The OFT's review of the £2billion payday lending sector has raised concerns about how lenders assess a borrower's ability to afford debt before accepting them for a payday loan or before rolling over payday loans into a second month.
Annual percentage rates (APRs) on payday loans seem extortionately high – Wonga, for example, has an APR of 4,214%. But because loans are only supposed to be taken out for a maximum of 30 days, the actual interest charged is lower – in Wonga’s case, it's 360%.
This means borrowers are usually charged between £25 and £100 in interest, depending on the amount borrowed.
However, the OFT believes that lenders focus far more heavily on the fact that payday loans are easy and fast to get hold of, rather than the price. Many of those applying for a loan will clearly be struggling financially and unable to get their hands on other forms of credit. As a result, says the OFT, too many borrowers are granted loans they can't afford to repay and are then permitted to roll their loans into the next month, causing interest to stack up further.
Clive Maxwell, OFT chief executive, said: "We have found fundamental problems with the way the payday market works and widespread breaches of the law and regulations, causing misery and hardship for borrowers. Payday lenders are earning up to half their revenue not from one-off loans, but from rolled over or re-financed deals where unexpected costs can rapidly mount up."
Rolling over loans in this way also means that lenders are less inclined to compete with each other because they already have a captive market.
In addition, there are concerns that some payday lenders don't adequately explain how payments will be collected and use aggressive debt collection practices.
The findings of the OFT's review align with figures from the Financial Ombudsman Service (FOS) which show that complaints about payday loans are on the rise. Between April and December 2012, the FOS received 387 new complaints, compared to the 296 complaints it received in the 2011/12 financial year.
Most of these complaints arose because borrowers felt their loan was unaffordable and they should not have been given it in the first place, the charges on the loan were too high, or the loan provider would not accept a suitable repayment plan.
The OFT believes a full investigation by the Competition Commission is needed to ensure payday lenders treat their customers better.
From April 2014, the Financial Conduct Authority (FCA) will regulate consumer credit and will be able to use the Competition Commission's analysis as it develops its rules. The FCA will have greater powers than the OFT which could see it cap interest rates on payday loans and impose a ban or limit how many rollovers lenders can offer.
A government clampdown also plans to limit the number of adverts payday loan companies can put out per hour and the times they can advertise, as well as ensure companies clearly display interest rates. Working with the Advertising Standards Authority and the industry, the government will endeavour to make sure adverts don't tempt consumers to take out a payday loan that's not suitable for them.
Should I take out a payday loan?
While payday loans are an expensive way to borrow, they can have their uses. However, they should only be relied on in an emergency, not as a way of financing a holiday or a shopping spree.
If you are thinking of applying for a payday loan, ensure you have a repayment plan in place so that you are confident you'll be able to pay it back without having to roll over your debt into another month.
If you have taken out a payday loan and are now struggling to pay it back, talk to a free debt advice charity such as StepChange or Citizens Advice.
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