Everyone seems to hate payday loans, but millions of people choose them voluntarily every year. So, do we know as much about payday loans as we think?
A recent “Liberty Street Economics” blog post by myself and three other authors summarize three sets of peer-reviewed payday loan research findings, with links to all of the relevant studies. Despite all the opinions on payday loans, commentators are not always armed with the facts. This type of research is therefore crucial.
What does the research tell us? First, while payday loans are indeed expensive, it doesn’t necessarily mean big returns for lenders. The typical payday lender charges $ 15 for every $ 100 borrowed every two weeks, which implies an annual percentage interest rate of 391%. But on the other hand, research shows that payday lenders don’t earn more than competitive profits.
At 391% APR, How Can Payday Lenders Break Even? First, these loans often default, so the stratospheric APRs are only expected rates, not actual rates. And the loan amounts are very small compared to loans made by banks, so in some cases the high APR is just enough to recoup overhead costs.
Payday lenders could theoretically charge even higher rates to improve their returns. But because there are more payday loan stores in the United States than Starbucks coffee shops, competition is intense and drives prices down, resulting in risk-adjusted profits for payday lenders that are comparable. to those of other financial companies.
Second, despite concerns about consumer protection issues with payday loans, the evidence is mixed as to the validity of these concerns.
A handful of peer-reviewed journal articles test whether access to payday loans is helping or hurting consumers. On the downside, studies show that access to payday loans leads to more difficulty paying bills, no more unintentional bank account closures and military preparation reduced by “airmen“who have had payday loan problems. On the aid side, studies show that access to payday loans is associated with less difficulty paying bills, fewer bad checks and reduced foreclosure rates after natural disasters. Two studies find neutral results.
Why might consumers be drawn to payday lenders if the product hurts them? We must consider the alternatives. If multiple checking account overdrafts are more expensive than taking out a single payday loan – and it can easily be – then a payday loan is a rational choice.
The third main area addressed in the body of research is the important question of “renewals” of payday loans, which can be very expensive. Typically, if a $ 100 payday loan was rolled over, the lender would charge an additional $ 15 for each rollover. About half of the initial payday loans are repaid within a month, so most of these borrowers only pay the fees once or twice. But about 20% of new payday loans are renewed six or more times. These consumers end up paying more in fees than the amount originally borrowed. Are these borrowers overly optimistic about their ability to repay a loan quickly? Again, the evidence is mixed.
A study found that advising potential payday loan borrowers on the cost of renewals reduced their demand for the product by 11%. A second to study finds that 61% of payday borrowers were able to predict within two weeks how long it would take them to pay off their loans, with the remainder evenly divided between those who overestimated and those who underestimated. A third finding from an expert reviewing the available evidence concluded that the link between over-optimism and renewals “is tenuous at best.”
Despite mixed evidence, the Consumer Financial Protection Bureau is proposing far-reaching new rules for payday lenders. Lenders would be required to engage in expensive underwriting to assess borrowers’ ability to pay. Borrowers would be limited to no more than two renewals for each payday loan, after which the loan would convert to a term loan at a lower or zero interest rate.
These regulations can simply drive payday lenders out of business, mirroring the experience of states that have capped payday loan APRs at 36%. Borrowers with low renewal rates would be worse off. High turnover borrowers may or may not be better off, depending on whether they can find other forms of credit and how much that credit costs.
My colleagues and I believe that more research should precede wholesale reforms. One area to focus on for future studies is how many loan renewals result in irresponsible use of the proceeds. If a payday loan is overused, converting a borrower to a longer term loan seems prudent and responsible. But how many rollovers are too many?
Existing research suggests that two renewals are probably too few to identify genuinely overly optimistic borrowers. Further studies are warranted, in part because some states cap the number of payday loan rollovers allowed while they are unlimited in other states. Careful analysis of how borrowers behaved in these two sets of states would help educate regulators.
Whenever possible, financial regulation should be based on the results of objective, peer-reviewed research, and not on “analysis” provided by industry or advocacy groups.
Robert DeYoung is Capitol Federal Distinguished Professor of Finance at the University of Kansas. He has no affiliation with the payday loan industry.