When Wonga announced their intention to sponsor Newcastle United FC, it generated no small amount of opprobrium. Despite the company's best attempts to generate a positive image for itself, it is still largely seen as a payday loan company, preying on the poor for a quick buck. So it was no surprise that smart a demonstration of that fact very quickly made the rounds:
Wonga are to pay £24million to sponsor Newcastle over 4 years. If Wonga lent that @ their typical APR over 4 years they'd have to repay £4bn
— James Dixon (@thejamesdixon) October 9, 2012
Anything with over 2,000 retweets is going to get fact-checked a lot, and debates soon broke out over whether the number was accurate. Is it?
Wonga's "representative APR" is 4214 per cent. When you take out a loan with it, it decides at the beginning of the period what your interest is, and charges it to you on the total amount of capital borrowed over that period. In other words, it doesn't compound the interest - which makes sense, because it would be hard to compound anything over a loan as short month. As a result, if you were charged an annual interest rate of 4214 per cent, then at the end of a four year period you would have to pay back:
£24,000,000 + £24,000,000 x 42.14 x 4 = £4,069,440,000.00
(That's the capital, plus four years interest.) A shade over £4bn. So James Dixon is correct.
Except that the 4214 per cent APR is already compounded. As Wonga explains, industry regulations require it to present interest at an annual rate even if it doesn't make annual loans. To do this, it is required to take the amount of interest you would pay on its longest loan, a month-long one, and act as though you rolled it over, taking out larger and larger loans to pay off the interest as you go along. If we compounded Newcastle's loan similarly, then after four years it would owe:
£24,000,000 x (1+42.14)^4 = £83,125,028,034,051.84
That is £83 quadrillion. It's over one hundred times world GDP, and in the ballpark for the total value of everything on earth.
But Wonga would maintain that using that interest rate is unfair. Although they are required to present their representative APR in that manner, they have never, and would never, charge it to a customer. The annual rate of interest which they actually charge is "just" 360 per cent, and the rest is made up of the compounding which they are forced to assume. If Newcastle's loan was taken out at that rate, it would have to pay back:
£24,000,000 + £24,000,000 × 3.6 x 4 = £369,600,000.00
£370m is still quite a lot to pay for £24m, but it's nowhere near billions. And in actual fact, Newcastle wouldn't even pay that much. It's not a person, it's a business, and Wonga have - controversially - launched a division exclusively for lending to businesses. The largest and longest loan it offers is £15,000 for a year, which costs £19,350 to pay back, implying an APR of 29 per cent. If Newcastle borrowed £24m for four years at that rate, then if the interest compounded, it would equal:
£24,000,000 × (1+0.29)^4 = £66,461,491.44
And if it was charged in one lump sum, it would equal:
£24,000,000 + £24,000,000 × 0.29 x 4 = £51,840,000.00
The root of the problem is that Wonga isn't actually in the business of making multi-year, multi-million-pound loans. The assumptions we make in trying to squeeze their business model into a shape that lets us make that comparison are important, because they're the difference between paying back £52m and £83qdrn.