A new NBER paper by Allcott, Kim, Taubinsky and Zinman takes a close look at the behavioral economics of payday loans and finds that most common regulations make borrowers worse off.
Critics argue that payday loans are predatory, trapping consumers in cycles of repeated high interest borrowing. A typical payday loan incurs $15 interest per $100 borrowed over two weeks, implying an annual percentage rate (APR) of 391 percent, and more than 80 percent of payday loans nationwide in 2011-2012 were reborrowed within 30 days (CFPB 2016). As a result of these concerns, 18 states now effectively ban payday lending (CFA 2019), and in 2017, the Consumer Financial Protection Bureau (CFPB) finalized a set of nationwide regulations. The CFPB’s then director argued that \the CFPB’s new rule puts a stop to the payday debt traps that have plagued communities across the country. Too often, borrowers who need quick cash end up trapped in loans they can’t afford” (CFPB 2017).
Proponents argue that payday loans serve a critical need: people are willing to pay high interest rates because they very much need credit. For example, Knight (2017) wrote that the CFPB regulation \will significantly reduce consumers’ access to credit at the exact moments they need it most.” Under new leadership, the CFPB rescinded part of its 2017 regulation on the grounds that it would reduce credit access.
At the core of this debate is the question of whether borrowers act in their own best interest. If borrowers successfully maximize their utility, then restricting choice reduces welfare. However, if borrowers have self-control problems (“present focus,” in the language of Ericson and Laibson 2019), then they may borrow more to finance present consumption than they would like to in the long run. Furthermore, if borrowers are “naive” about their present focus, overoptimistic about their future financial situation, or for some other reason do not anticipate their high likelihood of repeat borrowing, they could underestimate the costs of repaying a loan. In this case, restricting credit access might make borrowers better off.
First, the authors find that borrowers clearly understand their own behavior. When asked, borrowers predict that they have a 70% probability of borrowing again in the next eight weeks which is almost exactly (74%) the actual borrowing probability. Experienced borrowers are better at predicting their own probabilities of borrowing again so learning also takes place.
Just because they can predict their own behavior doesn’t meant that borrowers like their own behavior (a drunk might predict they will get drunk again without “desiring” to get drunk again) and indeed the authors show with a clever experiment that many borrowers are willing to pay to modestly constrain their own choices. Overall, however, borrowers gain from payday lending so when the authors model payday loan regulations with borrower preferences (their “best”, long-run preferences) regulation reduces welfare:
Payday loan bans and tighter loan size caps both reduce welfare in our model. By contrast, 18 states have banned payday lending, and some states have particularly stringent loan size caps, such as the $300 limit in California.
The best regulation in the model is a rollover restriction which prevents borrowers from borrowing again and again and again. Rather than a blanket regulation, however, I’d prefer a self-exclusion option which would allow people to ban themselves from borrowing in much the same way that people with gambling problems can ban themselves from gambling establishments.
The bottom line is that payday lenders are serving a need and benefiting their customers. Preventing people from accessing payday lenders typically makes them worse off but that doesn’t mean that the customers are entirely sensible or without problems both internal and external. The most revealing statistic in the paper is one the authors mention only in passing:
although our participants are liquidity constrained and we sent two reminder emails, our gift card vendor reports that only 44 percent of the $100 gift cards were claimed
It’s no surprise that people who leave free money on the table have planning problems and need to borrow, it’s just that preventing them from borrowing doesn’t make them better off.