The Office of Fair Trading (OFT) has referred the payday lending industry to the Competition Commission because of concerns about "deep-rooted problems with the way competition works".
The OFT said it found that customers found it difficult to identify or compare the full cost of payday loans.
The OFT added that there were barriers to switching between lenders when loans were "rolled over".
It was also concerned that competition was based on speed rather than cost.
"The competitive pressure to approve loans quickly may give firms an incentive to skimp on the affordability assessment which is designed to prevent irresponsible lending and protect consumers," the OFT said in a statement.
The OFT also said that some of the business models of companies operating in the payday loans industry were causing concern, because they were "predicated on making loans which are unaffordable, leading to borrowers paying far more than expected through rollovers, additional interest and other charges".
It said that lenders appeared to make 50% of their revenues from such practices.
Debt spiralAbout two million people in the UK use payday loans. These products are designed as short-term access to cash, at relatively high cost, until the applicant is next paid.
However, in many cases, individuals have struggled to repay and the compounded interest of loan after loan has left them in a spiral of debt.
This is what happened to Mark Todd, a former NHS consultant from Huddersfield.
End Quote Mark Todd Payday loan customerIt was irresponsible of us to borrow, but it was also irresponsible of them to lend"
He took out a payday loan while waiting to get back into work after being the full-time carer of his father. However, he was unable to find work and took out an additional loan to cover the first one.
"It was irresponsible of us to borrow, but it was also irresponsible of them to lend. They were under no pressure, we were under lots," he said.
He was concerned about the operations of brokers, as much as the loan companies themselves.
"Once they have got their teeth into you, they never let go. You just get email after email, text after text, all saying you are approved for x amount of money today," he said.
"When you have got nothing at all and you are struggling to put a meal on the table, then someone sends you a text saying we have got £300 for you ready and waiting right now and it will be in your account in 15 minutes, it is too difficult to say no sometimes."
The OFT will decide whether individuals such as Mr Todd should have had more choice over which payday loan to choose, based on the costs involved.
The OFT has found that providers target people by saying that they can provide the loan quicker than other lenders.
Lenders should only be offering loans to people with an income that means they can repay, which should have ruled out Mr Todd when he was out of work.
Lenders, consumer groups and regulators have been summoned to a summit about payday lending at the Department for Business next week.
The meeting aims to come up with solutions to the "widespread irresponsible lending" highlighted by the OFT's report into the payday industry.
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