Payday Loans

Robert Frank on the political and moral economy of payday lending:

Payday Loans Are a Scourge, but Should Wrath Be Aimed at the Lenders? - New York Times: [T]he outrage currently directed at lenders who extend credit at extremely high rates of interest to economically disadvantaged groups. Among these lenders, so-called payday loan shops have come under particularly heavy fire.... [P]ayday lenders typically offer short-duration loans of several hundred dollars secured only by a post-dated personal check from the borrower.... Many borrowers... quickly get into financial trouble once they begin to roll over their payday loans.... The problem is that many people have difficulty weighing the trade-off between immediate benefits and future costs. When confronted with easy credit access, some inevitably borrow more than they can reasonably expect to repay. Once they get in over their heads, they borrow more....

[E]asy credit... is more like heroin and cocaine than alcohol. This evidence recently led Congress to cap the annual interest rate on payday loans to military personnel at 36 percent. In New York and 10 other states, similar restrictions apply to loans to the general public, in each case making payday lending effectively illegal.

Those who feel that payday lending is a bad thing are inclined to vent their anger.... But outrage directed at payday lenders cannot prevent those hardships, just as outrage directed at alpha male lions cannot prevent them from killing cubs. A more deserving target would be legislators who supported lax credit laws in exchange for campaign contributions from lenders -- or, better still, those who have steadfastly resisted campaign finance reform.

I somewhat disagree: there is something wrong with somebody who goes into a business where what you sell--in this case, extremely expensive credit--makes your customers worse off.

Comments

[WaPoCritic]

"Those who feel that payday lending is a bad thing are inclined to vent their anger.... But outrage directed at payday lenders cannot prevent those hardships..."

Proving that there is benefit in the adage, 'Don't get mad, get even'. If you want to prevent people preying on the unfortunate, don't waste time getting mad. Just take away the legal means to make a profit on the bad behavior. Bring back the usury laws.

[BillS]

If payday loan shops are so lucrative, why doesn't competition across the street drive prices down. Or is this the type of business that has high barriers to entry -- such as the willingness to surrender your kneecaps to unfriendly competitors?

[Administrative costs are very high. It's not a tremendously profitable business to run.]

[Rob]

One thing that isn't pointed out enough, is that these places go through great lengths (like rent to own places)to hide the interest rates they are charging. They'll give you a weekly payment or a "fee" schedule but not what the rate of interest you're paying is. Basically they try their best to keep their customers as uniformed about their services as possible.

[will]

"The problem is that many people have difficulty weighing the trade-off between immediate benefits and future costs."

Maybe the problem is that many people are broke, but need to pay some bills so the electricity doesn't get shut off, or so they can drive to work next week. Getting a loan seems like the least worst option, except then they are utterly exploited by the loan giver. So maybe we should direct our anger at the loan givers.

[Sebastian Holsclaw]

"I somewhat disagree: there is something wrong with somebody who goes into a business where what you sell--in this case, extremely expensive credit--makes your customers worse off."

As someone who used payday loans at least four times during his student years, I would suggest that you don't understand the value of them. Unless you were willing to pay the towing company the fee to get my car out when it was wrongly towed, you might want to realize that such things can be quite useful. I mean sure I got my money back from the towing company eventually, but I kind of needed my car to get to work for those 3 months. When you are poor it is a HUGE help to be able to take immediate action when neccessary in ways that richer people dont understand because they can just whip out a credit card.

Which leads us to 'unfair' rates. Are they unfair with such a high default rate?

[Ultimate default rates aren't *that* high. Administrative costs are high--including the costs of chasing down and monitoring those who don't make the initial payment schedule. There has to be a better way of getting emergency liquidity to the relatively poor.]

[Charles]

There's a simple solution to this: raise wages and provide universal healthcare.

However, there's a possible problem with payday loans that I don't think that the mandarins discussing the matter here are fully aware of: it provides a mechanism to defraud the elderly.

This has inspired me to post an anecdote over at Mercury Rising.

[save_the_rustbelt]

I'm confused....

Since the Bush administration has created such a red hot economy, why would any workers need these loans??

Just kidding.

The offices that prey on our troops are the worst kind of sleazeballs.

[pjgoober]

Scientists have put in so much time trying to figure out how to warn people 10,000 years from now not to snoop around in the Yucca mountain nuclear waste site. Perhaps a little bit of time should be spent figuring out how to warn the short sighted among us about these payday loans. I suggest a law requiring the signing of a large paper with an easily understood warning in huge, bright, red letters.

[bigTom]

I think a little bit of basic finance, taught as part of the high school curriculum would go a long way. A huge number of our not so well off countrymen are vulnerable to this sort of abuse. Poor people are poor not only because they lack skills to compete for good jobs, but because their skills for holding onto money are also poor. A little bit of public education could go a long way here.

[otto]

Maybe we should be putting more pressure on Citibank, Bank of America etc to enter this market. It's clear there are massive profits to be made, and the entry of mainstream lenders would radically drive down the price of short term credit i.e. payday loans. But they want to avoid the criticism associated with lending to the poor, and so loan rates stay high...

[turkey turkey turkey]

"I somewhat disagree: there is something wrong with somebody who goes into a business where what you sell ... makes your customers worse off."

Like, say, the MSM and its associated right wing echo chamber. Being force fed GOP talking points does not make the public better off....

[Neil Bates]

Some people might really need those kind of ("pay-day") loans. But caps on interest are complained about by the providers, saying that they can't make enough money. Well, this gets to a point I've been on for a long time, which is: in general (not just pay-day lending), why not take away the whole idea that interest rates are the proper instrument for profit for a lender. Sounds amazing, but: interest compound with time and is a great burden for those who are late. Why not say that lenders can charge a fee of X % for lending, and then let the interest rate be aboout what covers for the lender the cost of waiting for the money. In other words, interest should go from being a fee to being a cost of delayed repayment, and the interest "fee" itself should be the source of profit. That could be in some intermediate way of course.

"Fine minds make fine distinctions."

[William Rhoads]

Payday lending is just another example of what behavioral economists call hyperbolic or quasi-hyperbolic discounting. David Laibson, QJE 1997. Now in the latest AER there is a model of "a sequence of short-run impulsive selves and a long-run patient self." Fundenberg and Levine, AER 2006, p 1449. fMRI studies indicate that different parts of the brain activate short-term impulsive behavior and long-term planned behavior. We need a new economics that can model "immediate gratification" and point the way to solving the problem in all its manifestations.

[GeorgeNYC]

It just seems sick that corporate borrowers with a Baa rating are paying 6% interest and that poor people are paying 500%. Maybe we should let them borrow in yen from the BOJ at .25%? Why can't they "leverage" ther paychecks and buy t-bills and live happily ever after,

There is definitely something wrong here. I guess the rich just get richer and the poor get poorer.

We need a serious economic crises before we will ever have a real debate about these issues. Our current concensus is based to a large degree upon an almost religious faith in "markets" that is divorced from reality. One can easily argue about the evils of any "regulation" on the marketsa nd postulate that a properly functioning market would be Nirvana.

I have asked this before and will ask this again. What are the prerequisites for a "market" to work properly? In other words, what needs to be in place before competition can work? What are the assumptions? What are the information flows? Clearly not all markets work like the New York stock exchange or commodity markets where all trades are open and known to everyone. Might that not be be a prerequisite for a market to work efficiently? If that is the case then most makets would fail miserably. If it is not, where does the "competition" come from? I guess in some instances two companies "competing" would lower their prices to "compete" but is that really the same? What if they can lie about the true quality of their product? Maybe some additional information should be required to be disclosed than just price? (i.e. Lemon Laws).

I would submit that the market for credit you are talking about is cleary not a true "marketplace." Is there really full "disclosure" of the terms? Is there really fair and open "competition"? If they are clearly in desperate straights are they really able to act rationally? This is not about a religious belieff in markets. Rater this is about utilizing the tools of economics to help to better understand how markets work and to try to make them achieve the efficiencies that they promise. Exploitation is not efficient as it crushes the productivity of decent people.

[otto]

"There has to be a better way of getting emergency liquidity to the relatively poor."

Name it, including considerations of administrative ease and political do-ability.

[Salmo]

If you think that the payday lenders are charging excessive rates, take a look at what banks actually charge for writing a post dated check on an account currently having insufficient funds. The payday lenders are doing very well by taking advantage of those living hand to mouth, but they are not the biggest sharks in these waters.

[Anon]

It would seem to be a trivial exercise to have welfare offices do emergency loans as well. An interest rate of perhaps 8% could be charged; similar to student loans. Since they are the Government, the likelihood approachs 100% that they'd get their money back eventually (next year's Earned Interest Credit, perhaps?). Marginal administration costs would be zero.

[Douglas Knight]

Charles: "There's a simple solution to this: raise wages and provide universal healthcare."

Healthcare causes bankruptcy, but it doesn't cause the short-term cash crunches that are relevant here.

[dale]

Anon,
interesting idea. I hope its given consideration.

[NBarnes]

"There has to be a better way of getting emergency liquidity to the relatively poor."

Name it, including considerations of administrative ease and political do-ability.

Paying a goddamn living wage, so that people can save for emergencies as well as affording the cost of living?

Dunno, maybe I'm a raving liberal freak on this one....

[Ronald Brak]

Here in Australia I have suggested the "I am an idiot" law which would require someone taking out a short term loan to sign a piece of paper that says, "I am almost certainly an idiot for borrowing money at this interest rate." The piece of paper would also give information on where to get financial help and who is eligible for a short term, zero interest loan the government here makes available. All advertising for short term loans would also carry warnings along the lines of, "You are an idiot if you borrow money at this interest rate." Currently advertising on TV that says you should take out a short term loan if you have a hot date. That's not exactly encouraging sensible behaviour.

But I'm not for banning short term loans as tends to lead to knee injuries when loansharks take over.

[Porlock Junior]

GeorgeNYC asked some reasonable questions, and apparently has asked them before. Since no one has posted an answer, here's a layman's view, or set of biases; maybe it will goad an expert into commenting.

Yes, classical market theory does assume that everyone who counts knows everything significant. It also assumes that a market consists of interchangeable goods sold by interchangeable sellers to interchangeable buyers.

(I suppose the proper term is "fungible", but Algie says he isn't likin' that word.)

Of course, not much of the modern world actually is like that. How closely those conditions match some poor and ill-educated person desperate to eat till payday: this is left as an exercise for the reader.

This is a real tragedy. I mean, the theory is so-o-o-o elegant! Works out beautifully, where it applies. The trick, therefore, is to get you to believe that the difference between the world and this set of assumptions is a matter of detail, and you can get a useful theory by just working some perturbations into the classical theory to acccount for the differences.

There actually is a market for payday loans that fits that elegant theory. Amazingly, this well-behaved market doesn't apply to working people but to large corporations and financial institutions. They have a more dignified term, though: repurchase agreements.

The market for Treasury securities and the things based on them, like repurchase agreements, has its problems, though, such as margins that are paper-thin and even then can be achieved only with lots of work. Free markets, the real kind, are like that. Whether it's farmers growing wheat or bankers trading Treasuries, pretty much everybody in a free market wants to get out of it. Hence agricultural price supports and the bid-rigging scandal that killed Salomon Brothers.

Back on topic, more or less: no, you can't have a classical Smith-Ricardo Free Market in payday loans or a zillion other things of real importance. (I assume this is obvious, since no one failed the exercise assigned above.) That you ought to, and must not let reality stand in the way of acting as if a free market were operating, is at least as dangerous a religious doctrine as the Christian version of Fundamentalism.

[zinc]

Usuary control in the US is a national disgrace, including credit card and pay day loan rates and revisions to the bankruptcy laws.

Hopefully, the populist shift in congress will repeal the lobby driven congressional work of the last 10 years.

[Ponzi Q. Globalization]

"I somewhat disagree: there is something wrong with somebody who goes into a business where what you sell--in this case, extremely expensive credit--makes your customers worse off."

Like how the current system of so-called free-trade was sold to American workers as a path to prosperity?

Oh, but I forgot about (drum roll please)...

*** COMPARATIVE ADVANTAGE ***

ZAP!! POW!! TAKE THAT YOU PROTECTIONIST ISOLATIONIST TROGLODYTE!!!

But as a wise man once said not so long ago...

"This is a real tragedy. I mean, the theory is so-o-o-o elegant! Works out beautifully, where it applies. The trick, therefore, is to get you to believe that the difference between the world and this set of assumptions is a matter of detail, and you can get a useful theory by just working some perturbations into the classical theory to acccount for the differences."

[divadab]

Loan sharks have always existed - but in jurisdictions which look out for their poorest, rather than exploiting them, there have been anti-usury laws. The edifice of conservative Republicanism appears to me to be based on the idea that it is not only ok to profit from exploiting others, it is actually commendable.

Payday loans are only part of the problem - the same usurious 400% rates are charged by tax preparation services which advance loans against refunds. These are usually to the poorest, whose refund consists largely of the child tax credit. These companies (check it out) are huge, national, publicly-traded enterprises. But they are still greedy usuring scum in my book.

[Scott Martens]

"There has to be a better way of getting emergency liquidity to the relatively poor."

Like Sebastian, I've been there. The existence of usurious payday loan services says that the free market sure hasn't come up with some better way to get emergency liquidity to the credit poor. In the old days, this need was met by organized crime offering loan sharking services, probably with even less efficiency and quite possibly lower profit, and they did even greater damage to their customers' lives. And before loan sharking, debtor's prison served to replace high interest rates. Payday loans are positively humane in contrast to the things they replaced.

Either you've got to start thinking of extra-market solutions to emergency credit shortages, or you have to force the poor to live with the credit terms the Mafia offers, or you have to live with legalized loan sharking in some form. If you've got any ideas for the first, I'd sure love to hear about them.

[Ashish Hanwadikar]

"The problem is that many people have difficulty weighing the trade-off between immediate benefits and future costs. When confronted with easy credit access, some inevitably borrow more than they can reasonably expect to repay. Once they get in over their heads, they borrow more....
"
So, if grown up people have difficulty weighing of borrowing options, what about young girls deciding about abortion?

[Ponzi Q. Globalization]

"So, if grown up people have difficulty weighing of borrowing options, what about young girls deciding about abortion?"

1. How young?

2. Do we want a society that rewards exploitation of the vulnerable? I guess most people would say no. However, we should always keep the costs in preventing such situations in mind.

One cost is the potential for infantilizing adults.

We should think about what America would look like if usury laws were put back on the books. Maybe it would be a better place.

3. In the lending case, the lender gains by providing a service to desperate and/or ignorant people. The lender's compensation is an essential factor to be considered when deciding policy.

In the abortion case, we basically are weighing the rights of the mother to control her own body with the rights of the fetus/child to exist. The abortionist's compensation is not so important.

[sajlk]

Ashish, surely you are right. Many young girls probably do opt for the delayed pain of child-rearing at a difficult age over the immediate physical and psychological pain of a first-trimester abortion, for the reasons outlined by Laibson et al. (Hyperbolic discounting would also explain the existence of second-trimester abortions.) However, given that the government is currently in the business of scaring people away from abortions, we have a ways to go before addressing the decision-theoretic aspect.

Sebasian, Scott: There are two sides to the problem you address, providing emergency funds to people who are (conventionally) credit-constrained and reducing the need for emergency funds. Given that payday loans are harmful to many (most?) of their users, we can potentially address your concerns by finding ways to remove the underlying problem. For example, do a large number of people use payday loans to get their cars back after a towing? Then mandate that towing fees be means-tested. What I suspect is that most people who need emergency funds are going through medical or legal crises. I think the gov't would be better focused on lowering the incidence of medical/legal financial crises than on providing cheap credit guaranteed by the EITC.

[JonF]

Re: Paying a goddamn living wage, so that people can save for emergencies as well as affording the cost of living?

I make a good income, but every now and then something happens and I have to use my credit card to cover a cash flow shortfall (that, and renting cars when I travel, are the only times I use the credit card; normal purchases go on my debit card). Now of course I pay off that balance before the next billing date so I never pay interest (Hmm, maybe payday lending should have grace period too?) But sudden cash emergencies can happen to anyone and having a decent or even high income is no insurance against them.

Re: Payday loans are positively humane in contrast to the things they replaced.

Once upon a time people also borrowed money from family and friends (and sometimes employers) in an emergency. Usually at 0% interest rate. I think that was a good deal more humane than payday lenders.

Re: For example, do a large number of people use payday loans to get their cars back after a towing?

Or simply stipulate that the car can be returned to the owner (if broke), but with a lien on it by the two company until the owner pays the towing fee.

Re: What I suspect is that most people who need emergency funds are going through medical or legal crises

Don't forget vet costs. My worst and most unexpected cash emergency happened when a cat needed a $900 emergency surgery. Now I had my credit card available for that situarion, but had to take money out of mutual funds to pay the bill eventually.

[Paul Neureiter]

Re: I somewhat disagree: there is something wrong with somebody who goes into a business where what you sell [...] makes your customers worse off.

Um, how many fine businesses would fit this bill? Krispy Kreme is one that jumps immediately to mind. Payday loan companies may be loathsome, but this standard might be a bit too high.

[Lyndsey]

People use payday loans because they cost less than bouncing a check, paying overdraft fees, late bill payment penalties or credit card late fees and is often more desirable than asking family for money or pledging personal possessions.

Think about it. If I bounce a $50 check, Bank of America will charge me $39. A payday lender charges me $15 to borrow the $100 to cover my check. If I pay that same $50 bill late, I'll get a late fee.

And the only way to rack up the 300%-400% APR is to renew the two-week payday loan for an ENTIRE YEAR.

[Charles]

Otto asks us to name a better way of getting emergency liquidity to the relatively poor

OK: wages.

This has been another edition of simple answers to silly questions.

(I see Ned Barnes beat me to it)
_____

Douglas Knight says Healthcare causes bankruptcy, but it doesn't cause the short-term cash crunches that are relevant here.

Incorrect, Douglas. People often take out payday loans in order to handle medical emergencies.
___________

Meanwhile, no one has answered the point that payday loans create protective cover for fraud against the poor.

[Biff Spaceman]

Payday loans are a license to enslave the working poor and punish those people whose sense of responsibility requires them to pay their bills. They are also a tool to abuse the mentally ill, particularly those barely able to manage their finances but not suitable or eligible for assisted living. It is no accident that our poorly paid military is besieged with pawn shops,rent to own places, and payday loan places lining the street to the gate like the camp followers of old.
It is time to regulate past-due fees, overdraft charges, ATM and point of purchase fees and other hidden fees that punish conscientious but poor people. I do not believe that usury is a public service.

[Maynard Handley]

"One thing that isn't pointed out enough, is that these places go through great lengths (like rent to own places)to hide the interest rates they are charging. They'll give you a weekly payment or a "fee" schedule but not what the rate of interest you're paying is. Basically they try their best to keep their customers as uniformed about their services as possible."

I don't buy this. As many others have pointed out, these loans cost a lot to administer. The reason the interest rates are high is that that's how the admin is paid back.
One could, obviously, restructure the costing: something like a much higher fixed cost, independent of the amount of money loaned, along with a lower interest rate that reflects the time value of money plus the risk of default. This obviously benefits some people --- those who are borrowing above average amounts of money, annd for above average amounts of time. It also penalizes those who are borrowing small amounts of money for a short time. It is not clear why this is progress.

[piotr]

JonF: once upon a time people were borrowing from friends in emergency.

I actually grew up in a "Communist" country, so credit was something you got when you were purchasing furniture and paying back in instalments. That was about it. Borrowing to and from friends or family was a constant feature of life.

About low profitability of usurious lending: competition by price is the last resort of a rational bussinessperson. If some line of bussiness is profitable, the first thing to do is not to compete on price, but on marketing, say, by opening more offices. Regulation can drive both the profits and costs down.

About selling services that make people worse of: hm, harumph, wow. What do we really, really need? For example, half of the stores in an average shopping mall seem to sell mostly little aesthetic monstrosities that can make your home much uglier than before (unless you already wasted a lot of money on such junk). I do not even touch cigarettes, alcohol, or gasoline (OK, I do in real life, but not in this discussion).

[Neil Bates]

Maynard: I made the same suggestion above about charging a fee but with lower interest rates. I can't understand why you can't see it as progress. Yes, some people spend more (prompt repayers) and others less (tardy repayers), but the averaging out of the costs isn't the point. The point is so those who can't pay back as quickly don't have such a high cost, to make it more the same cost for everyone. And aside from fairness of results or appearances, why not indeed for practical and logical reasons? Why should the profit come from the time delay, when the time delay has a certain cost (much less than what they are charging as interes) to the lenders? Why not let them make their money in fees, and let the interest be what is needed to cover the lender's cost of waiting to get the money back, maybe around 8% tops?

tyrannogenius

[TBanker]

Payday lending has been a lightening rod for criticism from all directions, including the mainstream media, the military, Congress, federal and state regulators, community groups, and the plaintiffs bar – to name a few.

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[aBlayon]

Hello Dr. Delong et al, I have recently come across your post while searching for a payday loan. I am glad that New York has such high standards to keep these companies from Preying on the unfortunate. I m what most people would call educated-MBA. I myself am in a rut trying to figure out how to obtain the financial means to be able to pay rent and attend interviews and keep my mobile phone on so potential employers can reach me in order to obtain employment. I admit I have overextended my credit trying to get an education. Now I am educated with skills and a background in finance and sales and unable to make my last financial obligation. I was referred to this idea by my younger sister who has used them in the past to meet emergency financial obligations.....While saddened that she has to use this means and her older brother can not help, these loans can be helpful, if there are not other means. anyone who has a better idea than a paydayloan, can shoot me a line at ablayonatgmaildotcom. I am open to any suggestions (as well as personal loans- lol). As parasitic as the are, sometimes there are no other options...
Your truly In need