is believed to be around a consistent six percent, as found in the Missouri Division of Finance’s payday lending surveys. While that number may not seem high, a six percent default rate actually reduces lenders’ profitability by drastic numbers.
For instance, imagine the lender in our above example who originates payday loans at an APR of 390 percent. If he lends money to ten individuals, each seeking installments of $100, that lender can expect to make a total of $150 (ten loans multiplied by $15 interest).
But with a six percent default rate on $1,000 lent, the lender can expect to lose $60 (six percent of the $1,000 lent), bringing his total net profit to $80 (or $60 subtracted from the $150 gross profit). If the lender decreases his APR, he risks falling into insolvency if that default rate rises any higher.
Since lenders are forced to keep their interest rates at very high levels in order to remain solvent, borrowers will continue to default at high rates. Thus this vicious cycle feeds off of itself in a never-ending merry-go-round.
The important thing for borrowers to remember is that payday loans should always be paid back as soon as possible. If rollovers are avoided, borrowers may find payday loans to be healthy financing options which can be used to deal with unexpected expenses between paychecks.