Thanks to the Financial Conduct Authority, payday lenders are now limited in the charges they can impose, and a loan can never cost more than 100% of the original value in fees or interest.
However, big name lenders like Wonga and QuickQuid have disappeared from the market as their losses mounted up.
Alternatives to payday loans are available, although some customers may be unable to access them.
How are payday loans regulated?
Payday loans are a short-term loan originally designed to help borrowers bridge the gap between one payday and the next.
The Financial Conduct Authority took action to regulate these types of loan in 2015, putting the following rules into force:
- Initial cost cap of 0.8% per day - This means interest and fees must not exceed 0.8% of the total amount of the loan.
- Fixed fees of £15 if a customer defaults - This ensures that extra fees are limited if a customer can't pay but interest on unpaid balances and fees can still be charged.
- Overall cap of 100% - This means borrowers should never pay back more in fees and interest than the original amount borrowed.
They also limited the number of times a lender could 'rollover' the loan (extend the time to pay) to two.
In 2017, the FCA commissioned research to see how the cap was working and found that 760,000 borrowers in the sector had saved around £150 million per year due to the reforms.
Payday loan providers were also required to run affordability checks to ensure customers were going to be able to repay the money loaned to them without falling into financial difficulty.
Lenders have repeatedly failed to meet their obligations to check whether customers can afford their loans and we've seen many mis-selling scandals and collapses in the sector.
Payday loan company collapses
The payday loan market has altered dramatically since the FCA rules came into force, with lenders buckling under the weight of affordability complaints and reduced profits.
They announced big losses in 2015 as the number of loans they made dropped sharply after the FCA rules came into force then their attempt at a relaunch targeting more middle class borrowers failed to improve their fortunes over the following year.
When the company finally collapsed into administration in 2018, they left many customers awaiting payouts for mis-sold loans. The final level of compensation paid to customers was 4.3p per £1 owed when the company was finally wound up in 2020.
Despite US payday loan providers swooping in to plug the gap left by Wonga, many other lenders fell foul of increased consumer complaint levels too including:
Some of these providers (and others who have suffered issues) may not necessarily have marketed themselves as payday loan companies.
Payday loans, although they are a distinct group in Financial Ombudsman Service complaint figures, are a form of high-cost short-term credit (HCSTC) lending.
Complaints about payday loans
Even with many brands disappearing from the market, the high-cost short-term loan sector still receives plenty of complaints - and the majority are upheld.
If we look at the most recent annual figures from the Financial Ombudsman Service covering 2020/21, we see plenty of complaints and decisions upheld in the payday loans and instalment loans categories:
Number of new cases Total resolutions (non-Ombudsman) Total resolutions by Ombudsman Percentage of cases upheld by Ombudsman
Payday loans 5,208 5,429 722 61%
Instalment loans 7,397 8,548 918 67%
In the overall loans category, payday loans account for 7.89% of all new cases while instalment loans account for 11.21%.
This is far below the 34.22% and 31.52% share of complaints held by home credit (doorstep lending) and guarantor loans respectively, demonstrating that payday loan complaints are no longer a huge driver of complaints to the Ombudsman.
How do payday loans work?
Payday loans are a short term, high interest borrowing option which, as the nickname suggests, are meant to tide the borrower over until they get their monthly pay packet.
Customers make an application and undergo an affordability check with their potential lender. These are usually quick and designed to let customers know immediately whether they can take out the loan.
At the time of application, customers must be told:
- How long the loan is for
- How much they are expected to pay back
- What happens if the loan is not repaid
They must also be reminded that high-cost short-term loans are not suitable for long-term borrowing.
As we've discussed above, new payday loan rules in force from 2015 say a customer cannot pay more than 100% of the value of the loan in interest/fees.
This means that taking out a loan for £100 should never cost more than £200 to repay, for example.
Customers will usually have to set up a continuous payment authority (CPA) with a lender that allows them to take the money from their bank account.
If there isn't enough money in the account when the lender tries to collect the payment, charges will be added for late payment.
Providers must also provide regular updates to customers about their borrowing, allowing them to make more informed decisions about what happens next.
We've seen firms rebuked by the FCA for failing to do this in the past, with Shelby Finance having to write off £500,000 in loans in 2020 for failing to provide borrowing statements to more than 15,000 customers.
The representative interest rates on payday loans and other forms of high-cost short-term lending are huge.
Because they loan money for such short periods, looking at the annual rate of interest through an APR is often alarming.
However, it's important to remember that firms cannot charge more than 0.8% of the original loan amount in interest per day.
At the time of writing, we had a look at some popular payday lenders and found representative APRs between 91% and 1296.5%. When we looked a little closer at those two particular lenders, we found maximum APRs of 1294% and 1625.5%.
The representative APR of a loan must be available to at least 51% of customers according to the Consumer Credit Act, but that still means plenty of customers will be getting much poorer rates and have hefty repayments to make.
It's important to reiterate once more: interest and charges cannot cost a customer more than 100% of the value of the loan itself.
Under FCA rules, payday lenders can only allow customers to rollover or extend a loan twice.
This involves making a new agreement for repayment of the loan and allows lenders to charge extra interest and fees because the original loan is now another one.
Changes to rollover rules were prompted by research from the now-defunct Office of Fair Trading (OFT) that found rollover loans provided 50% of payday lenders' revenues.
If a customer does decide to rollover their payday loan, the lender must provide them with an information sheet explaining where they can get help with debt.
What's the problem with payday loans?
For many, payday loans are a solution to a simple problem: a short term lack of funds needs a short term injection of funding, one that people are willing to pay for.
What worries opponents of payday lending, however, is that the sector targets the most financially vulnerable consumers, the very poor, and those already in debt, making an already precarious situation even worse.
Research carried out on behalf of the FCA by Critical Research in 2017 (two years after the cap came into force) found that many customers who were accepted for a payday loan were using their first loan for day-to-day living:
- 30% were using it for living expenses
- 25% were using it for bills
The figures were broadly similar for customers taking out a subsequent loan, with 28% using it for day-to-day expenses and 22% using it for bills.
So, payday loans were not generally being used to bridge an unexpected gap but as a sticking plaster for an ongoing problem, even if there was some evidence in 2011 that middle-income earners were also using payday loans.
Yet, the Consumer Finance Association (now the Consumer Credit Trade Association) found in 2011 that policymakers and MPs didn't have the same perception of the harm of payday loans.
For some customers unable to get credit elsewhere, payday loans were (and, unfortunately, remain in some cases) the best way for low-income customers to get credit quickly.
There was even research in 2010 from Consumer Focus that found the extra fees and charges associated with credit cards and long-term debt was off-putting to people on low incomes.
The findings of qualitative research from the Consumer Finance Association and Consumer Focus doesn't necessarily mean that the majority of people think in this way, but it's a good example of how policymakers and those most likely to take out credit in this way might not be on the same page.
Alternatives to payday loans
Payday loans and other forms of high-cost short-term credit are not advertised on Choose and we don't offer customers the option to compare those types of financial products using our comparison pages.
Even after the regulatory changes brought in by the FCA, payday loans are a risky and expensive form of credit that still attract plenty of complaints and can contribute to people losing control of their financial situation.
There are some alternatives to payday loans that might work for some borrowers:
- Personal loan from a bank
- Credit card
- Arranged overdraft
- Credit union borrowing
Changes in regulations have also altered the way some of these borrowing options work in practice.
For example, thanks to tighter regulation on overdraft fees, accidentally using an unarranged overdraft does not cost more than an arranged one, although the rates for those overdrafts have been hiked in recent years.
We've got more information on credit unions and how they may be able to help in our guide, although it's important to note that even these lenders can get into financial difficulty and collapse.
It can be difficult for policymakers to understand why customers would choose payday loans over other forms of credit (as demonstrated in some 2014 research from the Competition Commission), but it's much better than the alternative taken by those most desperate for quick cash - illegal loan sharks.
One major fear of campaign groups is that, when payday lenders and other high-cost lenders disappear from the market, the options for customers struggling to make ends meet disappear too. This can lead to borrowing from unlicenced lenders with all the associated risks and none of the protection.
Research from The Centre for Social Justice published in March 2022 estimates that 1.08m people could currently be borrowing from illegal lenders, over 700,000 more than official estimates.
Their analysis suggests those using illegal lenders are among the most vulnerable in society:
- 62% have an income of less than £20,000
- 66% owe money to a legal creditor
- 48% live in social housing
- 65% have a long-term health condition
Whether these customers would previously have turned to payday loan providers who are no longer there or have tightened their borrowing criteria is unclear, yet there are evidently people in debt falling through the cracks in the system and that remains worrying.
Summary: Tightened rules
There has certainly been a shift in the payday loan sector since we reported in 2010 that 68% of people wanted a cap on consumer credit interest rates including those on payday loans.
It took time, with the Government warning in 2011 that they didn't want to make things worse for customers and only putting forward concrete plans in 2014 and payday loan credit brokers being shut down in the same year.
The sector's attempts to regulate themselves were largely unsuccessful and we've seen a steady trickle of lenders exiting the market over the last decade, something that turned into a flood following Wonga's demise.
We've come a long way in terms of regulation since the (then) Mayor of London Boris Johnson signed a deal with Wonga to advertise on the London Underground in 2010.
Yet payday loans are still the credit option of choice for many low-income and vulnerable households because they don't feel they can obtain credit in other ways.
Limited options can also push customers towards illegal lending, something that causes further hardship and comes with its own risks.
So, while the steps to ensure payday loans are properly regulated and customers are not being taken advantage of are welcome, it may be time to look further at how to stop the most vulnerable customers turning to even more harmful forms of credit.