Why People Focus on APR, and Why They Shouldn’t

Why People Focus on APR, and Why They Shouldn’t

Written by Steven Adsit, a 15-year Pawnbroker, NPA Member and Colorado State President

Reprinted with permission from the author

Recently, in a pawnbroker forum, the discussion turned to State Rate Caps on Payday Lenders.  Some pawnbrokers voiced opinions that Payday Lenders were predatory and charged too much.  Others defended and said the rates were needed based on risk and cost. I wanted to discuss some of the ideas and points that were made. 

In specific, I’d like to review the Payday Loan Model as it compares to Pawn Loans.  This includes the key differences for consumers, their impact on the lending process and APR, and a general discussion on why legislation may not be favorable to pawn lending.  Perhaps most significantly: I want to provide talking points as to why rate caps are dangerous to the client.

“Payday Lenders Have a Very High Interest Rate”

Well yes, it’s high, but it likely needs to be…  Most people see what seems like a high rate and don’t put much thought into it.   To put a very complicated P&L into a simple statement: a business needs to make more than it spends.  What it charges for its service is a direct reflection of that.   The important point that many forget or don’t even consider: Payday Loans are non-secured loans. Many have 25-45% Loss.  Picture your pawn loan balance: what would happen if 25-45% of your Pawn Loan Collateral just disappeared?  You have nothing to show for it, you gave them the money; they gave you nothing and just disappeared.  You have nothing to sell; now picture what that would do to your sales. 

Payday Lenders rates need to be high to offset the loss from bad loans.  Most Payday Lenders do not check Credit Score which makes it hard to establish “likelihood to repay”. While this model allows credit access to more people, this essentially forces all customers to pay for the defaulting customers.

People and lawmakers see a high interest rate and immediately vilify those businesses assuming they are predatory.  In fact, the APR is ALL they see; the APR is the focal point.

To use an industry comparison, think of a diamond shopper.  Customers often come in and ask to see your 1ct stones.  The Size is the focal point, they don’t ask to see your VVS stones or your EX EX EX stones, customers do this is because they only see Size as the main factor.  We all know there is much more to the diamond’s cost than the size shows, just as there is more to a loan cost than the APR.  However, the public sees diamond size as the main factor, just as they see APR as the main factor.

Payday Lenders have a high APR, but I’ve seen many Payday Lenders books and they aren’t making “obscene” profits with their high rates.  In fact, I often wonder how it’s worth it to them. But you don’t need to see their books to determine this; all you have to know is that when the state forces them to lower their rates, they go out of business.  If they could make a profit on the lower rates they would; I assure you none of them want to close down.

There is historical evidence that Payday lenders were usurous in the beginning when there was no regulation; mostly because of the cycle of re-borrowing that often occurred.  Free market competition began to drive those rates down, but by that point most local governments had already begun to regulate them. And perhaps that was justified.  The problem is they didn’t stop with the initial regulatory limitations.  At some point, in many states, (each state is different) Payday Lenders were running on much lower APR’s than they started with, and thus were no longer considered usurious.  But the stigma had already stuck and they became a focal point of many politicians.  Thus, regulations continued.  In many states, Payday lenders are no longer able to profitably operate at all. 

The point here is that APR is not an accurate representation of charges and cost.  What may appear to be a high rate may not be unjust.  Rates are usually in proportion to the cost of doing business. This is a direct relation to pawn.  This is a direct relation to any lender.  We have to look past the surface to know the cost of doing business and how it is structured, this is how some lenders can charge less and some must charge more.  APR is not an accurate representation of business operation, unfortunately, it’s all most people see.

This Cost of Business Factor, is in fact one of the best arguments FOR pawn. 

Because we hold collateral, we can operate at a lower cost than a Payday Lender. 25-45% of our loans don’t just disappear as they are collateralized, thus protecting the lender from loss and in fact saving the customer in the end.  Non-Recourse means the customer is free and clear.  This saves the customer from collection agencies, legal fees, etc etc..  Pawn is the BEST business model for servicing the population with a lower credit score.  Non-Recourse is the Key to our superiority.

The fact that Sub-Prime Credit Lenders exist, and have always existed, proves that the Industry needs to exist.  Obviously there is a demand for loan products to the unbanked, un-bankable, and even the banked who want fast and easy.    Denying access to a legitimate service that consumers want and need is an unintended consequence of rate caps.

Banks: “A bank can offer a lower rate”. 

Banks mitigate risk by using credit scores.  They don’t see a 25-45% loss because they wouldn’t even loan to that customer in the first place.  And if the risk is higher (Low Credit Score), they charge more.  That’s one factor that lets them stay profitable at a lower rate.  There are more..

            A bank charges Loan Costs directly to the customer. Banks require you to obtain insurance, appraisals, home inspections and other costs BEFORE you qualify for the loan.  This is all paid by the borrower as part of the qualification process, thus allowing them to charge a lower APR.  Imagine if someone brought a diamond into your store and wanted a loan.   If you used the Bank Model, You would tell them, “OK, you must first Pay to Ship this to GIA, pay to have it graded to find out its 4C’s, then you must pay to have it Appraised for Market Value, then you must pay the Servicing Fees and Administrative Fees for me writing this loan, then we will give you the loan.”  If that was the case, then of course you could charge a lower APR.  A bank makes the consumer pay all the costs then just sits back and collects the interest!  If they added all the upfront costs into the APR, it would certainly raise. But because the model does not work that way, the masses simply see a lower APR and give them a pass.

For a long term bank loan, cost is all at loan origination (Which is mostly paid by the customer directly), long term servicing of the loan is very affordable. The profit on a lower interest rate is likely higher on the P&L than a high Interest Payday Lender or Pawnbroker with short loan terms and high overhead.

Cost of capital: Most pawnbrokers operate on borrowed money.  Pawnbrokers have to pay for the money they loan out. Banks pay almost nothing for the money they lend out.

At a bank, when an “insufficient funds” check is paid by the Bank allowing an overdraft, the fee is often around $35. This is essentially a loan. What’s the APR on a $10 Overdraft Loan with a $35 Fee?

Banks are selective on whom they will lend to.  Thus, an alternative service must exist to service those that the banks will not… And the risk is much higher, thus the cost is higher, thus the cost to customer is higher…  

APR vs LOAN FEE

Often, when pawnbrokers think of 36%, they think “3% monthly loans”.  This is incorrect. APR is calculated to the day.  A $100 loan picked up in 15 days would collect $1.50, not $3.00.

Fees:  Most low interest states allow fees to be charged: Storage Fee, Origination Fee, Lost Ticket Fee, Maintenance Fee, etc etc. 

When Pawnbrokers in Low Interest states add up the fees charged and calculate to the day (not to the loan), they are well over 36% APR.  (Remember the bank fee schedule comparison from above.)

It’s very important to note: Many of the states that have Passed Payday Loan Rate Caps have INCLUDED ALL FEES IN THE APR CAP.  Meaning the total of ALL cannot be above 36%. NO FEES! This would end even the largest pawn operations with the lowest cost.

Side Note: Speaking of Storage Fees, I have numerous customers who tell me they only use us for storage.  They get a loan saying “I know it’s safe and insured and I’m happy to pay the monthly storage fee”; should that even be called a loan?

Low Rate Ripple effect on Pawn loans – Unintended Consequences:

States with lower Interest rate regulations see minimum loan amounts way up in the hundreds, while 20% states see minimum loans at just $5.  National average loans are in the $80-100 range, so there is an obvious demand for smaller loans.  Rate Caps force lenders to have higher minimum loan amounts.  This cuts out the lower income borrowers leaving them with no credit options. 

Risk mitigation: Low interest states see collateral lenders ONLY lending on Jewelry and other small items with little risk and small physical footprint.  20% state pawnbrokers will take almost anything for collateral, thus increasing credit availability to the customer.  This is also important to remember as Jewelry is becoming less and less popular as a consumer good.   

Loan vs Sell Price:  Low interest states will offer to BUY at a higher price, Loan at a lower price.  (15 day purchase hold vs 90/120 day loan hold) In many cases, this forces the customer to sell out of necessity, when they really would rather keep the item. The Buy vs Loan value difference becomes especially large with rapid value depreciation electronic items, such as Tablets, Laptops and Smartphones (a smartphone can easily lose 30% value in 120 days).  Now keep in mind how easy it is to sell things online for a customer these days… Pawnbrokers beat out Facebook Marketplace because we offer loans; they don’t have to give up the item, not in the scenario where they need more money and the pawnbroker has to offer less to loan.  When forced to sell, the customer ends up paying more to replace that item later at retail price, than the interest they would have paid if they could have gotten a loan. 

Low interest pawn models only work with huge loan balances.  Only a select few can survive.  All power is then concentrated and no one can enter the market because startup is cost prohibitive.  This creates a huge barrier to entry for the industry.  There aren’t many small business opportunities left in this country, most government regulations create a climate where only large corporations can exist.  There aren’t many mom and pops that can open a store and hope to have a million dollar loan balance in a couple years.  And even if there were, this model can only work in large densely populated cities.  A low interest rate pawn shop is not sustainable in a less populated city or area.  This in fact removes access to credit for people who need it and want it.  This would leave the majority of the country with no access to a pawnbroker.

Lack of Competition is bad for the consumer, and in fact it’s bad for the pawnbroker.  How many services are included for free in a 20% state: Text Reminders, Free Grace Periods, Postcard Reminders, enough employees to prevent a long line wait (good customer service), Insurance, Security. etc etc… These all have cost!  Reducing APR limits all these and actually lowers performance of business; so much of what we do to attract the clients is motivated by competition and profit.  It encourages us to innovate and to try new things.  This is better for everyone; business owners, all consumers (not just our direct customer), and the entire industry as a whole.  We all want to “give ‘em the pickle” as much as we can, however with very limited profit that is hard to do.  (Hopefully only a few of you had to google “Give ‘em the pickle”)

Rate Competition exists naturally!  In free market 20% states, you will see “Jewelry Only” pawn with lower rates, or Take Anything Pawn with adjusting rates.  Some stores offer different hold periods, some offer reduced rates for large loans. Competition allows this and leaves choice and option to the borrower.

This is an appropriate time to mention that pawnbrokers serve much more than just low credit and unbanked consumers. The simple fact is that we service people of all income levels.  A pawn loan is fast, safe and discreet.  We loan to business owners, entrepreneurs, middle class borrowers, upper class borrowers, and many others.  Our fast easy process, customer service, and no recourse loans are extremely attractive to customers at all income levels.

Forced lowering of APR limits all these options and lowers performance of business, constrains operating models, limits consumer choice and most importantly denies access to financial services to millions.

Buy / Sell

“If they lower the interest rate I’ll just become a Buy / Sell Shop”. That was a possible thought before Craigslist, Facebook Marketplace, Poshmark, Stock X, Let Go, etc etc etc.  Now, loans are all pawnbrokers have. The ability to repay and KEEP the collateral is what sets us apart. When forced to sell, very few will sell you an item at half value when they can put it up on Marketplace for 75-90% value and sell it quickly. (We also provide a safe way to sell; don’t forget to remind people of that when you remind them that they can KEEP their items)

What is the Buy / Sell effect on the consumer? All evidence illustrates the customer need for loans, not a place to sell.  The problem is de-collateralizing people.  Forcing them to sell products to get money destroys their asset base and reinforces a cycle of poverty.  The cost to replace an asset is much higher than the cost of a loan, thus putting the consumer even further behind. 

Some Used to only charge 36%. 

“My Grandfather Ran a store for 50 years and only charged 3% per month.”

As we clarified before, they charged 3% per Loan, not APR.  Also, most charged some fees. But let’s move on….

Simply put, your grandfather did not have the overhead and risk we have today. Not even close.  In fact, not even in the same ballpark.

Years ago, I was looking at an old pawn ticket (yes I collect them) from 1936 that showed a 3% monthly Rate (not APR, but 3% per loan/month).  I wondered how they could do that.  I decided to see what it would look like if I did that.  I did a quick little experiment on my P&L.  It wasn’t perfectly scientific but it illustrates the point.

I added a Column to my P&L called “1936” and I adjusted each line item to represent the 1936 estimated cost and rate.  I changed my annual pawn interest income to reflect proportionately a 3% rate (which is under 3%).  Then I adjusted each expense to reflect an estimate of 1936 cost.  Most of the costs would not exist in 1936. 

Yep, you guessed it.  I would have made a higher profit operating in 1936 at 3%/month than I do operating in 2020 at 20%/month.

Look at your line items.  How would they look 50 Years ago?  Did your grandfather pay $1000 per month to operate Air Conditioners?  Did he pay to build and maintain a Website?  What % of profit did he pay to third party online retailers? How much was his Pawn Insurance? Unemployment & Workman’s Comp Insurance?, Payroll provider? Credit card processing? Accounting expenses to figure it all out? Security system & monitoring? Surveillance system? Sigma, XRF, Synthetic Diamond Tester? OSHA / ADA Compliance Costs? Licensing Costs? Bond Costs? Software Cost, Computer Maintenance, Smart Safe Cost? Broken/Locked electronics write offs? Property Taxes?  I’ll stop there…. I could make this list go on for an entire page.  Look up for a moment and look around you at all the things you have and need to operate.  The fact is we have high overhead, and it gets higher every year.

Remember also; a lot of the things your grandfather did himself are now too complicated and time consuming to do alone, they must be hired out… Payroll, Credit Card Security Compliance, Website Building…

Worry about Lending Caps? 

Voters don’t understand.  If they see a ballot title they like, they vote for it with no understanding of the ramifications.  The government never takes away regulations, they only add.  And they get larger and larger. Remember when the MLA didn’t include pawn transactions? Well guess what, it got larger and larger and now it does.  In a few years will we will be saying “Remember when they only capped Payday Lenders?”

This country is quickly heading to a full Government or Giant Corporation control model, if not Government control, then Giant Corporation.  Bernie wants the Post Office to give loans, Amazon is offering Loans now…  Google (Alphabet) has its hand in some loan companies, Facebook has some loan programs.  I’d say those guys might have an upper hand to your operation.  And when a Government regulation puts you out of business you can bet that one of those big corporations will still be able to do it somehow. 

Voters don’t understand any of this.  Voters simply see a high rate and think they should vote it down.  The do not understand Costs, Profit, Loss, Overhead, Cost of Loan Acquisition, or any of these.  They don’t understand the ripple effect and how Forcing/ Manipulating one thing will affect another. 

A ballot initiative might have this title: “Put a Rate Cap on Loans”.  But voters don’t understand the consequences of this. Perhaps the title should be “Force all Small Lenders to Close”.  Perhaps it should say “Take all credit options away from people with lower credit scores”.  How about these titles: “Only allow Large Corporations to offer financial services, no small businesses allowed” or  “Prevent the unbanked from getting financial services”, “Increase the profits of banks collecting bad check fees”, “Force people to sell personal property to secure funds”, “force property transfers to only happen in unsafe and unregulated environments”.

This is the ripple effect.  Do you think those ballot titles would get the same number of votes?

Most voters don’t understand credit as it relates to our industry.  How would they feel if they were told suddenly that they could no longer use a Credit Card.  Pawn is simply a credit card to our customers, but voters don’t make that connection. Just as a credit card is essential to many, Sub Prime Credit Loans are essential tools for a large portion of the population. People need actionable tools to manage cash flow issues.  They do not need regulations denying them access to help.

What to do?  

I hope this does not sound like Doom and Gloom.  I try to stay upbeat and offer solutions.  It’s hard at this moment.  I’m writing this as the 2020 US election has just finalized. I’m thinking about how much I’ve spent on additional security this year, I’m thinking about how much payroll cost has gone up, I’m thinking about how much property taxes have gone up and how much more all taxes may / will go up.  I’m thinking about how many proposed legislative items will directly raise costs and prevent parts of our industry from operating as normal.

I’m remembering Operation Choke Point and having my Credit Card Services Stop on a busy Friday without notice, then having it happen two more times in the next months; then getting a 30 day bank termination notice.

I’m also thinking of how proud I am of what I do; how proud I am of what all Pawnbrokers do.   I’m thinking about how hard we work to provide a service that is desperately needed.  I’m thinking about how many jobs we provide and how we fit perfectly in the economic cycle.  I’m thinking of how accepting and understanding pawnbrokers are: of all people, from ALL walks of life.  I have never met a more rounded person than a pawnbroker.

So what can we do?  Educate People and Leaders!  If people understood that we provide a service that no one else is willing to do.  If people understood that we don’t make “Obscene” profit.  If they understood the crazy hard work required to operate.  If people understood the high overhead and risk compared to other lenders.  If people understood that collateral loans don’t discriminate based on anything: credit score, race, sex, age, income, religion etc.  If people understood how we provide safe financial access in an unsafe world. They need to understand all this BEFORE they get to make a knee jerk vote that they don’t understand.

It should not be in the government’s interest to deny consumers of a legitimate service they want and need.  This must be kept in the mind of legislators, as the public does not understand this when voting. It should never even reach a ballot!

I once heard someone say to a pawnbroker, “you guys charge too much, my brother got a loan and couldn’t afford to pay it back”.  The wise pawnbroker replied, “Well why didn’t you just give him the loan?”  The man thought for a moment and then said, “good point”.

We provide a much needed and important service that no one else can or will provide.  This is Fact.  This is fact even in today’s crazy modern, almost cashless, digital, connected world.

The NPA tirelessly helps educate lawmakers and the public.  You should help them do that.  You should help your state organization do the same. Many already do this, but many don’t.  If you don’t, now is the time get proactive.  Join the NPA, Join your state association. Once you join, help them, your money is not enough.  Then, Talk to your local officials, police, sheriff, county commissioner, mayor, fellow business owners, customers, anyone you can.  Don’t just tell them you are a pawnbroker; tell them how great pawnbrokers are, and explain why.

I’ll end with a suggestion for further reading: PAWNSHOPS, BEHAVIORAL ECONOMICS, AND SELF-REGULATION by SUSAN PAYNE CARTER & PAIGE MARTA SKIBA, 2013: https://scholarship.law.vanderbilt.edu/cgi/viewcontent.cgi?article=2041&context=faculty-publications

This research article is scientifically conducted and dives deep into consumer behavior in relation to pawn.  Here is an excerpt from its conclusion:

“We view pawnshops as a potentially attractive alternative to other forms of high interest credit. Pawnshops offer simple transactions in which anyone can participate. No credit is needed and no credit check is conducted. Interest rates on pawnshop loans are lower than those associated with many other types of credit, even mainstream credit. The combination of the existing regulations on interest rates and what appears to be consumers’ self-governing repayment behavior or “self-regulation” seems to work well in this market. While we cannot say for sure what behavioral factors are at play, repayment rates on pawnshop loans, particularly those secured by sentimental items, are high. Some combination of sentimentality, loss aversion, and discounting seems to help borrowers make good on their pledges. A deeper welfare analysis is difficult for us to conduct without additional data, but we are convinced that pawnshops can be a good alternative source of credit. Further research on pawnbroking and its customers will give policymakers, consumers, and academics a better grasp of this ancient and yet still popular and important institution.”

written by Steven Adsit, a 15 year Pawnbroker, NPA Colorado State President