Payday lenders have been ordered to play fair or risk being banned from the sector after a study found "explosive" evidence of irresponsible lending.

The Office of Fair Trading found reckless practice was widespread, while firms failed to comply with even basic standards, which can leave hard-up borrowers in even worse shape (see our Debt Problems guide to help get out of the mire and our payday loan guide for cheaper alternatives).

It's giving the leading 50 payday lenders, which account for 90% of the market, 12 weeks to change their ways or risk losing their licences.

The watchdog has also proposed to refer the market to the Competition Commission after it found evidence of deep-rooted problems in how lenders compete with each other.

The OFT is particularly worried about lenders emphasising how quickly they can hand borrowers cash, rather than the high prices they charge for that money.

Huge fees

Payday lenders sometimes charge fees of £35 for each £100 borrowed over a month, but late payment fees can makes costs soar. Borrowers risk being charged hundreds of pounds in additional fees, which can far exceed the original loan amount.

The new Financial Conduct Authority, which will replace the OFT in overseeing the consumer credit market from next year, will make tightening payday lending rules a priority. In particular, it will be able to cap costs.

Dan Plant, head of editorial, says: "There is no surprise in this damning indictment of the payday loan market. We regularly hear traumatic tales of borrowers facing real hardship after taking one of these loans.

"The message is simple: avoid payday loans unless an absolute necessity. If you're in desperate need of cash, speak to your bank about extending your overdraft (don't breach your limit or risk huge charges) or talk to family and friends to see if they can help.

"If you're in a serious debt spiral, then talk to a fee-free debt charity, such as StepChange or Citizens Advice."

'Misery and hardship'

OFT chief executive Clive Maxwell says: "We have found fundamental problems with the way the payday market works and widespread breaches of the law and regulations, causing misery and hardship for many borrowers.

"Payday lenders are earning up to half their revenue not from one-off loans, but from rolled over or re-financed deals where unexpected costs can rapidly mount up."

Abuses uncovered by the OFT include:

  • lenders failing to conduct adequate affordability assessments.
  • failing to explain adequately how payments will be collected.
  • using aggressive debt collection practices.
  • not treating borrowers in financial difficulty with forbearance.

Labour MP and fierce payday loan critic Stella Creasy says: "The OFT report is explosive stuff and a damning indictment of Government failure to regulate legal loan sharks."

Advertising crackdown

Meanwhile, payday lenders face new rules on how they advertise under a Government clampdown to make sure firms don't take advantage of people who are already drowning in debt.

The plans include limiting the number of ads firms are allowed to broadcast per hour, the times they can advertise and forcing them to make sure their interest rates are clearly displayed.

The Government says it will work with the Advertising Standards Authority and the industry to make sure advertising does not tempt consumers into taking out payday loans that turn out to be unsuitable.

It is also planning to do more to stop consumers taking out multiple loans from different lenders.

Economic Secretary to the Treasury Sajid Javid says: "The Government is introducing a fundamentally new approach to regulating consumer credit, which will ensure that irresponsible firms and bad practice will have no place in the consumer credit marketplace.

"Consumers can have greater confidence that the new Financial Conduct Authority will intervene early and decisively in their interests – thanks to its more focused remit, objectives and powers."