Making large extrapolations from small bases can be dangerous. Case in point: I recently bought steel at the rate of $1,700 a ton for one of my projects. A few days later, I bought more steel from a different vendor, which charged only $800 a ton.
Was I cheated in the first transaction? Was I stupid to pay so much for the first when it was available elsewhere at half the price?
Consider that the first purchase was for 23 pounds at 85 cents per pound. The second was for 45 pounds at 40 cents per pound. Paying $27 for one lot versus $18 for the other seems less disproportionate. Moreover, I made the first purchase near my home, and someone had to cut a piece to length. For the second, I drove 10 miles through city traffic and picked through a pile of miscellaneous remainders to find what I wanted. Considering the convenience of the first purchase, I thought the price was fair.
Keep this in mind when you hear of exorbitant interest rates for “refund anticipation loans,” “paycheck loans” or loans at pawnshops. The interest rate calculated isn’t necessarily as exploitive as you might think.
I’m not saying that all such credit extended to poor people is fair or that abuse never occurs. But one must be careful in calculating interest rates on small, short-term loans.
Anyone running a business or a nonprofit can tell you that it costs something to cut and later reconcile a check. It may be $5 or $20 but it is not zero. Issuing and collecting even small loans involves similar costs.
Consider a $500 loan at 2 percent interest a month plus a one-time fee of $20. If repaid after one month, the $10 in interest and $20 fee result in an effective annual interest rate of 101 percent. Is such a loan abusive?
Some income tax preparation firms earn a great deal making “refund anticipation loans.” They offer immediate payments to clients due refunds from the Internal Revenue Service. These payments are less than the refund expected. The client authorizes the eventual refund to be paid directly to the tax service.
With electronic filing, the preparer may get the refund in days. The computed effective interest rate on the loan can easily exceed 150 or 200 percent. But is it abusive?
Liberals often oppose high-cost credit for the poor even if that means the poor have no access to legal credit. Libertarians oppose any regulation of transactions between willing adults, period.
Most economists would agree that society is harmed when individuals are prohibited from making willing agreements with others, as long as no other third party is harmed. Most also argue that society is harmed when one party to an agreement is poorly misinformed about its circumstances.
The solution in terms of credit is to require disclosure of terms, but not ban entire categories of loans. The knotty problem is deciding what constitutes full or effective disclosure.
© 2006 Edward Lotterman
Chanarambie Consulting, Inc.