Is payday lending actually a lifeline for poor people? Nope.
Can't we argue borrowers are making decisions that are best for them? Still no.
How can you be so sure? Science.
In honor of the Consumer Finance Protection Bureau rolling out new regulations on the payday lending industry, This Week in Behavioral highlights some behavioral evidence on the predatory nature of these firms.
Some not-so-fun background facts about payday lending:
- Roughly one in six households regularly use payday lending.
- In 2007, Americans paid $8 BILLION in loan charges to payday lenders... and only borrowed $50 Billion.
- Typical amount borrowed is $375, and they pay a "fee" of $15 per $100 borrowed (Calling them "fees" instead of "interest" has at some points helped the industry dodge usury laws).
- So that's 15% interest...but only over two weeks! The APR is actually almost 400%.
- Oh and the average loan is almost 5 months so the average interest on the $375 loan is $520.
The arguments for the industry are roughly - the interest rates (or "fees") are high because they have to be, and they provide a service to a population who desperately needs it ("they choose to borrow!!!").
Researchers at Chicago Booth and Berkeley Haas ran a field experiment to get at the behavioral underpinnings of the demand for payday loans, and provide the first data on whether the arguments for the industry are valid.
Spoiler Alert: Turns out payday lending is praying on the poorly informed not the underserved!
In Information Disclosure, Cognitive Biases, and Payday Borrowing in the Journal of Finance (the top journal), Bertrand and Morse run a clever field experiment with a payday lender.
All of the treatments they run are designed to give the borrower better and more digestible information about their specific loan and payday lending in general.
- For example for some borrowers, on the envelope they received with their money is a little chart showing the APR for different types of loans: Payday Loan - 443%, Credit Card 16%, Subprime Mortgages - 10% and so on.
- Other envelopes converted interest into dollars for them: If you borrow $300, and repay in 3 weeks, you'll pay $270 to a payday lender, or $15 to a credit card company, and so on.
All of the information treatments decreased the amount borrowed when the customer came back. And the effects weren't small.
For example, providing the "dollar information" on the envelope decreased demand by 18%! And the APR treatment even decreased their odds of ever coming back for a loan.
It's easy to say that when someone takes out a payday loan, they want, or need to, and we should respect that.
But implicit in these sentiments though is that the service is being provided in a clear, understandable way. That's not the case.
When it was made clear what the customers were choosing in the experiment, demand dropped dramatically.
So the users weren't underserved, they were under-informed. That's not the sign of a valued product. That's the sign of a scam.
While we applaud the CFPB for their work on payday lending, we also acknowledge that conflicts of interest and sketchy marketing practices are all to common in the financial services industry. One only needs to look at the mortgage crisis to realize it's not limited to payday lending.
It's one of the reasons we created Frank. It won't solve everything, but we think it can help.
Lucas Coffman, Frank
Lucas is a professor of behavioral economics at Harvard University and the Chief Behavioral Officer at Frank