Consumer Credit Costs
( Originally Published 1939 )
Consumer credit (with the exception of life insurance and other loans based on savings) costs from two to six times as much as business credit. This disparity is due neither to discrimination against the wage or salary earner nor to a large percentage of bad debts. Net losses of the three largest instalment companies, including repossession and resale expenses, amounted to less than two-thirds of one per cent in 1929,48 and the losses of personal finance companies and industrial banks were on the same order.
Consumer credit costs more than business credit chiefly because it is a retail business. Just as coal bought by the bushel costs far more than by the car-load, so credit extended in amounts of $50 to $500 usually costs several times as much per dollar as in larger sums. Most of the cost consists of the sales, clerical, accounting and legal expenses of handling the application, investigating the applicant and collecting the repayments.
Information on consumer credit costs is hard to get because lenders (often deliberately) fail to publish their charges except in such general terms that exact calculation of rates is difficult. The advertising of many instalment selling and personal loan agencies is either vague or grossly misleading, describing the cost with some such phrase as "twelve easy payments," "actual cost" or "a reason-able charge." Where the cost is given as "6 per cent," what is usually meant is 6 per cent of the original unpaid balance for an aver-age period of six and a half months (equal to more than 11 per cent a year).
Because of the lack of definite information the average rates and amounts shown in Table 35 must be regarded as estimates and in some cases as no more than rough approximations based on uncertain assumptions. Excluding loans based on savings by insurance companies, savings banks, etc., on which the rate is normally 6 per cent (except on new policies beginning in 1939 in a few jurisdictions) , the estimated yearly interest cost on the $7.5 billion of "credit based on personal property and general credit" was nearly $1.1 billion, or an average of about 14 per cent. This average, however, conceals wide variations in the rates charged for various kinds of consumer credit.
(1) Instalment Credit
Instalment credit is one of the most important types of consumer credit. It may be extended directly by the retailer or more often by an instalment finance company. Under the usual contract the buyer makes a down payment and agrees to pay the remainder in equal monthly instalments over a period of twelve to twenty-four months or more. The lender retains a lien on the goods sold and may re-possess in case of default. Interest and other costs are not charged separately but are included in the total sum the borrower agrees to pay. Estimated average interest charges on instalment loans amount to about 15 per cent, or a yearly cost of $465 million on the $3.1 billion outstanding. Obviously instalment purchases usually cost more than cash. Also prices and mark-ups of instalment goods in some lines of trade are higher than for corresponding goods sold for cash, partly perhaps because the seller encounters less sales resistance in selling on credit than in selling for cash.
The cost of the instalment credit for automobiles is complicated by the inclusion of insurance in the price the buyer pays. Since the insurance is of value its cost should not be considered part of the cost of credit. However, there is a catch in many of these insurance provisions, for the insurance must sometimes be purchased at higher rates than the buyer would have to pay for the same cover-age from responsible companies. On the other hand one of the large automobile manufacturers gives the borrower through its own insurance company the advantage of even lower rates than outside insurance companies.
Instalment credit charges shown in the table have been adjusted to allow for these differences on the basis of typical New York City rates. The present insurance (comprehensive and $50 deductible collision) charge on a Chevrolet in New York City (based on an f.o.b. factory price range of $601 to $700) is $38.70. Such insurance costs $51.60 at manual rates, or about $45 from certain "out-side" companies.
(2). Retail Open Accounts
Retail charge accounts have always been an important form of consumer credit. Ordinarily these accounts run for only short periods with payment for purchases during a month due on the first of the following month. But many customers take advantage of the leniency of retailers and of the fact that no interest is charged and allow bills to go unpaid for two or three months or longer.
The real cost of credit extended by retail stores on charge ac-counts cannot be estimated because these expenses are a part of the general administrative costs of the organization. To the extent that operating costs are increased by credit operation both the cash and credit customers must meet this additional cost in the form of higher prices. Buyers with charge accounts ordinarily can purchase from department and other stores at the same prices as the cash buyers pay. Some retailers claim that credit sales really cost no more, or less, than cash sales. It is said that the charge sale requires less of the buyer's and seller's time and that the saving in cost and risk of carrying cash and making change offsets the expenses of the credit department and credit losses.
On the other hand cash stores probably sell at somewhat lower prices than many credit stores, one reason being the abuse of the return privilege by charge customers. If every customer were reasonable as well as honest the charge system might well be cheaper.
(3). Commercial Banks
Commercial bank loans for consumption purposes are of two kinds. The first-estimated at about $500 million-is in no respect different from the usual business commercial loan. A borrower with satisfactory credit standing or good collateral can discount his note for small sums whether the money is to be used for business or consumption purposes.
Interest on regular commercial bank loans may be paid either at the time the loan is made or when it is repaid. Repayment is usually in a lump sum, rather than in instalments. The rate of interest for small sums is commonly 6 per cent or on a discount basis, 6.38 per cent. In these days of easy money, however, a bargaining borrower of good credit standing or with ample collateral can often obtain a loan for 5 per cent or even less on larger sums.
Persons without credit standing or collateral may have access to the personal loan department. So far only a small proportion of all commercial banks have established personal loan departments but the number is growing rapidly. Discount rates of the leading New York City banks range from 4 to 6 per cent, but the average rate charged by personal loan departments of commercial banks is probably close to 10 per cent.
With the amendment of the New York banking law in 1936 legalizing 12 per cent per annum on unpaid balances a great impetus was given to the establishment of personal loan departments. The resulting increased facilities and the greater volume of business have made it possible for some banks to furnish this service at lower rates than before.
(4) Industrial Banks
Industrial banks like the Morris Plan have always been an important source of consumer credit for wage and salary earners with-out assets or credit standing adequate for ordinary bank loans. Industrial banks usually require one or more co-makers except on collateral loans. They usually discount a note for ten, twelve or fifteen months and refund less than the pro rata amount in case of earlier repayment. Thus they are expensive as a source of very short-term credit. The present charges of the Morris Plan Indus-trial Bank of New York for the typical co-maker loan are based on a discount of 6 per cent per annum, plus 2/5 to 2 per cent service charge, plus insurance. A $120 note repayable in fifteen monthly instalments of $8 is discounted for $107.10. If the insurance on $120 for an average of eight months is worth 58 cents (typical group insurance rate) the net cost is $12.32 for eight months' credit of $107.68 or at a rate equal to 17 per cent per annum. For col-lateral loans the cost may be as low as 6 per cent and certain other special types of loans are offered by the Morris Plan at rates from 10 per cent to 14 per cent on the average amount loaned.
Since rates outside New York are generally higher the estimated total of $350 million industrial bank credit outstanding probably costs the borrowers an average of about 16 per cent, or nearly three times the normal commercial bank discount rate on small business loans and half again as high as the average rate of personal loan departments.
Personal finance companies are generally the most costly legal source of credit to the borrower-except that instalment credit is often even more costly for amounts of less than $50. The standard personal loan contract calls for repayment in ten months for loans of less than $50 and for twenty months in the case of larger loans. These are longer periods during which interest must be paid than for most instalment contracts, but the borrower is free to repay the loan in full at any time and is charged interest for only the time actually elapsed on the actual loan balance.
These companies offer the borrower the following advantages: (1) loans can be obtained in smaller amounts-sometimes as small as $25-than from other lenders, and (2) many borrowers can obtain a loan without security except a wage assignment and a chattel mortgage on household effects, actual possession of which is retained by the borrower. No co-maker is required except usually the maker's wife or husband. Many of these borrowers could not borrow elsewhere without securing one or more outside co-makers, which they may be unable or unwilling to do. Wage assignments are commonly limited to 10 per cent of wages, and in practice fore-closure on household goods is resorted to on fewer than 0.3 per cent of the loans made.
(6) Pawnshops and Remedial Loan Societies
Pawnbrokers advance sums of money secured by the pledge of jewelry or other personal property of value. The amount loaned is usually determined by the sale value of the pledge. Their investigation and collection costs are small, but they have the additional expense and risk of caring for the collateral. Such collateral usually may be sold if not redeemed within the period for which the loan was made-usually one year. Pawnbrokers' rates vary widely, since they are fixed by state laws. They range from one to 10 per cent per month and extra charges are frequently allowed.
Many remedial loan societies make pawnbroking loans as well as loans on other forms of security. They usually are of semi-philanthropic origin and operate on a limited dividend basis. Their charges on pawnbroking loans range from three-fourths of one per cent a month to 3 per cent a month. The Provident Loan Society of New York is the largest and best known of the remedial loan societies. It has no stockholders, but is authorized to pay interest not exceeding 6 per cent per annum on funds contributed for its use. Its charge to borrowers, of three-fourths of one per cent per month or 9 per cent per annum, is said to be the lowest known rate on loans secured by pledge of personal property.
(7) Credit Unions
Credit unions offer credit at a reasonable rate of interest to those unable to borrow on a business basis or without collateral as required by the commercial agencies. Operating expenses are usually low compared with other agencies because of their cooperative setup, because loan investigation costs are less, because most of their clerical labor, and often rent, is obtained free and-in the case of federally chartered ones-because of tax exemption. A co-maker, or collateral acceptable to the credit committee, is generally required on a loan of $50 or more in excess of the value of shares held. Credit union charges cannot exceed one per cent a month on unpaid balances or 6 per cent discounted (about 11.78 per cent per annum, since loans are repayable in instalments) . Laws generally require refunding of interest for discounted loans repaid in less than the full period. Hence credit unions are a source of cheap credit for personal loans.
Axias (or Achtziahs) are a form of personal loan agency, frequently used by immigrants (especially Hebrews) before the World War, but now of dwindling importance.
(8) Other Types of Consumer Loans
The various other kinds of consumer credit-exclusive of that based on insurance policies and other savings accumulated by the borrower-constitute a relatively unimportant share of the total amount outstanding. Since insurance and savings are the safest collateral in the world from the lender's standpoint, the six per cent rate charged for this type of loan is lower than for other kinds of consumer credit. Even so, it might often be wiser for the borrower to cash in the underlying security rather than to borrow on it (providing that in the case of life insurance he is able to pass the examination for a new policy) unless the loan is to be repaid promptly.
Illegal lenders still flourish in many communities in spite of in-creasing competition from legitimate organizations providing consumer credit. They charge scandalous rates, so that the toll they extract from borrowers is undoubtedly a substantial one in spite of the fact that the total of this type of loans is relatively not large.
Estimating the amount of loans between friends and relatives, or the average rates charged, can be little more than guesswork. The total outstanding at any one time, however, is probably larger than the outstandings of many of the institutional forms of consumer credit. The average interest paid on such loans is probably low-if for no other reason than because neither the interest nor the principal is paid in many instances.