Are people taking payday loans because they are desperate or because they do not understand the terms?

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There have been a lot of pointing fingers lately, who is to blame for the unsustainable financial situation of many American families. Among the usual suspects— Wall Street quantitative, ephemeral mortgage brokers, the households themselves – none is an easier target than payday lenders. These storefront moneylenders are described by their detractors as crooks preying on the desperation and ignorance of the poor. A backlash on payday is already well underway— Ohio recently passed a law capping interest rates at 28% per year, and the Military Personnel Act limits interest charged to military personnel and their families to 36 percent. The average payday loan has an annual interest rate of over 400%.

The payday lenders themselves argue that they are victims of having provided a critical social service, helping those most in need put food on the table and cover the rent until their next paycheck. Charging what appears to be usurious interest rates, they argue, is the only way to cover the cost of providing $ 100 loans to high-risk borrowers.

If payday lenders really provide a much needed financial resource, why deny Ohioans and the US military this service? A recent study by economists from the University of Chicago Marianne bertrand and Adaire Morse suggests there could be some middle ground, allowing payday lenders to continue lending, but requiring them to better explain their long-term financial cost. In a nationwide experiment, Bertrand and Morse found that providing a clear and tangible description of the cost of a loan reduced the number of applicants choosing to take out payday loans by up to 10%. It turns out that better information can deter borrowers vulnerable to the lure of quick cash while still maintaining the possibility of immediate financing for those who really need it.

An average visitor to a payday loan store expects to get a loan of around $ 350. Lenders typically charge a loan fee of $ 15 for every $ 100 borrowed, with principal and interest to be repaid on the date of the borrower’s next payday. Since most employees get paid twice a month, a client who takes out a $ 100 loan each payroll cycle and pays it off the next will have spent almost $ 400 in a year, bringing the 400% annual loan percentage rate. (By comparison, the APR on most credit card debt is 16%; for a subprime loan, it’s 10%.)

Before receiving the loan, the borrowers sign an agreement that includes a government required disclosure of this stratospheric APR. It is therefore natural to wonder why Bertrand and Morse would expect other information about the costs of the loan to have an impact on the decision whether or not to take the loan.

Researchers argue that many payday loan clients may not know what an APR is, let alone have any basis for judging whether 400% is high or low. (Some states require applicants to sign a waiver confirming that they understand the APR, but they are certainly not tested for understanding the APR.) So Bertrand and Morse devised three alternative ways to explain the high cost to them. borrowers and worked with a national chain of payday loan stores to see what effect this additional information might have on potential payday customers at 77 stores nationwide.

On random days, in addition to receiving the usual loan documents, borrowers were given the opportunity to participate in a University of Chicago study. (They received a free magazine subscription to participate.) Volunteer participants completed a short survey on education level, level of self-control (“Do you describe yourself as a planner? Impulsive?”), the purpose of the loan, and the number of weeks they expected to pay back. Then, instead of getting a standard package with only the loan due date printed on the front, participants received an envelope with additional information on the cost of the loan.

A group of loan seekers were presented with a chart of APRs, listing the cost of payday debt compared to credit cards and subprime mortgages and highlighting the relatively high cost of payday loans compared to to these other forms of financing.

The second group of potential borrowers in the study received a graph showing the cost of using a $ 300 payday loan for three months ($ 270 in interest payments) versus credit card debt. credit ($ 15). Here, Bertrand and Morse tested the thesis that borrowers can view each small loan in isolation, regardless of the full impact of payday loans on their finances. It’s $ 15 here … $ 15 there … peanuts in the grand scheme of things (hence the aptly named peanut effect in behavioral economics). But over a few months, it adds up to real money.

Finally, economists wanted to assess whether payday borrowers are as hopelessly optimistic about their future finances as the rest of us. Bertrand and Morse surmised that when most potential borrowers take out a two-week loan, they expect it to be one-time only, only to find themselves in the same dire straits two weeks later. To counter this misperception, Bertrand and Morse gave a third group a graph showing the average number of payday loan refinances (four in 10 borrowers refinance at least five times).

Compared to a control group of participants who simply completed the survey (but never got additional information about payday loans), Bertrand and Morse found that presenting borrowers with a comparison of a payday APR with the APRs of mortgages or credit cards had no effect on borrowing in the months that followed, perhaps because these other forms of financing are generally not available to payday borrowers and therefore are not relevant to their decisions. But borrowers who received a chart explaining the three-month cost of a payday loan were 10% less likely to take out a loan in the following months. Among those who took additional loans, the total amount borrowed averaged about $ 195, compared to $ 235 for the control group. The graph showing average borrower refinancing rates had little impact on the fraction of clients taking additional loans, but reduced the amount of future loans among those who continued to borrow. (Unsurprisingly, the effect of better information was greater for those who saw themselves as prudent planners rather than impulse spenders.)

Thus, presenting borrowers with a clearer explanation of the cost of the loan could prevent some people from falling into the payday debt trap. But what about the remaining 90 percent of borrowers, who, even when presented with evidence of long-term costs, still took out the loan? For many of these borrowers, there is no information that will deter them. These may be candidates for what Richard Thaler and Cass Sunstein call a “nudge”Excluding payday loans. Economists Dean Karlan and Jonathan zinman have offered such a boost: imposing a cooling off period before a payday loan is offset to discourage impulse borrowers (although this somewhat defeats the purpose of a payday loan, which is for people who need money now).

A recent policy document through Michael barr (now Assistant Secretary of Treasury for Financial Institutions), co-authored with Behavioral Economists Sendhil Mullainathan and Eldar Shafir, places the payday lending activity in the context of the larger problem of a banking sector that is not meeting the needs of the poor and unbanked. Among their suggestions is a tax credit for banks that provide safe and affordable accounts and lending services to the poor.

All of these ideas recognize that we do not live in a world of fully informed consumers making rational decisions in well-functioning markets. This research and these proposals come at a time when the myth of the rational market has exploded. The White House, meanwhile, is now occupied by an administration that may be willing to use the government’s hand – guided by the work of researchers like Bertrand and Morse – to give payday borrowers the information they need to take. decisions that serve their own interests. rather than those in the financial sector.



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