06/04/2013 05:15 EDT | Updated 08/04/2013 05:12 EDT

What Really Makes a "High Interest" Loan

A recent study in the U.S. examined the cost to the economy of payday loans. This study led to numerous news reports and spurred a debate about the merits (versus the costs) of short term financing -- aka "high interest loans" -- in general. The focus of the debate has been on the interest rate and other costs of the loans, presented as an Annual Percentage Rate (or APR).

While the concerns regarding the potential negative impact of certain high interest loans are legitimate, the debate has failed to consider the context in which high interest loans exist.

It is too simple to label a loan "high interest" by looking only at the annualized interest rate. There are many other factors that determine the true cost of borrowing.

For illustrative purposes, let's consider two loan options:

Loan 1 has an interest rate of 3.0%/month (36.0% APR) and a term of 3 months.

Loan 2 has an interest rate of 12.0%/year (12.0% APR) and a term of 1 full year.

Which loan is cheaper? Which loan is better? Which loan should you choose?

The answer of course is; it depends. For someone looking to borrow and repay quickly, the seemingly higher rate of interest is actually the better choice. For someone who needs more time to pay back the money borrowed, then locking into a longer term at a lower rate makes sense.

In 1981 a 5-year fixed mortgage cost 21.75%. That was the rate charged by all the major banks in Canada. Is that considered high interest?

Are loans considered high interest on an absolute or on a relative basis? By the early 1990s, mortgage rates "dropped" to 14.0%. Were the rates in the early 1990s high or low? If you compared them to rates in the early 1980s, they were a steal. If you compared them to mortgage rates today, you'd say they were highway robbery. But when you wanted or needed to buy a house in 1990 you weren't comparing the rates you could get at that time to any other rates throughout history. Instead you were assessing whether you could afford to pay that rate and how much you really wanted or needed that house. The same holds true for business owners at the time. If an entrepreneur was able to borrow money at the prevailing interest rate at the time and use that money to make more money than it cost to service the debt, it made sense and that entrepreneur rationally should have capitalized on that opportunity.

What makes sense for wants, needs, circumstances and capabilities is all about context for the borrower - and likewise, what is a reasonable rate of interest to charge, is all about context for the lender.

As a lender that offers short term loans using personal assets as collateral, I can say there is an inherent trade off that my company makes with our clients: Zillidy makes loans based on the value of the collateral and not based on credit scores, company financial statements or current financial position. We fund loans very quickly and if a client defaults on a loan with us, it does not impact their credit score. What is that worth to a risk-taking, self-employed entrepreneur who needs capital quickly to take advantage of an immediate opportunity? Because our loans are structured this way, we need to charge an interest rate that is higher than the rates offered by traditional bank sources. Does that make our loans fall into the category of "high interest loans?"

In determining what interest rate to charge, lenders must go through the same analysis as any other business. A shoe store will look at the cost for the store to buy the shoes from the manufacturer, the overhead and staffing required to run the store and the cost to provide its customers the service they demand in terms of returns and exchanges.

The same holds true for a lender, but instead of shoes as inventory, the lender's inventory is money. And in addition to calculating the cost of the lender's inventory (the rate the lender needs to pay to use the capital that it lends out) and the overhead required to service the client, lenders have an additional variable to consider: the default rate.

A bank is able to charge a lower interest rate because they are highly selective in who they will lend to and have dominion over cash (meaning they control and hold your bank account). The bank also takes a personal and/or corporate guarantee so they believe they are secure and have exceptionally low defaults because of this. Alternative lenders, like Zillidy and others, lend to those who cannot or do not want to get a loan from a bank. This tends to mean there is a heightened credit risk that leads to higher default rates. Because lenders don't know which loans will default, the rates for all borrowers have to be higher to compensate for the delinquent borrowers - essentially forming a subsidy. Alternative lenders tend not to make windfall profits from their loan portfolio because of this subsidy, despite the portrayal in the media, and instead make their profit through volume of loans.

Politicians and the media may have the best intentions when they condemn high interest loans and call for high interest loans to be banned or to be capped at a maximum interest rate. But we need to consider the context of these loans before broadly referring to all loans over a certain interest rate as "high interest".

Obviously there are many other factors that need to be considered and debated, along with interest rates, in order to ensure borrowers are fully informed and protected. These include, but are certainly not limited to, curbing the abuses of some lenders and improving the transparency of loan costs and I look forward to addressing these in a subsequent column.

Steven Uster is the Founder of Zillidy, a Canadian private lender that provides personal asset loans secured using jewelry, luxury watches, gold, diamonds and precious metals as collateral. Zillidy's loans provide a line of credit without impacting credit scores or requiring the sale of valuable or sentimental assets. You can follow Steven on Twitter at