Thursday, 25 July 2013

Welby and Wonga; Why APR is a meaningless number for small short term loans.

APR; Annual Percentage Rate. In theory, a useful measure to compare the cost of a loan. In practice almost meaningless.

What is a reasonable cost for a short term loan? 
Ignoring the term (length) of the borrowing, for a company to lend money it incurs administrative costs, such as transferring money, keeping records, performing a credit check, chasing up payments, running the website, etc.

This is before considering the cost of capital (ie how much money costs Wonga to borrow) or the likelihood of borrower default (ie the chance that a borrower will not repay the loan).

If one goes to Wonga's website, and looks at the cost of  borrowing just £1 for 1 day, the fees and interest are £5.57.

Now if you were a moron you would conclude that this was an outrage because the APR is;


OR you would wake up and realize that it is an utterly stupid measure.

There is an absolute cost of lending money and performing transactions that has no relation to the size of the loan, is £5 for a loan really outrageous?

Welby would perhaps say that a credit card APR is more "fair", that would mean that the cost of borrowing £1 overnight would be 0.05p ie less than one twentyth of a penny. Nobody in their right mind could think that you could make a loan and record a transaction, check a credit score and transfer money for that price.

I could go into more detail, obviously Wonga lend to people with poor credit quality, that means they are exposed to high number of people that will default on their loan, and as such they need to charge more to just breakeven. Even if 5% of customers failed to repay a one week loan, that would necessitate an APR of over 1000%, before you consider any administration costs, or heaven forbid the cost of capital or the firm's profit.

I hope that people will stop being "outraged" by numbers that are meaningless and inappropriate.

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